2021 was the year of supply chains. Get ready for the sequel

From container-ship pileups at West Coast ports to the Ever Given's viral weeklong blockage of the Suez Canal to shortages ranging from the quirky (cream cheese) to the catastrophic (semiconductors), the supply chain has never been as top of mind as it was in 2021.

Case in point: The best-performing industrial stock on the S&P 500 as of Friday was Old Dominion Freight Line Inc., a provider of less-than-truckload logistics services. 

There are some encouraging signs that port operators, logistics providers and manufacturers are slowly making progress in clearing the logjams and that the supply-chain stress has plateaued — albeit at a high level. Drewry's global benchmark freight rate for a 40-foot shipping container climbed 2.3% this week but is down about 11% from the September peak. The cost of shipping goods along the busy route from China to the West Coast has bounced around more, but that, too, is down almost 30% from the highs, according to data from Freightos.

Not Getting Worse
Shipping rates have ceased their precipitous climb but are still elevated

Nearly 100 ships are anchored outside the twin ports of Los Angeles and Long Beach or idling farther offshore, well above normal levels. But the bottlenecks on the dock are improving; the number of long-lingering containers has dropped by about half in the past six weeks, Port of Los Angeles Executive Director Gene Seroka told Bloomberg Radio this week. Railroads are picking up their cargo within about two days, down from 13.5 over the summer, he said. Truckers are taking longer, but dwell times — a measure of how long the container waits before a driver can pick it up — have also shrunk in recent weeks, Seroka said. Availability of durable goods has improved; there are still shortages, but empty store shelves aren't as common, particularly among the largest retailers, Sanne Manders, chief operating officer of Flexport Inc., said in an interview. It no longer takes six months for a bicycle to get delivered, for example, he said. Walmart Inc. and Target Corp. have said they have plenty of inventory for the holiday season. 

And yet, as I have written frequently, these improvements are a promising milestone on the road to recovery but don't mean that the problems are magically fixed. About half a million containers are waiting on the ships outside of Los Angeles, burning up working capital for companies — or worse, leaving them without inventory they need for the holiday season, Manders of Flexport said. Before the pandemic, it would take about 45 days from the time cargo was picked up at a factory in Asia for it to depart the West Coast ports by rail or truck for a warehouse; today, it takes 105 days, he said. Ocean freight rates are supposed to drop as the holiday shipping push fades, but they are still near record levels. 

Big Winners

The best-performing industrial stocks on the S&P 500 through 10 December.

Carrier Global Corp. is "still paying a lot for electronics, logistics costs remain high, and it's causing some factory disruptions," Chief Executive Officer Dave Gitlin said at a conference earlier this month. 3M Co. warned at the same event that it would come in at the low end of its fourth-quarter organic growth forecast, citing supply-chain challenges and a slower-than-expected recovery in elective health-care procedures. "There are green shoots and some signs of progress that we're starting to see," C.H. Robinson Worldwide Inc. CEO Bob Biesterfeld said at another conference, citing the decline in ocean freight rates, better rail performance and more fluidity at the ports. "But we've got a long ways to go." 

Part of the problem is that the supply chain is extremely complex and improvements simply take a while to work their way through. Someone recently explained it to me by invoking the boa constrictor in "The Little Prince" that's attempting to digest an entire elephant: that doesn't happen overnight. Another issue is that a big driver of the supply-chain challenges in the US has been consumers' insatiable appetite for stuff, and that is showing little signs of easing. Volumes at the Port of Los Angeles are up 22% year-to-date through October compared with the same stretch in 2020 and up about 15% compared with 2019. The expected spending shift away from goods to services as pandemic lockdowns eased hasn't played out as expected. Consumers are spending on restaurant meals, airline tickets and entertainment again, according to aggregated credit and debit card data from Bank of America Corp. But they're still spending heavily on furniture, home improvement projects and general merchandise, too: Card purchases in these categories were up 34%, 39% and 17%, respectively, in the week ended 4 December relative to 2019 levels. 

