By Scott Budoff and Victor Krupinski, Saw Mill Capital
During the last five years, unprecedented change has resulted in huge investments in power generation followed by substantial excess capacity in certain markets and declining wholesale power prices. These changes have created a new and volatile business environment for utilities and IPPs, as well as for the suppliers that support them, often causing substantial deterioration in financial performance.
To improve profitability and repair weakened balance sheets, many utilities and IPPs have focused on maximizing cash flow by exiting volatile merchant operations, selling non-core businesses, reducing capital spending, and downsizing existing core operations. The cuts have been so draconian, that even core operations and maintenance budgets have been significantly reduced, in some instances potentially compromising the safety margin required for long-term reliability.
Industry leaders recognize that a joint effort between customers and their supply chain is essential to long-term success. Select industry participants have begun to focus on the development of strategic supply chain alliances designed to reduce O&M costs and increase profitability, while at the same time increase reliability and operating performance.
Wild Ride for the Power Industry
As a private equity firm that invests exclusively in power industry suppliers, Saw Mill Capital has witnessed first-hand the impact of the current business cycle and the dramatic changes in market conditions that have affected power industry suppliers.
Many suppliers have been whipsawed by recent events in the power market. In the late 1990s, suppliers met the demands of power companies that were investing capital in power plants at an unprecedented pace. At the same time, these customers were reducing fixed overhead by downsizing and outsourcing many O&M functions. When the party was over, these trends reversed themselves quickly, leaving many suppliers with diminished opportunities, excess capacity, and in some instances, customers who couldn’t afford to pay their bills.
Many OEMs have announced dramatic declines in profitability. GE and Siemens-Westinghouse saw their gas turbine sales drop sharply. Babcock Borsig became insolvent and subsequently liquidated its business. Babcock and Wilcox is operating under Chapter 11 protection as a result of mounting asbestos liabilities, while Foster Wheeler, Stone & Webster, and Washington Group have struggled to stabilize their businesses. And, of course, smaller suppliers have similarly suffered as capital and maintenance budgets have been slashed by customers struggling to rebuild their balance sheets.
Certain suppliers that reacted too slowly to changing market conditions have gone out of business. Others restructured their business models to reduce overhead costs and identify ways to work more closely with customers and sub-suppliers to become more competitive.
Shared Objectives and Communication are Critical
To develop win-win strategic relationships that drive value creation as opposed to pure cost reduction, customers and suppliers need to approach the buy-sell relationship as partners in the supply chain as opposed to unrelated auction participants.
Competitive bidding and auction-based pricing may make sense for commodity purchases where multiple venders provide identical goods and services, and lowest price is the principal differentiating factor. However, when selling engineered products and services, “cheap” may ultimately be inferior. In this case, to secure orders, suppliers might be incentivized to offer no more than is requested in the RFP to ensure low price. As a result, opportunities for creating value are often missed or simply not discussed with all qualified vendors at the time the initial purchase decision is made. Ultimately, this may not result in selection of the best long-term solution or supplier.
Smart customers use the bid process as a first step to winnow down the field of suppliers to identify and pre-qualify the best strategic partners. They then revert to a more interactive procurement process geared to maximizing value creation, as opposed to lowering costs by squeezing supplier margins and scope.
To create effective partnerships between customers and suppliers, it is critical to understand each party’s objectives and to find ways to achieve an appropriate and “fair” resolution to common issues. Saw Mill Capital has conducted several surveys to determine key decision criteria that customers and suppliers regularly consider while evaluating and negotiating supply decisions:
- In addition to cost, customers usually mention on-time delivery, reliability, quality and supplier responsiveness as the most important factors influencing their buying decisions. Depending on the type of product or service purchased, other criteria considered may include: technical capabilities, supplier track record, breadth of product line, willingness to provide bonding/performance guarantees, safety record, ability to provide turnkey services and local/global support capabilities.
