The End of Globalization: What the Invasion of Ukraine Signals to Your Middle Market Business and How to Prepare

This is the first in a multi-part series on the “End of Globalization” and its impact on the middle market.

In his annual letter to shareholders, Larry Fink (the leader of the world’s largest asset manager, BlackRock) highlighted how the Russian invasion of Ukraine will have impacts that have only begun to be understood. He stated that “the war in Ukraine is heralding the end to three decades of increasing globalization.” With NATO’s unprecedented sanctions on Russia, Western firms are exiting the Russian economy in droves. Trade is banned, Russia-owned airlines are banned from NATO countries and US airspace, and Russian factories reliant on foreign supplies are closing.

Background

When the USSR dissolved in 1991, Russia was welcomed into the global economy, invited into the G8, and they are now the second largest oil exporter (11% of all crude, 4.6MM barrels daily), the largest wheat exporter (37MM tons), and the largest fertilizer exporter.

After Russia illegally annexed Crimea in 2014, they were dropped from the G8.  Today, as a response to Russia’s invasion of Ukraine, President Biden is urging our allies to drop them from the G20 as well.

As part of Russia’s aggression tactics, they are blocking Ukraine’s Black Sea ports. Ukraine’s grain exports (18MM tons) are now frozen. And if the war continues through the Spring, farmers who would normally plant next year’s crop in Ukraine will still be on the front lines fighting. The dramatic increases in oil, wheat, and metal commodity pricing are being amplified by the sanctions that most of the free world have imposed on Russia. The longer-term financial impacts of the Russian invasion have yet to be felt.

We have crossed into a new Cold War era of Authoritarian rule vs Democracy

Many recent articles highlight Putin and Xi Jinping celebrating their friendship as having no limits. Is Xi supporting Putin’s invasion? They are both autocrats, trade partners, and nuclear nations. Imagine for a moment that China invaded Taiwan, not unthinkable given Xi’s position on reunification. China’s economy is more than 4 times the size of Russia, and their manufacturers serve every major democracy. Is the free world’s trading relationship with China a powerful enough deterrent to prevent war? Hard to know, but what would the impact be on your company if the US and NATO imposed sweeping sanctions on trade with China?

What we do know is that the world has changed. We have lived with COVID for 2+ years and are now entering an era of walking (almost galloping) inflation, a shortage of critical components, and escalating demand. Europe is fighting the biggest war in nearly 80 years. The Ukraine invasion has exacerbated the price of critical commodities including oil, wheat, coal, iron, steel, nickel, aluminum, platinum, palladium, and neon. Concurrently, central banks around the globe are raising interest rates to stave off inflation. Inflation in the US now stands at 7.9%, which is the highest inflation rate in 40 years.

Every middle market company will be impacted. 

Rising interest rates signal the end of “easy money lending.” It is a seller’s market for top talent. Shipping costs are up 8-10X in some markets—if the product is even available. Critical commodity prices are increasing and displaying increased volatility—making product costs nearly impossible to predict.

With globalization in decline and the war still raging, the effects of these pricing, supply chain, and trading sanctions are just beginning. Every middle market business leader should be preparing for a very different and more uncertain future.

While some of the challenges that middle market business leaders currently face are specific to their industries or the present state of evolution of their respective businesses, certain universal and fundamental challenges need to be reviewed and actioned in these disquieting times. In our role as trusted advisor, we are helping our clients better understand how to cope with the unprecedented challenges in their operating environments. These challenges include, but are not limited to the following

People: In a time of great change, the importance of people rises to the forefront. In our experience, many executives who can competently lead companies in a relatively stable environment are not well-suited to recognizing, analyzing, shaping, and leading the initiatives required to survive rapid change. It is not enough to pay lip service to change; leadership must be strategic, proactive, and earn the trust of their stakeholders in order to position the company for the inevitable sacrifices that accompany any transition. Unfortunately, time is the enemy and companies that sit on the sidelines will be run over by or lose market share to competitors who agilely take steps to reevaluate and capitalize on the changing environment.

Being proactive about people-related change is crucial to middle market firms for three reasons:

• First, the leadership teams are usually small which means every person has a large impact on the ability to successfully navigate change.
• Second, owners may recognize the Peter Principle in people who have “helped get them here” but they feel obligated to that person and are hesitant to make the change.
• Third, the CEO may themselves be the problem and believe that “working harder at what they have always done” will get them through this crisis.

