Post-Natural Disaster Appraisal and Valuation
Lessons from the Japan Experience
Date december 2011
Featured in The Secured Lender
On Friday, March 11, 2011, a powerful undersea earthquake occurred 43 miles east of Japan. The event generated highly destructive tsunami waves that inflicted widespread damage throughout the northeastern coast of Honshu, Japan’s main island.
Adding to the destruction, the tsunami caused a series of nuclear leaks that affected not just the hundreds of thousands of people in the immediate areas, but also caused a severe power shortage. The combination of disasters prompted Japan’s prime minister at the time, Naoto Kan, to call it “the toughest and the most difficult crisis for Japan” after World War II.
Local Disaster with Global Ramifications
For Gordon Brothers Group, this natural disaster struck close to home. Since 2006, we have had a substantial presence in this market through Gordon Brothers Japan, a joint venture between Gordon Brothers Group and the Development Bank of Japan, which is focused on developing the asset-based lending market in that nation.
After the earthquake struck, our initial focus was on ensuring the well-being of our local employees, clients and business partners. In the days, weeks and months that followed, our focus transitioned to the business implications of this tragedy, as it became apparent that this was a natural disaster with potentially deep worldwide repercussions, given Japan’s position in the global economy.
The electronic and automotive industry sectors, both areas in which the Japanese economy plays a pivotal role, suffered serious inventory contractions in the immediate aftermath of the disaster. In Japan, in particular, the supply chain for advanced materials industries is composed of a tightly integrated web of hundreds of small companies. Should so much as one company cease to operate as usual, the entire supply chain can be adversely affected.
Even as we worked closely with our Japan-based clients to understand their situations and develop strategic plans, we also immediately commenced partnering closely with multiple asset-based lenders that sought to understand what the ramifications of the Japan disaster would be for their asset-appraisal and valuation activities.
Understanding the Key Questions
For ABLs, a natural disaster that disrupts the global supply chain — combined with attendant confusion and uncertainty — will directly affect asset valuations and appraisals.
Under such circumstances, ABLs should move quickly to understand the following key questions, among others:
- How does the event affect imports and exports?
- What industry sectors are most vulnerable?
- What industries could face particularly increased demand in the near or medium term for inventory?
- How long will the supply chain disruption likely last?
- What valuation distortions from government and other forms of intervention can be expected?
- How will the event affect valuations?
Key Factors That Drive Post-Disaster Valuations
The Japanese crisis and its effect on the global supply chain offer several key considerations for ABLs in the wake of a natural disaster.
Beware of the risks of overestimating the duration of supply chain disruptions, and as a result, understating the value of assets in affected industry sectors. When dealing with asset valuations immediately following a natural disaster, lenders should ask this central question: What are the affected companies’ track records for dealing effectively with calamities? If a substantial level of resilience already exists, then ABLs may want to assume that recovery times will be faster than what “at the moment” projections indicate and plan accordingly.
For example, in the weeks and months following the Japan disasters, many people quickly assumed that the global supply chain for electronics (encompassing everything from semiconductors to hardware), automotive goods (replacement parts, in particular) as well as related machinery and equipment would be affected in many areas for close to, if not over, one year. But, in fact, Japanese companies have historically been standard-bearers for crisis preparedness and responsiveness, and this most recent natural disaster reinforced this collective track record. Widespread industry and economic data demonstrate that the electronics supply chain from Japan — including the highly sensitive semiconductor industry — has resumed precrisis production levels by now. Industry studies also indicate that the Japanese automotive supply chain, which has recovered far more quickly than anticipated, should be operating at 90% of pre-earthquake levels by the fall of this year.
Asset mobility and interchangeability are critical to the valuation process. The more lightweight and interchangeable the manufacturing assets in affected industries are, the more minimal asset value fluctuations will be postdisaster. For example, panic and power outages in the Japanese electronics industry caused immediate supply interruptions, but the supply chain was restored within two weeks. In large part, the fact that electronic components are typically lightweight and can be air-freighted helped the situation considerably, thus avoiding log-jammed shipping ports. At the same time, basic electronic components are often interchangeable among different electronics brands. Due to the minimal interruption, there was no meaningful impact on asset prices in this space.
By contrast, automotive parts in any large quantity are cost-prohibitive to air-freight for an extended period of time. Automotive subassemblers and sequencers that Gordon Brothers Japan monitored postdisaster felt longer-lasting effects. Plant shutdowns and delays at Japanese ports resulted in line shutdowns in the United States. These types of shutdowns, in turn, can decrease revenues for up to three months if a company is unable to secure alternative sourcing. Notably, although this is bad for business, it is not necessarily bad for asset-liquidation values, as short supply typically increases demand and price.
As always, consumer seasonality matters. Once they establish a more realistic time horizon for supply chain recovery, ABLs should bear in mind the seasonality of consumer behavior and the effect this will have on asset valuations.
