Core Category Detail

by Michael Petro

Executive Observations
The overwhelming story during the third quarter was the consistent drop in metal raw material prices since mid-July. Global steel prices fell an average 27 percent, while non-ferrous prices fell to levels not seen since the start of 2005. The lower prices are a result of decreased global demand for metal products, as companies react to the current economic crisis in the U.S. and around the globe. Despite the turbulent metal markets, metals sourcing activities at Ariba reached the highest levels since the fall of 2006, as buyers attempted to meet their annual sourcing objectives before the close of 2008. Some of the most influential trends during the past quarter included:

• Steel prices plummeted during the quarter, with prices dropping more than 36 percent in China and Central and Eastern Europe, 21.5 percent in Western Europe, and 12.2 percent in the U.S. This is in stark contrast to the sharp spike that steel achieved during the second quarter, when prices increased more than 31 percent.
  
• Non-ferrous prices also dropped during the last three months, with significantly lower prices for aluminum, copper, nickel, lead, zinc, and others. Nickel and copper led the way with decreases starting in July and ending in October at 45 percent and 43 percent lower, respectively. Aluminum and zinc prices also fell substantially during the quarter, with early October prices that are both 30 percent lower than the start of July.
  
• Ferrous scrap prices fell from $865 per ton in early July to $220 per ton by the middle of October. This sharp decline came on the heels of a historic spike upward of more than 113 percent during the previous quarter. The extreme volatility in scrap is causing all steel product suppliers to remain skeptical about future pricing, and therefore attempt to compensate for the volatility by adding costs to all quotations.
  
• China continues to see strong growth in their GDP, although not at the same levels that occurred in 2007. GDP growth in China was 10.1 percent in the second quarter of 2008, compared to the annual GDP growth of 11.7 percent in 2007. The perceived slowdown in Chinese production and consumption of metal products is misleading—the Chinese economy is still growing at very high levels, albeit at a slightly slower pace.

Third Quarter Trends
The average savings identified in metals projects concluded by Ariba in the third quarter was 11.6 percent, which marks the lowest average savings figure since the fourth quarter of 2006. The drop of approximately three percent in savings compared to the previous quarter is due to the suppliers’ response to extreme volatility in raw metal pricing during the quarter. While raw metal prices did fall during the quarter, many suppliers viewed the early declines with skepticism due to the sharp spikes that occurred in previous quarters. Project savings should rebound in the fourth quarter as raw material costs continue to drop. Machinings, stampings, and sheet metal fabrication projects delivered the highest average savings, while castings and fasteners projects also provided considerable sourcing opportunities.

Ariba concluded the highest number of metals sourcing projects since the third quarter of 2006, as many buyers looked to achieve difficult sourcing goals before the end of the year. The number of sourcing projects involving metal components increased by more than 38 percent compared to the previous quarter. More than two-thirds of all completed metals projects were for machinings, sheet metal fabrications, and stampings commodities. The strong increase in metals sourcing activities can be attributed to buyers that are being tasked to deliver against increasingly challenging sourcing goals being imposed upon them from executives as companies struggle to maintain the bottom line given the current state of the global economy.

Non-ferrous prices fell significantly during the third quarter, with global prices now approaching levels not seen since the start of 2005. As illustrated in the graph that follows, non-ferrous prices peaked in late 2006 through late 2007, with copper, nickel, lead, and zinc all reaching levels that were more than 150 percent above the prices at the start of 2005. These commodities plunged consistently last quarter, as aluminum, copper, zinc, and nickel prices all fell by 30 percent or more. Uncertainties in the wake of the recent global financial crisis have driven many financial institutions to pull money out of the metals futures markets, which saw investments in metal commodities that exceeded $40 billion USD in 2008 alone. In response to the liquidation of the non-ferrous physical assets on exchanges such as the LME and NYMEX, inventories in the warehouses increased sharply in September and October. The LME warehouses saw an 18 percent increase in aluminum inventories during September alone. Non-ferrous prices are expected to continue their downward trend during the fourth quarter as financial market concerns continue to impact futures market investments.

Steel prices continue to capture much of the industry’s spotlight, as intense volatility remained the leading metals story. As shown in the steel price graph that follows, global steel prices declined an average of 27 percent during the third quarter, with China and Central and Eastern European prices leading the way with more than 36 percent declines. Global demand has slowed significantly in response to declining automotive and construction demand in North America, as well as slowing demand growth in China. In response to the falling prices and cooling demand, global steel mills have begun to sharply cut production to avoid an oversupply condition. The volatility in steel pricing is forcing raw material suppliers to decline requests to hold prices fixed for any period longer than three months. Adjustable pricing is also now being seen in less raw material-sensitive commodities, such as fasteners, which do not traditionally allow for raw material price adjustments.