Any of these factors on their own is exactly how companies become irrelevant and go out of business. Without the right change-focused leadership in place, it severely handicaps any business hoping to remain profitable – or grow – in the current environment.

Pricing: The level of margin compression facing companies today has not been experienced for over 40 years. Most of our clients are seeing supplier and commodity input costs increase by more than double digits on a quarterly basis. In many middle market companies, there is no formal process for responding to changes in input pricing, and price increases are simply “not part of the culture.” Their salespeople, and executives, are reluctant to proactively manage pricing. In today’s environment, this thinking is a sure path to declining profitability.

One client told us that “their customers would never accept price increases,” although their input costs were increasing by double digits. We worked with them to build a by-client Cost to Serve financial model that explained and justified price increases. They were able proactively manage multi-millions in 2022 price increases and established a quarterly process to proactively manage future increases…without losing any clients.

To further emphasize how the world has changed, many of our clients are successfully managing pricing multiple times a year with customers who in past years were their most ardent resistors of price changes. These same customers understand the pressures in the market. In this market, if your company does not understand the true Cost to Serve your clients and how input prices are impacting margins, you are setting yourself up for failure.

Hedging Strategies: Leaders today are experiencing huge quarterly profit “misses” and are wondering how to cope with dramatic price swings in commodities ranging from wheat to microchips. The answer in many cases is through hedging.

In larger companies, hedging of key commodities is a critical function that is often handled by separate divisions. Unfortunately, most middle market leaders still consider it too risky and akin to “playing the market.” But when a company’s commodity product requirements are predictable, and a futures market exists for that commodity, hedging is a prudent practice to lock in margins.

For a food client who used several seasonally volatile commodities (that were critical to the most profitable products), we developed a hedging strategy that saved more than 15% on input costs. In today’s environment with commodities like wheat, aluminum, nickel, and lumber experiencing 50% (and greater) pricing changes, a hedging strategy would be prudent for many middle market companies.

Supply Chain/Suppliers: When your suppliers are forced to move to an allocation approach, where will your company be prioritized? Some of your suppliers will likely fail. What contingencies have been established? Should you be holding higher reserves of raw materials if demand could collapse? These questions and other scenarios should be reviewed and constantly updated. The ability to adjust quickly to the “unknowns” could mean the difference when even the best of the best will not be able to anticipate all the coming disruptions.

When is the last time you had to tell a customer they were on “allocation” because you were unable to fulfill the complete order? Or worse, their order would be delayed for weeks or months! Messages like these are all too common in today’s supply constrained world. Globalization and low-cost shipping have made many companies complacent about adopting a “just in time” supply mentality—even with critical components that are shipped thousands of miles. The world of globally sourced, dependable, low-cost components has been disrupted—and may never return to “normal.”

“The recognition of these negative aspects of globalization has now caused the pendulum to swing back toward local sourcing. Rather than the cheapest, easiest and greenest sources, there’ll probably be more of a premium put on the safest and surest.”
–Howard Marks, Oaktree Capital Management memorandum

Today, the move is toward onshoring, multi-sourcing, and in some cases vertical integration. Building redundancies and hedges into your supply chain around material inputs and transportation and reviewing geographic risk is essential. Just in time (JIT) inventory is being replaced by a safety stock mentality—where inputs are consigned by the supplier until used. This assures supply and minimizes purchaser working capital requirements. The most proactive companies are installing systems to ensure they have accurate tracking of not just inventory on hand but also inventory en route.

We are recommending for our manufacturing, construction, and distribution clients Sales Inventory and Operations Planning (SIOP) processes that track and coordinate all activity from the first demand signal through end product or service delivery. To be competitive in today’s environment, real-time knowledge of all the details inherent to sourcing, manufacturing, and delivery is essential

ERP Systems: Here’s a question for you: Imagine that you have just returned from a vacation where you did not have your phone or computer and you are back at your company on the weekend with no other employees around. What reports would you consult to get up-to-date on the status of the company and point you to the priorities for Monday? In an environment when your company is cruising comfortably in stable air at 30,000 feet, you may be able to survive without real-time knowledge of your environment. But when you hit turbulent air and a hurricane is lurking on your flight path, you are in real trouble without that data. These highly turbulent times remind us that everything is connected. Sadly, many leaders have never developed a comprehensive reporting mechanism to provide them with the critical measures of current performance and readings on external factors that predict future performance.