As just one example, if the Japan disaster had occurred in the few months prior to either back-to-school sales in August and September (when product needs to be shipped) or in the few months prior to the retail sales peak in December, it is likely that price distortions for electronics inventories would have been significantly more pronounced.
Distinctions between converted and nonconverted assets become more important than ever before. ABLs, more than most other professionals, recognize that not all assets are equal. History — including recent experiences with Japan-affected industries — shows that converted assets will often enjoy a substantially higher recovery rate than nonconverted assets for the simple reason that nonconverted assets have greater potential to remain that way for at least some time to come. Converted assets, which can be used immediately, are less affected by upstream delays in the supply chain.
Silicon, for example, is a commodity with continuous production. If electronic components are backlogged and manufacturers simply cannot produce circuit boards, the price of silicon will drop because suppliers cannot immediately cut off the supply.
In the immediate aftermath of the Japan disaster, before electronics prices stabilized in fairly short order, this was precisely what we witnessed. Semiconductor mills, mainly in China, began to cut pricing on silicon metals used in semiconductors as the production of silicon wafer in Japan came offline due to the earthquake.
Industry sectors that will contribute to recovery and rebuilding efforts generate significant increases in demand — and price. Demand for assets not related in any way to these sectors will tend to go down at the same time. As with all forms of supply chain disruption, natural disasters will also generate a boost for certain industry sectors that are involved with repair and recovery. ABLs will need to build the generally positive trends into their loan models, at least in the near-to-medium term, with respect to inventory, related machinery and equipment valuations for companies in recovery-related industries.
Specific examples related to the Japan experience encompass construction and building materials, such as steel and concrete, as well as energy alternatives, particularly coal. In the months since the earthquake and concomitant disasters, demand from Japan has consistently increased for these materials, with correspondingly higher prices across the board.
Similarly, retail appraisal values for basic foodstuffs and supplies within the nation increased temporarily, but continuing power shortages have boosted broad Japanese demand for energy-efficient appliances on a more sustained basis.
At the same time, although Japan has historically been a sizeable market for luxury-branded goods, the disaster exacerbated the already downward-trending demand for such inventory, which affected the value of such assets within the nation.
Expect direct and indirect government financial intervention and the accompanying distortions that brings. Almost immediately following the earthquake and related disasters, the Japanese government undertook a raft of financial initiatives designed to stabilize and support the economy. These ranged from special government loans for the private sector, to partnering closely with lending institutions, to rescheduling, and, in certain instances, waiving loan repayments. History shows that such government financial intervention in the wake of a natural disaster is to be expected but can have unintended consequences for appraisals and valuations within certain industry sectors.
As just one example that is even closer to home, immediately before and subsequent to the Katrina disaster, the Federal Emergency Management Agency (FEMA) rushed to purchase 145,000 trailers and mobile homes. The agency reportedly spent a total of $2.7 billion purchasing these units through no-bid contracts. As the affected areas were rebuilt and the FEMA-purchased trailers were no longer occupied, these trailers were auctioned off by the agency, causing the mobile home industry to see a glut of inventory that depressed valuations on both ends of the supply chain in the subsequent years.
For the ABL, such circumstances offer both opportunities and challenges to consider carefully. For ABLs that already have provided loans to affected companies, government financial intervention may be a source of reassurance when it comes to repayments, and ABLs should therefore not revise loan covenant assumptions dramatically. Most important, however, is that government intervention almost always introduces an element of uncertainty that can make accurately predicting postdisaster asset valuations and appraisals challenging.
Natural Disasters Versus Man-Made Disasters
It is, of course, worth noting that these strategic considerations for ABLs vis-à-vis natural disasters are not precisely the same as for man-made disasters (terrorist attacks, bursting asset bubbles and systemic financial failures). Arguably, man-made disasters can have more far reaching, deleterious and therefore deeper ripple effects for the ABL.
Quite simply, this is because man-made disasters undermine fundamental trust in our institutions and in the good faith and reciprocity that is required for any successful transactional environment. As one key example of this, in many respects, the global economy continues to suffer the long-tail effects of the Lehman Brothers collapse and the subsequent financial crisis, which was, in essence, a crisis of trust and confidence.
How the ABL Can Prepare for Disasters
Based on the Japan disaster, ABLs should ask themselves, “If a natural disaster struck in a major contributing nation to the world economy today, what would be the impact on our loan portfolio?”
Although it is impossible for ABLs to have a detailed disaster plan for every loan in their portfolio, there are certain actions they can undertake in order to react best to the opportunities and challenges that a natural disaster would create.
- First and foremost, work closely with your asset-valuation advisors to understand thoroughly what is in your loan portfolio, set regular loan portfolio reviews and understand the weeks of supply metrics stemming from today’s just-in-time inventory philosophy.
- Perform your loan-portfolio assessments with a particular eye on better understanding where the assets on which you are lending fall within the global supply chain of inventory and related machinery and equipment.
- Determine how susceptible clients in your loan portfolio generally are to fluctuations in asset valuations and what the “before and after” picture could look like in the event of near-term and severe supply contractions.