In addition to declining steel demand, free-falling steel scrap prices are pushing steel prices lower on a daily basis. Scrap’s erratic volatility was unprecedented last quarter, with prices peaking at $865 per ton to start July, only to fall to $220 per ton by the middle of October. The record high in July marked a 113 percent increase over January 2008 prices, while the current low represents a 45 percent decline since the start of 2008. A significant contributing factor is the drop in demand for scrap from steel mills, which are intentionally limiting production due to lower demand and falling prices for finished steel. This extreme volatility is encouraging some progressive steel component buyers to now include references to a steel scrap index to be used for raw material cost adjustments in all supplier contracts.

Fourth Quarter Trends
Ariba expects the recent decline in ferrous and non-ferrous costs to continue through the fourth quarter based on declining global demand. Analysts predict that apparent steel demand will likely drop 3.5 percent in 2009 compared to 2008 levels. To combat the decreasing demand, raw metal suppliers are expected to strongly cut back on production in an effort to avoid an oversupply condition. Arcelor Mittal recently announced their intentions to decrease global steel production by 15 percent during the fourth quarter, and other global mills are expected to follow this trend. Capacity utilization for global mills is still above 85 percent on average, so there is still room for the mills to cut back supply without facing overly severe production outages. Buyers of raw metal products are reportedly shopping around prices with suppliers to learn the market price, but are often withholding making purchases to allow prices to continue to drop. The decreasing demand is allowing inventories at metal distributors to increase. This has been particularly helpful for buyers in Mexico that have been able to satisfy their steel demand in the region despite their recent challenges with supply.

The Mexican supply base is expected to continue to have limited available capacity, despite the recent slow down in the North American economy. Mexican metal product suppliers have been at or near full capacity for many months, as many North American buyers have adopted a near-shoring strategy for metal products. The movement toward localized sourcing strategies is being driven by buying organizations’ desires to minimize logistics costs, reduce finished inventories associated with LCC sourcing, and avoid damaging currency volatility. The decline in the automotive industry is starting to impact Mexican suppliers, but many suppliers are beginning to branch out to support non-automotive industries including aerospace, appliances, and electronics. Non-automotive buyers looking to buy metal products from Mexico are encouraged to expand their supplier search to include some suppliers that typically have been known to only service the automotive business.

Ariba expects to see a new round of mergers and acquisitions in the upcoming months, since the economic value of many global suppliers are diminished due to the current decline in financial markets. Many global steel mills and non-ferrous suppliers still have excess profits that were stemming from sustained high prices over the first half of 2008. Additionally, any monies that were previously budgeted toward internal capacity expansion may be available as raw metal suppliers avoid building internal capacity during a period of suppressed demand. The merger and acquisition activities are expected to include competitive, upstream, and downstream companies.

One growing trend among metal buying companies working with Ariba is for buyers to attempt to consolidate their supply base. Buyers are attempting to reduce the costs associated with maintaining costly quality approvals as well as the risk of being impacted by suppliers facing poor economic performances in a downward economy.

Production and consumption figures coming out of China are somewhat mixed, as much publicity is being given to China’s slowdown, even though statistics still show China is expanding rapidly. Recently published GDP statistics show that China’s GDP growth in the second quarter “fell” to 10.1 percent, compared to their annual GDP growth of 11.7 percent in 2007. The GDP for all of 2008 is expected to remain close to 10 percent according to the Development Research Centre (a leading Beijing policy-making organization). This group also projects a GDP growth of nine percent per year over the next decade. Additionally, the Chinese government recently cut interest rates in September down to 7.2 percent, which is the first drop in more than six years. Despite the talk about a cooling Chinese economy, the growth potential in China is still staggering. McKinsey and Company recently made the prediction that as China industrializes in the next 20 years, it will build as many as 50,000 skyscrapers—a number roughly equivalent to 10 New York Cities. Additionally, BHP Billiton recently made the prediction that China will consume as much steel over the next 10 years as the U.S. consumed for the entire 20th century. Whether or not these statistics fully materialize, it is certain that China’s growth will continue to dominate the global manufacturing outlook for many years to come.

Industry Grapevine
The Precision Metalforming Association (PMA), a group of metalforming companies in the U.S. and Canada, recently published the results of a survey of member companies that emphasizes the deteriorating market conditions for metalforming companies.

