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.

 

 

 

high margins vs. low

Many traditional growth investors characterize the ideal investment as being a company with substantial intellectual property–pharmaceutical research or computer chip designs or proprietary software–protected by patents.  This allows them to charge very high prices, relative to the cost of manufacturing, for their products.

Some go as far as to say that the high margins that this model generates are not just the proof of the pudding but also the ultimate test of any company’s value.

As I mentioned yesterday, the two issues with this approach are that: the high margins attract competition and that the price of maintaining this favorable position is continual innovation.  Often, successful companies begin to live the legend instead, hiding behind “moats” that increasingly come to resemble the Maginot Line.

In addition, high margins themselves are not an infallible sign of success.  Roadside furniture retailers, for example, invariably have high gross margins, even though their windows seem to be perpetually decorated with going-out-of-business signs.  That’s because furniture is not an everyday purchase.  Inventories turn maybe once or twice a year.  Margins have to be high to cover store costs–and, in normal times, to finance their inventories.

Although I am a growth investor, I’ve always had a fondness for distribution companies–middlemen like auto parts stores, or pharma wholesalers, or electrical component suppliers, or Amazon, or, yes, supermarkets (although supermarkets have been an investment sinkhole that I’ve avoided for most of my career).  My experience is that the good ones are badly misunderstood by Wall Street, mostly, I think, because of a fixation on margins.   In the case of the best distribution companies, margins are invariably low.  So that’s the wrong place to look.

Where to look, then?

the three keys to a distribution company:

–growing sales, which will leverage the fixed costs of the distribution infrastructure,

–rapid inventory turns, measured by annual sales/average inventory.  What a “good” number is will vary by industry.  Generally speaking, 10x is impressive, 30x is extraordinary,

–negative working capital, meaning that (receivables – payables) should be a negative number   …and getting more negative as time passes.  Payables are the money a company owes to suppliers, receivables the money customers owe to the company.  For a healthy firm, its products are in high enough demand that customers are willing to pay cash and suppliers are eager enough to do business that they offer the company generous payment terms.

A simple example:  all a company’s customers pay for everything (cash, debit or credit) on the day they buy.  Suppliers get paid 90 days after delivery of merchandise.  So receivables are zero; payables will end up averaging about 90 days of sales.  This means the company will have a large amount of cash, which will expand as long as sales increase, available to it for three months for free.

not just cash generation

The best distribution companies will also have a strategically-placed physical distribution network of stores and warehouses.

They’ll have sophisticated inventory management software that ensures they have enough on hand to meet customers’ needs + a small safety margin, but no more.  It will also weed out product clunkers.

They’ll have stores curated/configured to maximize purchases.

Monday

…the curious case of Whole Foods.

 

 

the A&P bankruptcy

a Chapter 11 filing

The Great Atlantic and Pacific Tea Company has just filed for Chapter 11 bankruptcy protection.  According to the radio reports I heard yesterday, this is the second time in three years and the fifth overall bankruptcy filing for the venerable supermarket chain.

A&P said it did so in order to preserve the flow of fresh produce and other perishables into its stores.

In one sense, it’s not surprising that supermarket chains might be in trouble, given the relentless expansion of Wal-Mart into grocery over the past couple of decades, the rise of Whole Foods et al, and the change in lifestyle and consumption habits being spearheaded by Millennials.

A&P as a useful template for investors

A&P, however, is also an important illustration of how creditworthiness can deteriorate in ways investors seldom suspect.

the key:  trade creditors’ bankruptcy standing

The key to understanding what is going on is to realize that in Chapter 11, trade creditors go to the bottom of the list of who gets repaid.  They rank ahead only of equity holders, who as a general rule are wiped out completely.  Trade creditors usually fare little better, if at all.The amounts involved can be substantial.  In the A&P case, for example, McKesson is listed as a major unsecured creditor, owed $39+ million.

trade creditors defending themselves

Knowing that any outstanding bills will likely be voided by a bankruptcy court, suppliers of inventory and services watch the creditworthiness of their customers very carefully.  They hire third-party credit services to provide periodic reports, and they monitor any differences in customer payment patterns very carefully.

