The Cruelest Shortage and Supply Chain Snafu

I've been away from writing Empire Financial Daily for a couple of weeks... The market has fallen about 4% since I last filed a daily about three weeks ago... but the damage feels much worse. It's always hard to get into the groove with writing these essays after briefly stepping away, and given the incredible […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] The Cruelest Shortage and Supply Chain Snafu By Berna Barshay --------------------------------------------------------------- [The 'inflation proof' stock no one's talking about]( Legend who bought Amazon at $48 and Apple at $0.35 is pounding the table on a [$4 inflation-proof play](. --------------------------------------------------------------- I've been away from writing Empire Financial Daily for a couple of weeks... The market has fallen about 4% since I last filed a daily about three weeks ago... but the damage feels much worse. It's always hard to get into the groove with writing these essays after briefly stepping away, and given the incredible volatility in the market, I had grand illusions of coming back and attempting to make sense of what just happened while offering a playbook for going forward. But that essay is a little too ambitious for today... It's a dark day in America. Like many people in this country, today I woke up sad, angry, frustrated, and tired. This isn't the right forum for discussing these tragedies that keep on happening and why they keep happening. But it feels wrong to jump into talking about business and the markets like nothing has happened. So I'm acknowledging the elephant in the room: the tragedy in Uvalde, Texas, where 19 elementary school students and two teachers lost their lives. As a country, we need to do better. Let's examine another story grabbing the headlines, which happens to also be a tale of America failing to protect its children... Unless you've been living under a rock, you've heard about the baby formula shortage gripping this country. Shortages have been a hallmark of the last few years. Early in the pandemic, the cause was demand surges for essential items. Soon, lockdowns and shutdowns of production facilities would lead to the emptying of inventory stores in the supply chain that would take months to refill. Once production was back to normal in the U.S., outbreaks and subsequent shutdowns across the globe led to inventory upheavals in products ranging from semiconductors to sneakers. Bottlenecks at ports, shortages of rail cars, too few truck drivers... All these complications in the freight and transportation system served to worsen shortages, as did the obvious fact that you can't make a 100-part product with 99 parts. Failure in any one part along a supply chain – no matter how small – can bring a production system to a crashing halt. But as annoying as it may be to not be able to find your favorite brand of cereal, wait nine months for a couch to be delivered, or hand your kid an "IOU" at Christmas for a PlayStation 5... these are all admittedly high-class problems. All these are examples of delayed gratification for wants, not needs. The baby formula shortage is an entirely different animal... Formula is a life-or-death need. For many people, formula is not a choice... It is the only option for feeding a baby. Without food, eventually people will die... and unlike adults, the time a baby can survive without food is measured in days, not weeks. As of a couple of weeks ago, 40% of formula was sold out nationwide, and some states were even worse than that. The problem had been building for months... The out-of-stock rate for baby formula at retailers hovered in the low to high single digits during the first half of 2021, but then began to build steadily starting last summer. As out-of-stock inventories became more and more frequent, consumers took notice of the empty shelves – and those who could afford to stocked up. It's the same kind of hoarding that exacerbated shortages in the earliest months of the pandemic. As a result, some retailers started putting limits on how many units customers could purchase in a transaction. As scarcity soared in recent weeks, parents of infants scrambled to find formula, sometimes going to great lengths, as described on CNN.com a couple of weeks ago... Finding standard formula has become difficult for parents, many of whom described the extraordinary lengths they've gone to in order to score even a single can or bottle. Specialized formula is even harder to locate amid the widespread shortage. Parents are driving to neighboring states to try their luck, and many are pleading for help on social media, imploring strangers to share or even barter any extra supply they may have. As often is the case in adversity, people have banded together to find solutions to the problem. My social media feeds have been filled with people sharing screenshots of store shelves where new supplies of formula have just come in. I've even seen women in the community offering to donate their excess breast milk to those in desperate need. While it's heartwarming to see communities come together like this, in a wealthy, industrially advanced country such as the U.S., it's hard not to wonder... how did we get here? Like most times the supply chain breaks down, it's not just one factor at play... It's the perfect storm of a few factors. The more obvious causes of the shortages are a bacteria and a virus. You've probably heard about the U.S. Food and Drug Administration ("FDA") shutdown of the Abbott Labs' (ABT) formula plant in Michigan, where a bacteria called cronobacter sakaszakii was found. Stopping production at that plant as well as recalling product from it that had already been distributed to retailers was one big factor in the current shortages. We're also still feeling the impact of the COVID-19 virus on formula supplies, long after lockdowns may have interrupted production. That's because back in 2020, parents hoarded formula, afraid of shortages like the one we are seeing now. As a result, sales of formula dropped in 2021, as it took time to work down the inflated amounts of inventory sitting in Americans' pantries and cupboards. Manufacturers, seeing the drop in demand in 2021, cut production. That production cut met a small uptick in the birth rate in 2022 as well as a recent dramatic drop in breastfeeding rates. This alone would have left supplies tight even were it not for the problems at Abbott's Michigan facility. One other factor is how concentrated the baby formula industry is, and how much government policies have encouraged that concentration... Using data from 2008, just three manufacturers make up nearly 98% of all U.S. formula sales. Abbott, which makes Similac, had a 43% share in 2008. Mead Johnson, a division of the U.K.'s Reckitt Bensicker (RKT.L) and maker of Enfamil, sat just behind at 40%. And Nestle's (NESN.SW) Gerber was the third player with a 15% share. In consumer-packaged goods ("CPG"), as in most industries, great benefits come from economies of scale. Not only do production costs come down on a per-unit basis, but marketing costs and overhead