• 54 percent of companies surveyed project a decrease in incoming orders for October, compared to 25 percent of respondents in October 2007.
  
• 67 percent expect general economic activity to decline during the next three months, compared to 23 percent that felt this way in October 2007.
  
• 30 percent of U.S. metalforming companies have at least a portion of their workforce on part-time or layoff status, which is the highest level since November 2002.
  
• 30 percent of respondents said their customers were paying them less promptly compared to 17 percent in October 2007.

Ariba’s take: The PMA survey serves to quantify the general sentiment of metalforming companies in the current market. The supply base is already feeling the effects of a down economy, and further declines are expected by the end of the year. While rising raw materials were a major concern for suppliers in 2007, the reduced demand and negative outlook on incoming business in the coming months is an even larger concern for suppliers.

Global steel prices are dropping fast and starting to approach the magical $650-per-ton mark, which is the estimated cost of producing one ton of steel, according to steel industry consultants World Steel Dynamics. Despite the sharp drop in steel prices and profits for mills, global raw steel production is expected to increase more than five percent during the next 12 months.

Ariba’s take: Declining prices that approach the actual cost to produce steel will quickly “weed-out” the global mills that are uncompetitive in terms of operating and management costs. The strong global mills will be able to feed off of the sustained period of high profits earlier in 2008, while the mills that did not do a great job in cutting costs during this period of prosperity will begin to post poor financial performances. Look for weaker mills to become merger and acquisition targets in the upcoming quarters as healthier mills take advantage of reduced prices for these poor-performing companies.

Aluminum suppliers have begun to cancel expansion initiatives that were planned for late 2008 and 2009. For example, Alcan recently announced the cancellation of their planned build of a large aluminum smelter in Abu Dhabi for 2009. High energy costs and uncertainty in near-future demand are being cited as primary concerns by aluminum suppliers.

Ariba’s take: While the delay or immediate cancellation of industry capital expansions may not have an immediate impact on the price of aluminum or other non-ferrous metals, this is a trend to watch in the upcoming quarters. The global demand for raw metals is expected to increase steadily during the next five years or more, as global industrialization continues in many regions of the world. While the supply and demand balance may not be immediately impacted by suppliers’ cancellation of capacity expansions, a sustained hold on new capacity growth would have a long-term impact on pricing due to supply concerns.

Two major U.S. steel mills settled union contract negotiations in October, with most analysts agreeing the results were strongly in favor of the union workers. U.S. Steel and Arcelor Mittal came to terms with union representatives that ultimately shared some of the enormous profits that the mills enjoyed during the previous year of high steel prices and profits.

Ariba’s take: While the favorable contracts for union workers was expected, the timing was poor for U.S. mills that are seeing demand shrink considerably and prices plummet to start the fourth quarter. The profits taken by global mills during 2008 were unprecedented, but this will not shield the mills from feeling the pain of lower profits and higher labor costs if the current drop in steel prices is sustained well into 2009.

A growing trend to watch in the quarters to follow is for the sourcing of high labor content and low-complexity parts moving away from Central and Eastern Europe in favor of Asia. Ariba has encountered many instances of Western European companies migrating their sourcing of the low-complexity, high-labor content parts to Asia in an attempt to obtain the lowest-delivered cost.

Ariba’s take: Western European buyers are sourcing more of these parts to Asia partly due to their efforts to avoid some of the volatility associated with Central and Eastern European exchange rates compared to the Euro. Ariba expects this trend to continue in the upcoming months.

The shipbuilding industry continues to grow rapidly. Demand for oil tankers and cargo ships has increased as a result of strong growth in China and other developing nations. In response to global demand for more ocean vessels, global plate mills are making large capacity expansions to keep up with demand for shipbuilding plate.

Ariba’s take:Robust demand for crude oil and many other goods being shipped to China has created a glaring shortage of Capesize and Panamax ocean vessels. In response to the increasing orders for transport vessels, global plate mills are having a difficult time keeping up with supply of plates used for the shipbuilding industry. Manufacturers of heavy equipment and other applications using plate steels will benefit from the strong emphasis to expand on this segment of the steel industry. Look for plate mills to continue their expansions, as well as new plate capacity additions at mills that historically focused on only sheet product. While new capacities are not expected to create an oversupply of plate steel, the increased production should help to offset the growing demand for plate.