If a customer shows A&P-like symptoms (according to Bloomberg, A&P had been having net cash outflows of $14.5 million monthly during fiscal 2015), a vendor can take several related actions to lower its risk:

–it can send less merchandise on credit to the worrisome customer

–it can send lower-value or lower-quality merchandise, or only items that have an extremely short sales cycle

–it can refuse to extend credit; it will demand payment in advance.  This is a lot more serious than it sounds, since the customer may be depending on being able to use the cash from a sale for a week before paying the vendor.

(An aside:  I’ve even seen instances where a trade creditor has sued the customer for payment, knowing that a favorable judgment will force bankruptcy.  The idea is that some third party who doesn’t want a Chapter 11 filing–a bank or other long-term debt holder, or an equity holder–will settle the debt while the case in court.)

Of course, none of this is good for the cash-strapped concern.

reversal of form

Once the firm is in bankruptcy, the situation reverses completely.  Suppliers no longer have to worry about having unpaid bills nullified.  And the bankruptcy judge will ensure that trade creditors are put at the front of the line to be repaid.  So just as the flow of new merchandise into a cash-short enterprise slows down as Chapter 11 becomes a realistic possibility, it speeds up again once the company has filed.

 

 

the inventory problem: holding costs vs. stockout risks

The domestic auto industry reported November vehicle sales yesterday.  The numbers were very good.  But most of the (negative) media attention centered on the elevated level of inventories–about three months worth of sales–on dealer lots. Yes, that may eventually be a worry, but I don’t think it’s the right way to look at the current situation.

The auto news also gives me the occasion to write about the balancing act every manufacturer and retailer faces in deciding how much inventory to have.

the simplified story

There’s an often convoluted dance between supplier and distributor/end user about return policy, payment terms, co-op advertising…in negotiating over how much of a product to buy and at what price.  Nevertheless, the decision about how much inventory to hold ultimately comes down to weighing two opposing risks:

stockout costs.  This is when your brilliant national advertising campaign, your sterling reputation for high quality and service–or sometimes just random factors–prompt a potential customer to either go online or enter a physical store with the intention of buying an item.

You’re out of stock.  You try to interest him in a substitute, or promise to have the item tomorrow.  He says thanks, leaves and buys the item somewhere else.

You’ve lost a sale.  And the person you’ve disappointed is at least marginally less likely to have you first on his list next time he’s shopping.

That’s stockout costs.

inventory holding costs are much more straightforwardly quantifiable.

There are three main factors:

-financing costs, which in today’s world are negligible;

-liquidity risk of having your capital tied up in inventory rather than in cash during the time it tales you to make a sale; and

-the possibility that the items either become obsolete, go out of style, or–like fresh food–exceed their shelf life before they can be sold.  Then your asset has become a wirtedown.

complications

(In the stock market, there are always complications.)

In good times, companies want to hold more inventory (because they see stockout as a greater risk than holding costs); in bad times sentiment reverses and everyone wants to hold as little as possible.

If prices are rising, procurement managers see the chance to make windfall profits and order more than they need; if prices are falling–as is chronically the case in industries like consumer electronics–inventories are kept trimmed to the bone (except in really good times, when everyone throws caution to the winds).

In industries with low fixed, high variable costs, manufacturers see no percentage in upping production volumes.  In industries like autos, with high fixed costs and therefore tons of potential operating leverage, there’s a tremendous incentive to make extra units once a firm reaches breakeven.

The competitive structure of an industry doesn’t change the nature of inventory risk, but it can change who it is who’s assuming them.  This may not always be obvious from even a detailed study of the working capital sections of the balance sheet.  If a manufacturer were to have a policy of unlimited returns (that would be crazy, but let’s just suppose), then it–not anyone farther down the distribution chain–would ultimately be responsible for any unsold goods.

 

More tomorrow.

 

 

 

 

 

J C Penney (JCP) just borrowed $850 million…why?

the 8-k

Yesterday, JCP announced in an 8-K filed with the SEC that it has borrowed $850 million on its newly expanded $1.8 billion bank credit line   …even though it doesn’t really need the money right now.  It also said it’s looking for other sources of new finance, which I interpret as meaning finding someone to purchase new bonds or stock.