- Along with profit margins, suppliers generally focus on order size, order repeatability (i.e., single vs. multiple-unit orders), standardization (vs. custom orders), and the certainty and timeliness of receiving the orders. Other factors influencing supplier’s decisions may include types of pricing arrangements (e.g. firm bid, cost-plus, cost-sharing, etc.), liquidated damages/penalties, bonding requirements, payment terms, accuracy of specifications, delivery schedule, and, increasingly, customer creditworthiness.
Although the issues that arise during the negotiation of these factors are generally case specific, in many instances the lack of open communication on key decision criteria is the biggest impediment to identifying shared objectives and to creating mutually beneficial arrangements. Investing the time and effort to understand each other’s objectives and key decision-making criteria through open and timely communication provides greater transparency and increases the likelihood of developing a strategic supply chain relationship, as opposed to a one-off purchase with limited long-term value.
Even modest changes to the standard RFP process will often yield benefits to both customers and suppliers. Customers and suppliers can reduce transaction costs and increase overall value for both parties by developing a transparent feedback mechanism. This mechanism should include: a) clear evaluation factors; b) full transparency on bidding and project schedule; c) accurate and timely specifications; and d) rewards/incentives for bid/project enhancements.
Partnering Opportunities Exist
Smart suppliers are more than willing to develop and/or customize their offerings for their customers if justified by the long-term profit potential of the relationship. Smart customers, on the other hand, are starting to identify key suppliers and require that they compete for long-term strategic alliances on the basis of “value creation” instead of “lowest initial cost of procurement.”
Various approaches are available to more closely align customers’ and suppliers’ interests:
- Alliances/Partnerships — By developing strategic alliances with customers in a team-oriented framework, critical needs are identified up-front, knowledge is shared, and unnecessary sales and marketing costs are eliminated. As a result, a customer/supplier partnership is formed that is focused on mutual value creation as opposed to price reduction only. In this way, a “win-win” outcome is facilitated as suppliers are positioned to deliver the best solution relative to actual needs, while at the same time reducing performance risk and, ultimately, customer cost.
- Identifying Opportunities for Enhanced Performance — By working together to develop performance-based solutions, customers and suppliers can jointly identify opportunities for enhanced performance that may not have been considered in a rigid RFP specification. As new solutions to improve performance are developed, new products and services are identified that provide revenue opportunities to suppliers, while increasing ROI and reducing operating risk for customers.
- Gain-Share Pricing — By identifying value added opportunities with customers, suppliers can develop pricing models keyed to incremental megawatts or steam generated, or emissions reduced. When the correlation between the suppliers’ value-add is clearly linked to output, these forms of sales can be very profitable for both parties.
- Solutions-Based Product Offering — By assembling a combination of products and services into a turnkey solution, suppliers are positioned to enhance their product offerings, reduce risk and create incremental value for customers.
- Best Practices/Shared Resources —Select OEMs (like GE and Siemens), have helped sub-suppliers to reduce costs and increase competitiveness. Examples of this practice include: shared purchasing to take advantage of volume benefits, access to internal resources to teach best practices (such as six-sigma, and cellular manufacturing), and personnel and logistical support when opening new facilities in more cost advantaged locations.
- Standardization and Modularization — By standardizing and modularizing products, outsourcing is facilitated, and cycle times and inventory levels are reduced, resulting in greater flexibility and lower costs to both parties.
- Outsourcing Non-Core Operations — By focusing on value added activities as compared to commoditized activities, customers and suppliers can identify opportunities to outsource commodity-manufacturing operations, thereby focusing key suppliers on activities designed to increase long-term value and reduce overall product cost.
Although the alliances discussed above offer the potential for mutual benefits to both parties, customers must be sensitive to the fact that suppliers often incur considerable costs in developing and customizing their products and services. Unfortunately, many suppliers have been burnt by customers that utilize the vendor’s knowledge and willingness to develop value-added opportunities, only to have the contract bid out and awarded to the lowest cost provider, without recognition of the time, effort and money invested by the initial supplier to develop the solution. Clearly, establishing a relationship of mutual long-term trust is essential for alliances to truly work.
