Part 2
Customer behaviour
As was noted in Part 1 of this article, the management of DDL is in control of the economic resources of the company and has little to fear from shareholder activism. It was also noted that, despite the control that management exercised by virtue of the sizable internal equity available to it, leading the company into the future would be no cakewalk for the new president. Already, DDL’s contribution to factor costs has declined markedly.
A further examination of its external dynamics through trends in its gross profit margin also suggests that the company has much to contemplate. The biggest challenge is managing the customer and vendor relationships. What happens at that point in the business determines to a large extent what happens in the rest of the organization. The revenue that a company earns is influenced by many factors, but the ultimate determinant of revenue growth is customer behaviour. A company must be able 
to sell quality goods at prices that customers are willing to pay. The relationship between customers and the company must be such that customers are willing to resist purchasing substitutes as prices rise. This objective is important because customers are the main source of financing for any company. Quantity and price make the day.
No efficiency gains
Part 1 of this article showed that the contribution of DDL to manufacturing had declined from 31 per cent in 2006 to 17 per cent in 2012. The contention was that DDL might be losing market share. Corroborating evidence for this point of view lies in the inventory picture of the company. In 2003, DDL was carrying $3.5 billion worth of inventory. That level of inventory represented about 43 per cent of the annual sales of the company.
By 2012, it was carrying $9 billion worth of inventory which represented 88 per cent of the annual sales of the company. Another way of looking at this story is through the time span it takes for inventory to become sales. The inventory values of 2003 amounted to 155 days of net sales in inventory. By 2012, it was carrying 320 days of net sales in inventory.
The company is holding twice as much inventory of its net sales as it did 10 years earlier. The higher ratio is evidence that there was no efficiency gains from increasing the day’s sales held in inventory.
In reality, the consequence of this unfavourable trend was the loss of approximately $5 billion in sales last year alone. That outcome cannot be a situation that the new leader would likely tolerate.
There is reason to believe that DDL enjoys customer loyalty and that with the right strategy the declining gross profit margin situation could be turned around. DDL has exhibited growth in revenues of three per cent over the last 10 years and even more robust growth of eight per cent in the last three years. The slower moving inventory meant that, for revenues to grow, prices had to be increased.
Cost side
But the challenges facing the new leader are not only on the revenue side. They are also on the cost side. Whether he likes it or not, part of his business strategy would have to include controlling input costs. In the last 10 years, the production costs of DDL averaged about 65 per cent of sales. This meant that DDL had 35 per cent of the financing provided by customers to meet administrative, selling and other operational expenses.
However, the numbers relating to input costs have crept up over the last three years and now average 72 per cent of sales. This means that the company is using a greater share of the financing provided by customers to produce the goods and services that it sells. It also means that DDL has less money provided by customers to meet the other operational expenses.
The trend in the area of input cost is one that would clearly be of interest to shareholders. Lower gross margins lead to lower net profits. This in turn leads to lower returns to shareholders. This latter interest group would clearly want to see a reversal of such a trend. Influential shareholders would clearly have something to say about the matter of rising input costs and would more than likely share this feeling with the incoming leader.
The weight of their influence is another matter. Current data show that the investments of equity holders make up six per cent of the long-term financing of DDL while management controls over 80 per cent of the money needed to keep the company operating.
Control of assets
This control is best understood in the context of an assessment of how efficiently the assets are being used. The control of these assets and how it uses them reflect a tighter relationship between management and its customers than between management and its shareholders.
It revolves around market share but more importantly brand loyalty. The degree to which brand loyalty exists would be reflected in the elasticity of demand for the product. The more loyal customers are to the DDL brand the less likely they were to switch when prices increase. It boils down to how well the new leadership would manage the assets of the organization in the face of changing market and operating conditions. This future responsibility must be contrasted with what has gone on in the past.
At the end of 2012, DDL had about $22 billion in total assets invested in the company compared to 2003 when it had around $10 billion in total assets. The asset base has doubled in value, but might not have helped to improve the return on assets.
An assessment of how assets performed sharpens the view of the company’s efficiency level. The largest proportion of assets is contributed by inventory which accounts for 43 per cent of the value of total assets. This is five percentage points higher than it was in 2003. The earlier discussion of inventory has already shown that this asset is placing a strain on the company’s performance.
The next largest contributor to the asset size is the productive asset group consisting of property, plant and equipment. This category of assets accounted for 40 per cent of the total assets. In looking at it, the resources to produce the inventory and the inventory itself are responsible for 83 per cent of the economic resources under the control of management. Despite the substantial control, the performance of the assets as measured by asset turnover leaves much to be desired.
In 2003, DDL was generating 79 cents in net sales for every dollar of asset invested. That situation was drastically different by 2012. DDL was generating 49 cents in net sales from every dollar of asset employed. The 30 cents decline in asset turnover between 2003 and 2012 is equivalent to the loss of net sales of $7 billion.
An alternative view is that had DDL maintained the asset turnover level of 2003, the company would not have had to tie up $11 billion in the business. This is money that could have otherwise gone to the shareholders.
Unable to ignore
With the several categories of assets under its control, it is possible to ascertain where DDL might be having trouble. As was noted earlier, the majority of assets are in the form of productive assets or in inventory. A review of the long-term investment in productive assets reveals that DDL has managed this aspect of its business operations well. Total assets grew by 10 per cent and so did current assets.
Productive assets on the other hand grew by nine per cent. The behaviour of productive assets seems consistent with the behaviour of assets overall.
However, all assets seem to have grown much faster than sales which over the 10-year period grew by an annual average of only three per cent. A look behind the scenes reveals that inventory and the asset group classified as “others” have grown way out of line with both the trend in asset growth and sales growth. Inventory grew by 12 per cent, two percentage points in excess of total assets and nine percentage points in excess of sales.
The worst management of assets might be in the others category. There, the growth rate was 15 per cent per annum, representing a five percentage point over total assets and 12 percentage points over sales. This is a situation which the new leader of the company would be unable to ignore if he is to keep his company competitive and as a strong economic performer.
Depth of challenge
The depth of DDL’s challenges is also reflected in the receivables situation. This is a variable on which the new leader would have to keep his eyes. On average, DDL has been able to convert credit sales into cash in 26 days over the period in review. But this was not without some effort.
In 2003, DDL converted credit sales into cash in 19 days. It successfully reduced the conversion period to 12 days by 2005. From 2006 to 2010, things seemed to get out of hand. By 2006, DDL had to wait 22 days to collect its cash.
It peaked at 43 days in 2008 and has continued on a downward trend since then. It took 24 days to convert receivables into cash in 2012. This figure is still above the 11 days achieved in 2005, but is part of a positive trend line. This trend has shown up in the improvement in the efficiency with which the company manages its cash. By operating the business with 2.77 days net sales invested in, DDL has increased its efficiency by $59 million.
All the best
As one seeks to harbour a positive outlook for DDL, an eye must be kept on the long-term working capital of the company. Current data suggest that DDL is facing a tighter period of working capital than meets the eye. A review of the last 10 years shows that from 2003 to 2005, DDL had working capital that covered its expenses for 93 days. The situation was even better by 2007 when DDL had 107 days of working capital available to it.
As the new leader takes the reins of the company, he would be facing a different situation. The working capital would be covering 86 days of activity. A major challenge for the new leader would be establishing the right level of working capital. Under the circumstances, one could only wish the new leader of DDL all the best and additional prosperity as the New Year comes around.