My guess is that as the company needs seasonal working capital finance it will borrow more on the credit line rather than deplete its cash balances, which should now amount to around $1.8 billion.  This despite the fact that paying the current 5.25% interest rate on the $850 million will cost the company $44.6 million a year.

Why do this?

We know that the Ackman/Johnson regime inflicted terrible damage on JCP.  Part of this is actual–the stuff about lost sales and profits that we can read in the company’s financial statements.  Part of it is psychological–we don’t know how deeply JCP is wounded, how long it will take for the company to heal, nor even how much healing is possible.

a psychological plus

By borrowing the money now, JCP is in a sense buying itself an insurance policy on the psychological/confidence front by establishing several things:

— it now has enough cash to be able to weather two more ugly years like 2012, rather than one.  This gives it much more breathing room to negotiate any asset disposals, to say nothing of getting customers back into the stores.

–it has lessened the possibility that its banks will withdraw or reduce the credit line if sales continue to deteriorate.  After all, they now have their $850 million that’s in JCP’s hands to protect.

–it demonstrates to suppliers that the company has ample cash to pay for merchandise.  JCP will likely get better payment terms with the money on the balance sheet than without it, although it’s not clear to me that payables still won’t shrink this year.   More important, in my view, is that suppliers won’t restrict either the quantity or selection of merchandise they deliver to JCP for fear they won’t be paid.

–it avoids the negative publicity (see my 2011 post on Eastman Kodak) that would likely have been generated were JCP to wait until it genuinely needed the funds, or until its banks might be getting cold feet.

so far, so good

So far, Wall Street is taking the move in stride.  The stock showed no adverse effect from the announcement.  And in pre-market trading today, it’s up.

operating leverage (III)

You may notice that I’m working my way down the income statement in discussing operating leverage.  Yesterday I wrote about the leverage that comes from product manufacturing.  The key to finding this leverage is identifying fixed costs.

All the profit action takes place between the sales and gross profit lines.  This is also the most important place to look for operating leverage for most firms.

operating leverage in SG&A

Today’s topic is the operating leverage that occurs in the Sales, General and Administrative (SG&A) section of the income statement.

The general idea is that large parts of SG&A expense rise in line with inflation, not sales.  So if a company is growing at 10% a year while inflation is 2%, SG&A should slowly but surely shrink in relative terms.  And the company will have an additional force making profits grow faster than sales.

For many non-manufacturing companies, this is the major source of operating leverage.

why this leverage happens

There are several reasons for SG&A leverage:

–most administrative support functions reside in cost centers, meaning their management objective is to keep expenses in check.  Employees here are not directly involved in generating profits, so they have no reason to demand that their pay rise as fast as sales.

–as a company gets bigger and gains more experience, it will usually change the mix of administrative tasks it performs in-house and those it outsources, in a way that lowers overall expense.

–a small company, especially in a retail-oriented business, may initially do a lot of advertising to establish its brand name.  As it becomes larger and better-known, it may begin to qualify for media discounts and be able to afford more effective types of advertising.  At the same time, it will be able to rely increasingly on word-of-mouth to gain new customers.  In addition, it will also doubtless be shifting to more-effective, lower-cost internet/social media methods to spread its message.

negative working capital

Strictly speaking, this isn’t a form of operating leverage.  It has its effect on the interest expense line.  And in today’s near-zero short-term rate environment, it’s not as important as it normally is.  But, on the other hand, one day we’ll be back to normal–when being in a negative working capital situation will be more important.  It’s also one of my favorite concepts.

If a company can collect money from customers before it has to pay its suppliers, it can collect a financial “float” that it can earn interest on.  The higher sales grow, the bigger the amount of the float.  If the company is big enough (or, sometimes, crazy enough) it can even use a portion of the float to fund capital expenditures.  The risk is that the float is only there if sales are flat or rising.  If sales begin to decline, either because of a cyclical economic downturn or some more serious problem, the float begins to evaporate, as payments to suppliers exceed the cash inflow from customers.

Lots of businesses are like this.  For example, you eat at a restaurant.  You pay cash.  But the restaurant only pays employees and suppliers every two weeks.  And it pays is utility bills at the end of the month.

Hotels are the same way.  Utility companies, too.  Amazon and Dell, as well.