A Tale of Two Spending Categories

Spending on international travel dipped amid concerns about the omicron variant. But as recently as November, spending had actually inched above 2019 levels. Home improvement spending has been consistently gangbusters.

This creates an interesting paradox. The warehouses surrounding the ports are chock-full of inventory, which is contributing to the the gridlock because there's limited space for newly arrived goods. But those inventory levels are low relative to expected sales. And as retailers try to plan for that demand, they're adjusting orders to prioritize top sellers. That's one reason some products can be shipped to the customer's front door fairly quickly while others take two months and why the local Costco Wholesale Corp. store may be full but a specialty retailer is out of that one specific item you want, Manders said. "People just expect that sales will keep going through the roof," he said. Companies "would rather have a supply chain issue than miss out on a sale. This is the beauty and the beast of capitalism," he added. 

The obvious concern is that this optimistic view of continued demand doesn't play out and companies get stuck with a glut of inventory instead. Black Friday and Cyber Monday sales fell slightly short of estimates, but whether that's a reflection of consumers shopping earlier because they were worried about the supply chain or an indicator of weakening demand as inflation starts to bite is still up for debate. Flexport's Post-Covid Indicator still shows a strong bias for goods over services. A continued boom in consumer spending is in some ways a good problem to have, but it means the logistics industry will have to keep stretching existing infrastructure to meet elevated demand. The long-term solution to the logjams is to invest in upgrades at the ports, including rejiggering designs to allow for bigger vessels, adding terminal and yard space and more cranes and building up inland facilities and access points. "The infrastructure bill will help, but the timeline is 10 years, not 10 months," Manders said. "Even though we might get out of the worst of this bottleneck, long term, we have to solve it because the growth keeps going," he added. 

Cargo Dump

Shipping volume has exploded this year.

As we learned all too well over the past 18 months, there's no shortage of potential disruptions in the short term that could throw the whole system out of whack again. It remains to be seen whether the recently discovered omicron variant of Covid-19 proves more virulent than earlier iterations. Even if it doesn't, China has held firm to a Covid-zero policy and proved it's willing to shut down ports to stamp out cases. A repeat tied to omicron would have wide-reaching ramifications across the ocean that could linger for months. More tangibly, the International Longshore and Warehouse Union's contract for the West Coast ports expires next summer. These negotiations have a history of turning contentious, leading to productivity declines and lockouts. This time should be no different, with workers feeling empowered by widespread labor shortages and employers feeling greater urgency to invest in automation to deal with the deluge of cargo. 

And That's the Way the Paint Dries

The European Union Aviation Safety Agency this week said it had identified a potential safety issue on Airbus SE's A350 jet involving copper foil wrap that protects against lightning strikes. Portions of the material may not have been installed in all locations on the wings of 13 aircraft, the regulator said. EASA said this issue is separate from the increasingly loud complaints of surface and paint degradation from Qatar Airways, one of the biggest buyers of the A350, and maintains that there is no need for an airworthiness directive in connection with the paint problem. Qatar Airways has ceased accepting A350 deliveries until the surface deterioration issues are resolved, and CEO Akbar Al Baker said in October that local regulators have grounded 16 of the planes. Airbus said this week it's seeking an independent legal assessment.

Quote of the Week

"Without these wide-bodies, we simply won't be able to fly as much internationally as we had planned next summer, or as we did in summer 2019" — Vasu Raja, chief revenue officer of American Airlines Group Inc. 

Raja made the comments in an internal memo announcing that delays for Boeing Co.'s 787 Dreamliner would force the airline to trim flights to places including Dubrovnik, Prague, Hong Kong and Edinburgh. Boeing has bigger problems than paint; deliveries for the wide-body jet have been held up for most of this year while the Federal Aviation Administration reviews changes to analytics and process controls that the company put in place to address quality control lapses. The Wall Street Journal reported this week that deliveries may not resume until April 1 at the earliest, much later than previously expected. Elsewhere in bad news for Boeing, Airbus is reportedly close to persuading Boeing customer KLM to buy some of its A321 jets instead.