Alliances are a Strategic Necessity
Ultimately, the strongest utilities, IPPs and suppliers will survive the current market, but they must continue to develop mutually beneficial and creative long-term strategic relationships. Making key vendors part of the value creation team (as opposed to an adversary in the procurement process) can significantly improve profitability and cash flow for both sides.
The bottom line is that power companies have a vested interest in making sure that their key suppliers survive, prosper and continue to invest in innovative products and services. Strategic suppliers are uniquely positioned to identify opportunities to improve asset utilization and efficiency, extend the time between scheduled outages, reduce emissions and provide the lowest and most certain maintenance costs.
Regardless of market conditions, the underlying drive to improve the power industry supply chain for the mutual benefit of both customers and suppliers is critical to the long-term success and profitability of the power industry.
Supply Chain Success Stories
Although many examples of successful supplier alliances exist, a few examples will help to illustrate the value creation potential of these relationships:
- Gain-Share Maintenance Agreements — Maintenance agreements with suppliers have been transformed in limited cases from a costly one-off bid process to long-term arrangements based on cost per operating hour. These gain-share arrangements are designed to incentivize suppliers to extend useful life and reduce servicing-cost per megawatt produced, while reducing the total maintenance cost for suppliers. For example, soot blowers are wear-based products that are replaced on a regular basis. Clyde Bergemann, which is owned by Saw Mill Capital and the company’s senior management, has negotiated fixed price service agreements with certain utilities to take on wear cost risk, in exchange for exclusive supply arrangements with incentive-based pricing. This type of arrangement benefits both the utility, by providing maintenance cost certainty, and also benefits the supplier, by creating profit opportunities as a result of life extension and service cost reductions.
- Performance Improvements — Suppliers and their customers have a mutual interest in developing and transferring innovations across the utility’s fleet. There are numerous examples of successful one-time product installations that lack broad support and buy-in within the customer organization, and therefore experience limited adoption. Innovative customers incentivize plant management to develop new solutions with key suppliers and to ensure rapid and effective adoption across the entire fleet. One example is the use of Clyde Bergemann’s SmartClean technology, a sophisticated, on-load boiler cleaning solution, consisting of “smart sensors,” analyzing software and water cannons. These intelligent systems improve boiler efficiency, decrease NOx levels, reduce slagging and automate the cleaning process. Several large utilities have initially operated these devices at a single plant and then, following successful performance, have made the decision at the corporate level to adopt this technology across other generating units within their system.
- Cost-Plus Service Agreements — Several OEMs have negotiated broad-based service agreements with their customers to provide one-stop-shopping on an exclusive, non-bid basis. These types of relationships reduce sales and marketing costs associated with the bid process, allowing for a more competitive overall price to the customer. Beyond obvious pricing benefits, these arrangements provide the OEM with the opportunity to increase their depth of plant knowledge, allowing them to identify and develop value oriented solutions for the customer, in many cases beyond those initially contracted for. In most cases, value-added solutions identified by the OEM are incentivized by additional gain-share arrangements.
Scott Budoff is a Partner with Saw Mill Capital and Victor Krupinski is the firm’s Director of Research. Saw Mill Capital is a private equity investment firm that invests exclusively in manufacturing and service providers to the global power industry. Saw Mill Capital backs management teams seeking capital to divest from a corporate parent, to take advantage of growth opportunities or to provide for shareholder transition. The authors can be reached at [email protected] or [email protected] capital.com.
This article outlines some of the topics that will be discussed during a panel session at POWER-GEN International on Wednesday, December 10, 2003, entitled, “Power Industry Supply Chain Issues, Opportunities and Strategies.” Panelists include the authors and executives from Ontario Power Generation, Bechtel Power, Clyde Blowers Ltd. and Deltak LLC.