Category Perspective
Fasteners – Distribution

by Tomas Oplatek

Industry Overview
The 2008 global industrial fastener industry is estimated to be a $48 billion market. Global demand is expected to grow five to seven percent annually through 2010, with the largest gains being driven by the industrialization of developing nations located in Asia, Latin America, Eastern Europe, and Africa/Middle East. The chart below illustrates the demand for fasteners by region.

Currently, the four largest markets for fasteners are the U.S., Japan, China, and the EU, although it is anticipated that China's growth will make it the largest market in the next five to seven years.

The fastener industry is characterized by an extremely diversified product mix supplied by a fragmented supply base, comprised of several multinational conglomerates and thousands of small regional players. A small number of large distributors (in the twenties) are capable of supplying the needs of Fortune 1000 companies. Most of the leading fastener manufacturers offer a full range of distribution services. It is estimated that 45 percent of the total fastener market is channeled through third-party distributors.

Market Trends
In the past decade, a growing trend among large manufacturing organizations in the U.S. and Europe has moved fastener purchases away from direct manufacturers to distributors that offer vendor-managed inventory (VMI) programs.

The four main challenges the market is facing are the changeover from hexavalent chromium coating to trivalent, the REACH regulation, steel price increases, and antidumping practices. The potential level of European and U.S. antidumping actions against Chinese fasteners is impossible to predict, but the net effect will be increases in world fastener prices.

In July 2007, China reduced the tax rebate paid to fastener exporters, from 13 percent to five percent, and as the Chinese economy continues to expand, there is an expectation that the remaining five percent will be removed entirely.

Demand is expected to increase for high-performance fasteners that can replace mechanical fasteners in new car applications. Traditional producers may be affected if they are unable to produce and deliver new fasteners to the market quickly and at a competitive price.

Cost Drivers
The following chart shows the percentage breakdown of the primary cost components to the end user of a distributed fastener (screws, nuts, rivets, and bolts).

Raw material purchases for fastening elements are an important cost driver in fastener distribution. The cost of the fastener is dependent on its complexity and the material from which it is produced. Fastener pricing has been volatile throughout 2008 due to rapid fluctuations in raw metal and plastic resin pricing across the globe.

The cost factors identified in the previous chart illustrate that, from the end user's point of view, there is less value in trying to achieve savings by targeting the purchase price of the fastening element alone. Greater bottom-line savings can be achieved by competitively sourcing through distributors with a VMI program.

Supply Management Best Practices
Ariba has identified the following best practices:

• Target high-volume/high-cost items for competitive bid and source low-volume/low-cost items locally
  
• Maintain a written description of the VMI program and an up-to-date database of prints and specifications for all engineered/nonstandard fasteners for re-sourcing parts
  
• Clearly identify all proprietary/supplier-directed fasteners
  
• Aggregate fastener purchases within and across divisions where it makes sense in order to maximize purchasing leverage
  
• Use standards such as ASTM, SAE, and ISO where applicable and avoid proprietary fasteners when possible
  
• Identify fasteners under supplier IP protection (patents, licenses)

Category Assessment
Partner: High business impact with a high supply risk (may have limited number of qualified suppliers and obstacles to switching suppliers)

Manage: Low business impact with high supply risk (may be a limited number of qualified suppliers and obstacles to switching suppliers)

Successful Strategies: Partnership, LTA, standardization, cost reduction of overhead, cross-divisional consolidation, supplier consolidation, and cross-commodity leverage

Fasteners are increasingly being viewed as a strategic sourcing category due to their critical role in overall product quality. Consolidating supply across divisions to drive cost savings and improve supply chain efficiency is a key goal in sourcing fasteners. This goal requires a strategic approach to selecting and developing a partnership that meets the buyer's sourcing needs. Additionally, across the lifetime of the part, part resourcing can be managed as strategic supply partners are identified.

Case Study
Current Situation: A leading manufacturer needed to resource their Mexican divisions' fasteners spend from a fragmented supply base of manufacturers and distributors to a core group of distributors. Three divisions with three delivery locations identified more than 100 critical parts consisting primarily of standard threaded fasteners, washers, pins, and dowels.

Solution: The parts were sorted into categories based on fastener type and buying division to accommodate participation by more than two dozen existing incumbent suppliers. Over 100 fastener distributors from the U.S., Mexico, and Asia were contacted to determine their interest and capabilities for supplying the required parts.

Impact: Twenty-five fastener distributors were identified (14 from the U.S., eight from Mexico, and three from China). Suppliers competed aggressively to provide identified savings in excess of 20 percent. The results offered the buying organization the ability to consolidate its supply base to a minimum of three suppliers.

Contact these category experts
Mike Petro
Tom Optalek