1 1 Finance and SCM John H. Vande Vate Spring, 2006

2 2 Today’s Challenges Low Cost Competitors –Reducing Margins –Harder to grow sales Shorter Product Life Cycles –Less time to recoup investment Greater Product Segmentation –Harder to achieve economies of scale –Higher capital demands Competing for Capital in Global Markets –Investors can go anywhere

3 3 The Bottom Line Financial Performance is –Harder to achieve –More essential than ever

Return On Equity: Non-Financial Services Companies* *Based on a sample of approximately 2,000 publicly traded companies throughout the world in non-financial services industries like industrial, wholesale distribution and retail. Average Median 1 st Quartile 4 th Quartile

5 5 Financial Performance

6 6 Revenue Growth

7 7 Why Capital Utilization? Question: Effect on Net Personal Wealth? Salary $10,000/month Expenses –Food, Clothing, Utilities $ 5,000/month Net Operating Income $ 5,000/month Taxes (30%) $ 3,000/month Net Income After Tax $ 2,000/month

8 8 Capital Utilization Question: Effect on Net Personal Wealth? Salary $10,000/month Expenses –Food, Clothing, Utilities $ 5,000/month Net Operating Income $ 5,000/month Taxes (30%) $ 3,000/month Net Income After Tax $ 2,000/month Interest Expenses $ 3,000/month Change in Net Worth ($ 1,000/month)

9 9 Capital Utilization Question: Effect on Net Shareholder Value? Revenue $10,000/month Operating Expenses –COGS, SG&A $ 5,000/month Net Operating Income $ 5,000/month Taxes $ 3,000/month NOPAT $ 2,000/month Capital Charge$ 3,000/month Economic Profit ($ 1,000/month) AKA: Economic Value Added Shareholder Value Added

10 Corporate “Interest Expense” Opportunity Cost of Money Average Cost of Capital Sources of Capital –Shareholders – Equity –Bond holders and Lessors – Debt Question: –Which gets a higher return? –Why?

11 Average Cost of Capital % of Equity * Cost of Equity, e.g., +% of Debt * Cost of Debt (1-Tax Rate) Example: Adtran –From the Balance sheet ($000’s) Total Assets $559,942 NIBCLs$ 36,015 Capital $523,927 Debt $57,290 or ~11% Cost of Debt 5% Equity is ~89% Cost of Equity?

12 Historical Cost of Equity Adtran Stock closed at –12.78 in Jan 96* –29.17 in Jan 06 That’s a CAGR of 8.6% So investors expect these returns to continue Or use the CAPM *accounting for splits and dividends. Yahoo Finance will do these calculations for you

13 Average Cost of Capital % of Equity * Cost of Equity, e.g., +% of Debt * Cost of Debt (1-Tax Rate) Example: Adtran –From the Balance sheet Total Assets $559,942 NIBCLs $ 36,015 Capital $523,927 Debt $57,290 or ~11% Cost of Debt 5% * (1-31.7%) = 3.4% Equity is ~89% Cost of Equity 8.6% Cost of Capital 11%*3.4% + 89%*8.6% =7.7%

14 Adtran Economic Profit Average Economic Profit across broad range of publicly traded stocks is ~0%

15 Automotive

16 Computer

17 Working Capital Supply Chain Can Affect These

18 Days of Inventory Days of Inventory = Cost per Day is Cost of Goods Sold or Cost of Sales/365 Slightly different idea than Turns = Value of Inventory Cost per Day Revenue Value of Inventory

19 Adtran Example Inventory $ 42,316 Cost of Good Sold $193,455 Cost per Day $ 530 Days of Inventory ~ 80 days = 42,316/530 Note: A reduction of 1 day in inventory frees up about how much working capital? Turns ~ 11 = / Note: The company will talk about holding approximately 33 days of inventory. Explain the discrepancy between 80 and 33. Half a million per day Adtran’s gross margin is ~57%

20 Days Sales Outstanding Measures the average time to collect on sales This is capital you are lending to customers Adtran Example ($000’s) –Accounts Receivable $70,504 –Revenue per Day $1,250 = $454,517/365 –Days Sales Outstanding = 56+ days Note: Collecting one day faster frees up approximately how much capital? Accounts Receivable Revenue Per Day