can be amortized over a bigger sales base. Bigger is almost always better for the bottom line in CPG, so it's no surprise that the industry has consolidated this much, even if it is a risk factor to availability. On top of the natural inclination to seek scale to bolster the bottom line, U.S. food policy has encouraged this kind of consolidation. The largest purchaser of infant formula in the U.S. is the Department of Agriculture, through the Special Supplemental Nutrition Program for Women, Infants, and Children ("WIC"). More than half of all baby formula gets purchased through WIC programs. In each state, WIC determines one preferred vendor to fulfill formula vouchers in the state. The three big formula companies compete vigorously to win these contracts, offering huge rebates to state WIC programs, because history shows that whichever company gets the contract will tend to absolutely dominate market share within the state... Retailers tend to give much more shelf space and better placement to the state's WIC brand partner. Smaller stores may only stock the WIC brand and no others. Pediatricians may also revert to recommending their state's WIC brand to new parents, regardless of whether they are part of the WIC program. Becoming the state's chosen WIC vendor can lead to huge market share gains... For evidence, consider how much market share Abbott lost to Mead Johnson when California switched from Abbott to Mead as its WIC partner back in 2007... Source: U.S. Department of Agriculture Abbott's market share in California eventually fell from 90% to 5%, while Mead Johnson's rose from 5% to 95%. So while the baby formula market is extremely concentrated, it is even more concentrated within states, with one provider often making up the bulk of sales in the state. So when one supplier has a problem – in this case, Abbott – states that have a relationship with that manufacturer for WIC are going to see more severe shortages. The argument for sole manufacturer sourcing within a state was that the fierce competition for the contracts led to lower per-unit costs for the government – and this is indeed true. But it also has led to structural vulnerability and outsized regional dependence on just one corporation. Good intentions have gone awry here with regulatory policy... Few would argue that making sure no baby starves isn't a noble goal, but by trying to ensure food security in the cheapest way possible, the government enabled regional monopolies to be built, which has now ironically compromised the food security originally being sought. --------------------------------------------------------------- Recommended Link: [TIME IS RUNNING OUT!]( Whitney Tilson just warned America of an upcoming inflation shock that has the potential to drastically shift the markets for the remainder of the year and beyond. If you missed out, there's still time... But you must act fast! Those who don't act soon could feel the wrath of more inflation pain. You see, Whitney gave away his entire inflation playbook to prepare you for this upcoming shock. He even gave away the name and ticker symbol of a stock that could double your money. And yes... he gave all of that out 100% FREE. [Click here to see the replay and get Whitney Tilson's inflation playbook](. --------------------------------------------------------------- WIC isn't the only policy that contributed to this crisis... Trade regulations are also at fault. FDA regulation is extremely tight on the import of baby formula. As a result, most European baby formula is illegal to buy in the U.S., usually because of minor reasons like improper labeling. Ironically, many European formulas meet U.S. standards – and may even exceed them in nutritional benefit, having banned corn syrup and other undesirable sugars from the products. Most Canadian formula does meet U.S. FDA standards... but a new trade agreement drafted under the Trump Administration dramatically increased the tariffs on many Canadian imports, including baby formula. Now the tax on Canadian formula imports can be as high as 17% or more – which makes importation a high-cost solution. As with the way the WIC programs are structured, the intentions here were good: The idea was to build up the U.S. formula industry and increase self-sufficiency. But what was well-intentioned has backfired and left us vulnerable when it comes to supplies of an essential good. In a quest for self-sufficiency, we have been brought to our knees. The Atlantic spoke with an economist from the libertarian think tank the Cato Institute. His comments made me think about how the baby formula shortage is really a microcosm for how trade policy that seeks to make us stronger can actually weaken us... "The U.S. is a captive market for domestic dairy producers like Abbott, and during times of crisis, the lack of alternative supplies becomes a pretty big problem," Scott Lincicome, the director of general economics and trade for the Cato Institute, a libertarian think tank, told me. Conservative populists and even liberals who are skeptical of globalization sometimes argue that if the U.S. made everything within our borders, our economy would be more resilient. But the baby-formula shortage suggests that things don't always work out that way. Instead, we're seeing what happens when we reduce trade with other countries for an essential good: We're more vulnerable to emergencies like a bacteria-infested plant in Michigan. There is a better way. "What we should want to maximize is total global capacity and system-wide flexibility and dynamism," Lincicome said. "The location of the supply doesn't matter as much as having as much as possible within a nimble system that can replace one plant's supply with another's." Just last week, Congress voted to allow WIC to source more from foreign suppliers in an effort to ease the shortage. The bill passed overwhelmingly with 414 House votes, with just 9 Republican votes in opposition. It was unanimous in the Senate. A separate bill seeking an extra $28 million in funding for the FDA to work on easing the shortage has failed to get the same kind of bipartisan support. Meanwhile, President Joe Biden has invoked the Defense Production Act to step up formula production and has allocated government planes to fly in formula from other countries and move supplies around domestically to address shortages. This crisis shall pass, but the debate over whether domestic or global supply chains are more resilient in the face of shocks will persist. I'll return with the mailbag tomorrow... Has the baby formula shortage affected you or someone you know? I'd like to hear your experiences. Share your thoughts in an e-mail by [clicking here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). Regards, Berna Barshay May 25, 2022 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2022 Empire Financial Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Empire Financial Research, 601 Lexington Ave., 20th Floor, New York, NY 10022 [www.empirefinancialresearch.com.]( You received this e-mail because you are subscribed to Empire Financial Daily. [Unsubscribe from all future e-mails](