Data analytics is reshaping business operations (and effectiveness) all across the global economy. Timely and accurate information requires Information Technology systems, which is a topic that most middle market leaders would prefer to avoid because they are expensive and difficult to install correctly.

We often work to resolve information technology deficiencies in companies where owners have purchased well-respected systems, but the installation was not configured correctly, people are not trained on the system, and employees work around the system. Often these challenges have been known for years. In an unpredictable business environment, working through the challenges and building accurate, real-time information throughout a company is one of the highest return investments that a middle market leader can make. Those that have made the investments in technology need to be reviewing their cyber exposures and defenses and revaluating where exactly their systems are being hosted and by whom they are supported from a geopolitical perspective.

Financial Systems: In times of change, leaders should recognize that yesterday’s trends will not be a reliable indicator of the future. Most middle market companies know this. They invest in capable financial staff and ensure they can supply timely information that enables informed decisions. They also understand that building “a culture of performance” requires that accurate, timely information is available throughout the company.

That said, in some middle market companies, top financial people are really Controllers who are charged with A/P, A/R and closing the books. The books are closed weeks or months late, with large adjusting entries. This is not a wise practice even in stable times; it can be fatal in times of price and supply volatility.

Without effective financial control, it is easy to miss indicators of issues that, if left unaddressed, can become very costly. We had one consumer products client that “missed” over $350K in fines from online vendors because they had not implemented financial management systems that anticipated the disruptions in their supplier network. Rapidly changing input costs have become an issue for clients that need to stay ahead of these costs with pricing changes.

Middle market companies that depend on inputs where price volatility is an issue should install processes that enable their finance department to deliver “board level” monthly analysis of current and anticipated performance, along with sophisticated variance analysis. In 2022, the need for financial processes to monitor variances will continue to increase due to volatility in input prices, supply instability, transportation costs, last minute client requirement changes, staffing loss, staffing cost changes… and the list goes on and on. Comprehensive financial systems that deliver timely, easy to interpret reporting have never been more necessary.

Company Strategy: We often speak with leaders who focus their attention and investment on internal initiatives that provide “bigger, faster, cheaper’ results when the real advantages come from how much new technologies and business models can increase the value provided to customers. These middle market executives have aligned their operations with their “distinctive competitive advantage” position so tightly that they can’t adapt when circumstances in their supply chain—or customer base—change.

The middle market winners will be leaders who stop thinking in terms of beating the competition and start thinking in terms of how to provide their customers with “a better version of themselves”. Leaders who build strategies around this simple vision—to give their customers a better version of themselves—open themselves to becoming category creators. These category creators unleash whole new markets for themselves – and if they understand how to craft category architectures that scale, they unlock the untapped value in their most valuable asset—their customer base.

This concept of category ownership is not just for well-funded internet startups. It applies equally to middle market companies with existing customers. During times of dramatic external change, when customers are open to seeing things differently, is the perfect opportunity to design and execute a strategic adjustment that will enable the company to achieve greater value creation.

The previous is only a subset of essential steps you should be taking and scenarios you should be reviewing in this new world of greater uncertainty.  If you are not fully engaged with your team to review, analyze, rebalance, reduce, question your exposures, operations, supply chains, hedges, bets, and resiliencies you risk being able to react and pivot your business quickly enough to avoid costly and potentially catastrophic losses.  Failure to plan is planning to fail. For leaders of today’s middle market companies, planning for a very different, more regional and more volatile business environment is the key to success.

______________________________

Over the coming weeks we will be continuing this series with blogs on other meaningful topics aimed at helping middle market business leaders navigate through the seismic shift being caused in their industries and companies by the end of globalization as we know it.  Upcoming topics include…

• Leadership
• Strategy
• Information and Intelligence
• Enterprise Value Creation
• Environmental, Social, and Governance

If you’d like to see something specific in this series or would like our take on another topic of interest, please reach out to us today.

______________________________

At FortéOne, we’ve been on the forefront of change as thought and implementation leaders for more than 20 years. Our mission is to help Family and Privately Held Business owners as well as Private Equity and Family Office investors become performance leaders in their respective industries. We are more than consultants—we are problem solvers who work side-by-side with you to deliver a business transformation that improves performance and accelerates change in your middle market company.