21 Days Purchases Outstanding Days Sales Outstanding Measures the average time to pay bills This is capital your suppliers are lending you Adtran Example ($000’s) –Accounts Payable $22,856 –Purchases per Day $530 –Days Purchases Outstanding = 43+ days Accounts Payable Purchases per Day Typically use cost per day

22 Working Capital Longer Lead Times Greater Volatility More complex relationships Greater demand for Working Capital in Supply Chains

23 Cash-to-Cash Cycle How many days of operations the company must finance with capital Days Of Inventory + Days Sales Outstanding -Days Purchases Outstanding Adtran Example Days of Inventory80 Days Sales Outstanding56 Days Purchases Outstanding43 Cash-to-Cash Cycle93 days

24 Some Examples 39 days -43 days 167 days 52 days -52 days

25 Prof. Peter Klaus, D.B.A./Boston Univ. Chair Business Logistics, Universitaet Erlangen-Nürnberg and Head Fraunhofer ATL, Nürnberg Dr. Klaus’s Time-Money Map

26 Dell’s Magic Days Sales Outstanding + Days in Inventory Days Payments Outstanding Cash-to-Cash Cycle $ 4 Billion in Working Capital

27 Automotive Ford –32 days in 1991 to 29 days today (9%) GM –38 days in 1991 to 28 days today (26%) Nissan –45 days in 1991 to 27 days today (40%) % Reduction in Days of Inventory since 1991

28 Electronics HP –110 days in 1995 to 43 days today (61%) Itautec –112 days in 1999 to 68 days today (39%) Lenovo –56 days in 1999 to 22 days today (61%) Nokia 143 days in 1999 to 26 days today (82%) % Reduction in Days of Inventory since 1995

29 Aircraft BAE –81 days in 1999 to 36 days today (56%) Boeing –41 days in 1999 to 30 days today (27%) Lockheed Martin –57 days in 1999 to 19 days today (67%) Northrop Grumman –48 days in 1999 to 13 days today (73%) Embraer –138 days in 1999 to 143 days today % Reduction in Days of Inventory since 1999

30 Retail/Consumer Goods Carrefour –62 days in 1999 to 40 days today (35%) Royal Ahold –36 days in 1999 to 25 days today (31%) Unilever –43 days in 1999 to 36 days today (16%) Wal-Mart –56 days in 1999 to 49 days today (13%) Carulla Vivero –36 days in 1999 to 58 days today % Reduction in Days of Inventory since 1999

31 Growing Inventories Added Days of Inventory from 2003 to 2004

32 Cost of Holding Inventory Non-Capital Charges as % of Inventory –Warehousing –Obsolescence –Pilferage –Damage –Insurance & Taxes –Other Does this depend on the SKU? Typical charge is ~10% These are PRE-TAX costs Capital charge was AFTER TAX

33 Total Cost of Carrying Inventory Total (Pre-Tax) Cost of Carrying Inventory Non-Capital Charge (e.g., 10%) Capital Charge/(1-Tax Rate) Adtran Example Non-Capital Charge (we will guess 10%) 10% Capital Charge 7.7%/(1-31.7%) ~11.3% Total Cost of Carrying Inventory 21.3% What does this mean? –Adtran holds $42.3 Million in inventory –The annual cost of carrying that inventory is ~$9 Mill.

34 Why Reduce Inventory Reduces the capital and non-capital costs Reduces requirements for working capital Improves return on capital Then there’s lean…

35 Why Carry Inventory We will talk about this in two ways Deterministic inventory (the grease that let’s the gears move) Stochastic Inventory (the buffer that protects the gears from jolts)

36 Next Deterministic Inventory –Pipeline –Cycle Stock

37 Summary Financial Performance –Profitability, Growth, Capital Utilization Capital Utilization & Economic Profit Pre-tax cost of capital Working Capital –Cash-to-Cash Cycle Days of Inventory Days Sales Outstanding Days Purchases Outstanding Non-Capital Costs of Holding Inventory Inventory Holding Costs