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.

negative working capital

Working capital is all about the inventory cycle–meaning the journey from cash in the bank to production materials to finished goods to sales and back to cash.  For pharma distributors the cycle may take two weeks, for a scotch distillery six years.  Conventionally, however, working capital is defined as assets and liabilities being used over a 12-month period.

Manufacturers typically have lots of working capital, much of it tied up in inventory.  Retailers of consumer durables and jewelry do, too.

There’s another class of companies, however, like utilities, restaurants, hotels…that typically have negative working capital, meaning the company doesn’t need to feed cash into the production process to keep it going.  Instead, operations generate cash, at least for a time.   And the amount of cash grows as the business expands.

Why is this?

–A restaurant is an easy example.  In the US, sales happen either in cash or by credit card, where the funds are available for use almost immediately.  So it has no receivables on the asset side of the balance sheet and it has an inventory of maybe a couple of days’ food.  On the liabilities side, rent, utilities, salaries and food ingredients are paid for an average of, say, two weeks after their inputs are used.  So once it gets going, the restaurant has many more current liabilities than current assets and it has the use of the upfront payments for about 14 days.  If the restaurant prospers, the gap between liabilities and assets may expand in percentage terms, but even if not the cash “float” will grow in the absolute.

–An online service charging a monthly or yearly subscription fee–music, books, news, Adobe Cloud–works the same way.  People pay in advance for services provided bit by bit over the term of the subscription.

–hotels, cruise ships and public utilities, too.

There’s a temptation for negative working capital companies, seeing apparently idle cash of $100,000, then $125,000, then $175,000 (much bigger figures for publicly-traded companies) just lying on the balance sheet for years, to use this money to, say, open a second restaurant that would potentially double the size of the firm, create economies of scale…  In fact, the only company I can think of that steadfastly refused to touch any portion of its cash buildup was Dell in its heyday as a PC manufacturer.

The problem:  suppose a negative working capital company takes a risk with its “float” money and stumbles.   In our restaurant example, let’s say the company takes $50,000 out of its cash balance, uses it to set up a second location and the second restaurant flops.  All of a sudden, salaries, utilities, rent, food bills come due and there isn’t enough money.  Whoops.

Suppose the business begins to shrink.  If so, so too does the cash pile.  But at least initially the liabilities remain the same.  Potential trouble, unless the company adjusts very quickly.

More relevant today, suppose there’s a quarantine and incoming cash dries up completely.  In the restaurant case, in less than a month, the cash is all gone!   And the owner has to decide whether to inject more capital into the business, close its doors, or not pay the bills and see what happens.

CCL

A case in point is cruise line Carnival (CCL), which raised about $6 billion last week in a stock/bond sale, shortly after drawing down much, if not all, of its $3 billion bank credit lines.  Three entries on the balance sheet explain these moves to me.  As of last November CCL had $518 million in cash on the asset side:  liabilities:  $4.7 billion in customer deposits + $1.8 billion in accrued liabilities (= other stuff).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

warts becoming visible (i)

receivables vs. payables

I’ve always been a fan of analyzing working capital, which shows the flow of cash in the inventory cycle, from the bank account to raw materials to finished goods to sales and getting paid.

There are lots of standard ratios, but my favorite has always been receivables vs. payables.  Taken in its simplest form this shows how eager people are to obtain the company’s goods (small receivables, which means little financing provided by the company) vs. how eager suppliers are to have the company as a customer (large receivables, which means easy payment terms).

Whenever markets go south, some limitation or other–or some abuse–of financial reporting rules invariably comes to the fore.   This time, for me at least, the culprit is payables.

factoring

I’ve known for a long time about factoring receivables, meaning the company sells them to a third party, getting them off the balance sheet.  Whatever the motivations of management, factoring makes the demand from customers and the company’s need for cash look better.