Deals, Activists and Corporate Governance

Stanley Black & Decker Inc. agreed to sell most of its security operations to Swedish company Securitas AB for $3.2 billion. The transaction includes Stanley's commercial electronic and health-care security assets, including fire-detection systems, video-surveillance technology, health-care identification bracelets and emergency-call solutions. These businesses collectively generated an estimated $1.7 billion in revenue at a low double-digit adjusted Ebitda margin in 2021. Stanley will retain its automatic-door business. Speculation about a possible divestiture of the security division has swirled on and off since at least 2015, when CEO Jim Loree said Stanley was taking "a serious look" at whether the business should remain part of the company. The security unit has lower margins and long-term sales growth trends than other parts of the company, so this is a logical simplification that's made even more attractive by the relatively rich price tag. Barclays Plc analyst Julian Mitchell had estimated the entire security business might fetch $3 billion in a sale, and Stanley is selling roughly 85% of the unit for more than that. It wouldn't be surprising if Stanley eventually divested its automatic-door operations, too, he said. Stanley intends to use the proceeds from the Securitas deal to help fund a $4 billion share buyback. 

American Airlines Group Inc. is the latest airline to shake up its C-Suite. The carrier announced this week that Doug Parker will step down in March after two decades at the helm of the airline and its predecessors and two blockbuster mergers. He will be succeeded by President Robert Isom but will remain chairman for an indefinite period. The leadership transition should be smooth and is unlikely to herald any drastic strategy shifts. Isom was named president in 2016 and has worked with Parker for two decades. "The strategic direction that the company is headed in is absolutely one I've been heading us in," Isom told Bloomberg News in an interview. That provides something of a hedge against future pandemic disruptions. Still, American's willingness to put its CEO succession plan into motion signals the omicron variant is likely to be more of a bump in the road for airlines rather than a serious derailment of the recovery. US travel agency ticket volumes and Transportation Security Administration checkpoint data seem to support that attitude. 

Fortive Corp. agreed to buy health-care workflow management software provider Provation Software Inc. for $1.425 billion. This is the latest in a $10 billion buying spree for Fortive — largely focused on health care and software — since the company was spun off from Danaher Corp. in 2016. The takeovers have helped boost the company's margins and the percentage of its revenue that's considered recurring and thus less likely to be affected by economic swings, but each one has been more expensive than the last. Fortive is paying about 13 times Provation's expected sales in 2021. That compares with the roughly 10 times sales it paid for facilities maintenance software provider ServiceChannel earlier this year, a multiple that was already considered quite heady at the time. Fortive expects a high-single-digit return on its invested capital in the Provation deal after five years. RBC analyst Deane Dray points out that falls short of the company's stated requirement to achieve 10% returns on new platforms in five years and that relaxation of capital allocation standards can be a "slippery slope." 

Middleby Corp., which lost a $4.8 billion takeover battle for food-service equipment rival Welbilt Inc. earlier this year, agreed to buy Masterbuilt Holdings LLC for $385 million. Masterbuilt sells outdoor grills, smokers and fryers under its namesake brand and the Kamado Joe label. While Middleby gets most of its revenue from commercial customers such as restaurants and hotels, it has a smaller residential kitchen business that sells Viking cooking ranges and U-Line wine refrigerators. The Masterbuilt acquisition is a bet that the boom in backyard spending sparked by pandemic lockdowns has staying power. The purchase price works out to about 1.5 times Masterbuilt's expected revenue in 2021. 

Cie. de Saint-Gobain, a French building-products supplier, agreed to buy US construction materials and chemicals company GCP Applied Technologies Inc. for $32 a share, or about $2.2 billion after backing out the target company's net cash position. The deal is in part a bet that the Biden administration's $550 billion infrastructure bill will fuel spending on concrete, cement and associated additives. GCP has been a turnaround story and the shares have struggled over the past few years; the company tried and failed to find a buyer in 2019. The Saint-Gobain offer is about a 37% premium to where GCP shares were trading in late November before Bloomberg News reported on a possible transaction. 

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.