“It became a domino effect, as infected people took foolish risks, knowing full well they could spread the virus.” — Jason Medina, The Manhattanville Incident: An Undead Novel
“My worlds collide. When one thing happens, it just starts a domino effect – everything else goes on.” — Wanda Sykes
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The Fallout
Over the past 10 days or so, we have been having discussions with management teams at companies operating in many different sectors in Asia to understand the potential fallout from the 2019-nCoV coronavirus outbreak.
In some instances, we will mention the companies by name, please note this information is for your consumption not for public dissemination.
Before we get to the snippets from our discussions what seemed to be almost a constant across all discussions was the overarching conviction that China is almost certainly under-reporting the number of infected people there are across the Mainland
#1 De-Coupling from China is Not Easy
We recently met with the ASEAN retail sector team at GlaxoSmithKline (GSK), the British multinational pharmaceutical company. As an anecdote they shared that typically they have 90 days of inventory on hand of various versions of one its best-selling products, Panadol (generic: Paracetamol) — a level they recently deemed excessive and were implementing initiatives to bring it down to less than 60 days.
As of last week, in ASEAN their inventory at hand had dropped to less than one week of regular demand. Demand is anything but regular at present. Residents are in hoarding mode, particularly of medical, sanitary and food items.
Our discussion with the team at GSK revealed how difficult it is for multinational and regional companies to (1) re-engineer supply chains away from the Mainland and (2) de-couple from China.
Let us elaborate. Given the shortage in Panadol inventory, GSK reached out to manufacturers in Malaysia and offered a higher price than usual if the Malaysian outfit could do an urgent production run for them. The Malaysian producer rather than witnessing a surge in capacity utilisation found its plant almost idle and did not accept the order from GSK. The producer informed GSK that even if it accepted the order from them, it would not be able to fulfil it as the primary active ingredient used in production is sourced from China.
Chinese manufacturers have been temporarily shuttered by the government and will not re-start operations till at least 25 February. Chances of a further delay are not zero.
The issue has been exacerbated by inventory levels across most consumer facing industries already having been low prior to the outbreak due to production having been halted during the extended Chinese New Year break.
#2 Germany is Not a Viable Alternative
Dependence on Chinese manufacturing afflicts almost all industries with a physical product. So, we asked many of the companies what the alternative was. Most management teams were unable to come with a viable alternative. Others cited Vietnam and Germany as potential alternatives but lamented their relative lack of scale, the limited sophistication of the former and the much higher cost of the latter.
Companies operating in more sophisticated, higher priced categories could turn to Germany as a stop-gap measure and in some specific technology related cases to South Korea. For most industries, however, Germany is simply too expensive — anecdotally, 2 to 4 times the cost of China — and, for Asia-specific demand, too far, as shipments from Germany take 2 to 4 weeks longer to arrive. Worse still, in some cases China still becomes a bottleneck as a key input material or component is sourced from China during the normal course of business.
#3 Plastics and Petrochemical Producers to Feel the Pinch
Commodities are priced at the margin. At the margin, demand for petrochemical products is nil. Polyethylene, polypropylene, benzene and other such commodities have seen near-term demand plummet.
We spoke with the commodities trading team at Unilever (producer of consumer brands such as Dove, Red Bull and Lipton), which handles the commodities purchasing activities for the group from London, England to India to the ASEAN and pretty much anywhere in-between.
Our expectation, prior to the discussion, was that Unilever and its peers would actively be locking in lower prices and securing supply needed 9 to 18 months down the line. Turns out that is not the case. Rather, it has become a bit like a game of chicken.
Unilever worried that prices may drop further and that its key competitors may secure better prices is not buying. Instead, if notional loss limits are hit as set by internal policies, the team may be required to unwind positions and sell at prices they would prefer to buy.
We pressed on the point about competitors securing better prices and why it mattered. The argument goes that if they secure better prices, they would be able to offer higher discounts and gain market share at Unilever’s expense.
So, we turned to a contact at Reckitt Benckiser (producer of Dettol and other leading consumer brands), a direct competitor of Unilever across a number of categories. The argument made by Reckitt Benckiser was almost identical to that made by the team at Unilever.
The natural question then is what is their reaction function if prices start to rise. Turns out, they would probably rush to buy to lock in prices just in case their competitors lock-in lower prices…
That’s probably how V-shaped bottoms are formed in commodities markets.
#4 Interim Disconnect Between Finished Good and Commodity Prices
Unilever and Reckitt Benckiser have received an estimated 1 million units of additional daily demand for their Life Buoy and Dettol branded hand sanitizers since the start of the 2019-nCoV coronavirus outbreak, respectively. Regional production capacities are an estimated 250,000 units per day cumulatively.
GSK has little to no inventory of Panadol and other popular products remaining.
One of the leading ASEAN pharmaceutical chains is all out of thermometers, disinfectant sprays, surgical masks and many other hygiene related products.
Demand for many finished goods is far outstripping supply. Where supplies are available, price gouging is starting to occur, particularly on online market places.
Production has ground to a halt, hurting commodity prices and elevating retail prices. This disconnect could persist unless Chinese production comes online sooner rather than later.
#5 Chinese Aversion but Some Requests are Simply Ridiculous
A number of companies mentioned that Asian consumers are starting to show an aversion toward goods manufactured in China.
In response, one electronics retailer allegedly asked HP if they could provide a letter stating that their laptops, manufactured in Wuhan, would not transmit the virus. HP, obviously, would not expose itself to such a liability. HP laptops were duly removed from the unnamed retailers branch network.
Given all of the above, we think software remains one of the better sectors to be exposed to given the absence of supply chain challenges.
We may issue a follow-up piece to further discuss implications of the outbreak.
Thank you for reading!
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.