Until the financial crisis of 2008, financial accounting standards did not require that this activity be disclosed to shareholders.  Since then, as I read the FASB rules, big changes in the level of factoring, up or down, must be disclosed   …but nothing else.

reverse factoring

Something I’m just learning about during the current downturn is reverse factoring aka supply chain finance.  It’s the cousin of factoring, but on the liabilities side of the balance sheet.

This one’s a little more complicated, but there’s a bad case where a company arranges for a bank credit line.  A supplier essentially takes his payable to the bank for payment, creating a loan balance for the arranging company.  But this debt either doesn’t appear, or doesn’t appear in an easily understandable way, in the company financial statements.

This esoteric financing ploy only came to the market’s attention in the bankruptcy of Carillon in the UK in early 2018.   But the recent call by the big four accounting firms for the SEC to clarify what disclosure of reverse factoring must be made suggests that
Carillon is not an isolated case.

My sense is that this is not an issue for most companies but that highly financially leveraged firms may be in considerably worse shape than the reported financials show.  This presents a problem for anyone wanting to speculate on a turnaround in world economies or world stock markets.  The most aggressive strategy would be to bet on the companies that have been pummeled on fears they won’t survive the pandemic-related downturn.  To my mind, however, these are precisely the firms where risk of large “hidden” debt is the greatest.

 

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

Trumponomics to date

a plan?

It’s not clear to me whether Mr. Trump’s macroeconomic policy forms a coherent whole (so far it doesn’t seem to).  I’m not sure either whether, or how well, he understands the implications of the steps he’s taking.

The major thrusts:

income taxes

Late last year, the Trump administration passed an income tax bill.  It had three main parts:

–reduction in the top corporate tax rate from 35% (highest in the world) to 21% (about average).  This should have two beneficial effects:  it will stop tax inversions, the process of reincorporating in a foreign low-tax country by cash-rich firms; and it removes the rationale for transferring US-owned intellectual property to the same tax-shelter destinations so that royalties will also be lightly taxed.

–large tax cuts for the wealthiest US earners, continuing the tradition of “trickle down” economics (which posits that this advantage will somehow be transmitted to everyone else)

–failure to eliminate special interest tax breaks, or adopting any other means for offsetting revenue lost to the IRS from the first two items.

Because of this last, the tax bill is projected to add $1 trillion + to the national debt over time.  Also, since the reductions aren’t offset by additional taxes elsewhere, the tax cuts represent a substantial net stimulus to the US economy.

This might have been very useful in 2009, when the US was in dire need of stimulus.  Today, however, with the economy at full employment and expanding at or above its long-term potential, the extra boost to the economy is potentially a bad thing,  It ups the chances of overheating.  We need only look back to the terrible experience of runaway inflation the late 1979s to see the danger–something which would require a sharp increase in interest rates to curtail.

interest rates

Arguably, the new income tax regime gives the Fed extra confidence to continue to raise interest rates back up to out-of-intensive-care levels.  More than that, the tax cut bill seems to me to demand that the Fed continue to raise rates.  Oddly–and worryingly,  Mr. Trump has begun to jawbone the Fed not to do so.  That’s even though the current Fed Funds rate is still about 100 basis points below neutral, and maybe 150 bp below what would be appropriate for an economy as strong as this.  Again this raises the specter of the political climate of the 1970s, when over-easy money policy was used for short-term political advantage  …and of the 20%+ interest rates needed in the early 1980s to undo fiscal and monetary policy mistakes.

trade

This is a real head-scratcher.

“national security”

The Constitution gives Congress control over trade, not the executive branch of government.  One exception–Congress has delegated its power to the president to act in emergency cases where national security is threatened.  Mr. Trump argues (speciously, in my view) that there can be no national security if the economy is weak.  Therefore, every trade action is a case of national security.  In other words, this emergency power gives the president complete control over all trade matters.  What’s odd about this state of affairs is that so far Congress hasn’t complained.

 

More tomorrow.