following the money; the fashion industry and working capital

I was reading an article in the Financial Times the other day about pandemic-created issues in the high-fashion modelling agency business–something I’ll confess to knowing virtually nothing about.

Part of my interest is just securities analyst nerdiness. Part is that the FT is a highly reliable source, providing information that’s almost always accurate. Also, I think the story illustrates the more general point for us as investors that a simple look at receivables and payables on the balance sheet can provide a lot of insight into the economic power relationships in an industry.

The main players here:

–the models. They’re freelancers. They get assignments from modelling agencies, pay all their own expenses and get paid after they do the work (in arrears, as the accountants say)

–the agencies. They’re middlemen. They get assignments from branded merchandise companies and fill them with models they’re in contact with. The agencies also get paid in arrears

–the fashion brands. After crafting selling campaigns for their merchandise, they hire agencies to fill their need for photography and runway models. The brands pay in arrears.

in general…

…in a commercial relationship the entity that receives credit (or services in advance of paying for them, which is basically the same thing) is in a stronger position than the one that supplies it.

–Models would seem to be in the worst position of the three groups, since they pay for all their working expenses in advance and get paid only after the assignment is over. In accounting jargon, they are converting an asset on their personal balance sheets, cash, into another, less valuable, asset, receivables (meaning trade IOUs)

–Agencies are in a somewhat better position. They make a few phone calls, get an assignment from a fashion brand (the money from which they list on their balance sheet as a receivable) and line up a model (whose compensation they list on the liabilities side as a payable). Assuming the agency is a money-making enterprise, the receivable is considerably larger than the payable)

–Fashion brands hold the market power. They order a model and pay the agency for services afterwards. They list what they’ve promised to pay the agency on their balance sheets as a payable.

This is the first round of analysis: having all payables and no receivables is the best position to be in; having receivables without payables is the worst. For firms with both, the net of the two–payables minus receivables–is what counts.

round two

Round one is usually enough to get a sense of market power. There are a couple of wrinkles to consider.

–not everybody pays on time; in fact, not everybody pays, period. The balance sheet reserve for doubtful accounts will reveal what a firm’s historical experience has been

–if receivables are due to be paid to you in three months but your payables are due in two weeks, you have a cash flow problem. The typical solution is a growing amount of short-term debt. This situation is also a sign of lack of market power. Customers can demand very favorable payment terms, while suppliers insist on being paid almost immediately.

about the modelling industry in particular

According to the FT, modelling agencies are facing hard times for several reasons. Fashion houses are doing what many big firms do when times are tough–they are slowing down payments to their suppliers. As well, some smaller clients have gone out of business before paying their bills, making those receivables worth little, if anything. Both developments make it harder for agencies to pay models who have already completed assignments.

more changes brewing

Worse for agencies and models, the FT says fashion brands are being forced by travel restrictions and social distancing rules to innovate away from the elaborate, model-intensive runway shows they traditionally stage to introduce new merchandise. The same for elaborate photo shoots used to generate publicity materials. In fact, Gucci and Burberry have both used their own employees as models to launch new collections.

My guess is that many pandemic-forced “fixes” by the fashion brands will become permanent. Two typical motivations: the firms will find that eliminating large in-person events and lavish photo displays will have little negative effect on revenues, so their necessity will begin to be questioned; it’s usually much easier to convince the board of directors to cut large outlays than it is to get the funds reinstated.

Perhaps most important, if I’m correct, the weakening of the scope and influence of these expensive displays, or their demise, will remove a significant barrier to entry for newer, smaller brands.

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