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.


…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.


(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.

return on equity (II): cleaning up a mess

a company as a project portfolio

Every company can be seen as a collection–maybe a portfolio–of investment projects, each with its own risk and return on investment characteristics.  This is not the only way of looking at a business.  And it’s probably not the best way, as the ugly collapse of the conglomerate craze in the US during the 1960s illustrates.  Nevertheless, looking at the business as a project portfolio highlights an issue that the top management of a firm can face.

the BCG growth/cash matrix

One common way of sorting projects  is to use the growth/cash generation matrix invented by the Boston Consulting Group in the 1960s: stars = high growth, high cash generation cash cows = low growth, high cash generation questions marks = high growth, low cash generation dogs = low growth, low cash generation. loaded with canines What do you do if you’re a company with a boatload of dogs?  ..or just one really big dog. To see the issue clearly, let’s simplify: –let’s say that equity is your only source of funding (no working capital or debt), and –let’s say you have only two projects, with 100 units of equity invested in Project 1, which earns 20/year, and 100 units in Project 2, which earns 1/year. the problem: the sterling 20% return on equity of Project 1 is obscured by the near breakeven status of Project 2. The overall return on equity for the company of 10.5%. Why is this bad? Wall Street loves high return on equity–and loathes low return.  And the computer screens that even many professional investors use to narrow down the vast universe of available stocks into a more manageable number to investigate will toss a company like this on the reject pile.  So you’ll be overlooked. What should management do? The possibilities: 1.  eliminate inefficiencies in Project 2 and in doing so raise the ROE to a respectable figure 2.  if that’s not possible, sell Project 2 to someone else who, mistakenly or not, thinks he can do #1 3.  close Project 2 down and write the equity off as a loss, or 4.  divide the company in two, and either (a) spin Project 2 off as a separate entity (that is, give it to shareholders) or (b) gradually sell it to the investing public.

cutting to the chase

Let’s skip down to #4, since what we’re ultimately concerned with is what motivates a company to create a REIT.

why #4?

How can a company get into a situation where solution #4 is the best alternative? In my experience, this almost always involves long-lived assets, where the investment is big, and a company puts all the money in upfront, in the hope of getting steady income over 20 or 30 years.  Examples: a chemical plant, container ships, hotels, or mineral leases. One of two things happens –either the company soon discovers it has wildly overpaid for the assets, or –some unforeseen change, like technological change or a sharp increase in input prices, alters the economics of the project in a fundamentally negative way.

two forms of cash generation

Any project generates cash in two ways: –a return of the capital invested in the project, and –profits. In describing Project 2 above, I said it produces 1 unit of profit per year.  But that profit is after subtracting an expense of, say, 5 as depreciation and amortization. D&A are ways of factoring into costs the gradual wearing out of the factory, the machines or the other investment assets that are used in making the project’s output. In the case of a motel, D&A is a charge for the gradual deterioration of the structure over the years, until the building is too shabby to be used any more and must be razed and rebuilt.  Similarly, big machines either wear out or become technologically obsolete. The key fact to note is that depreciation and amortization aren’t actual outflows of cash–they’re inflows.  But they’re classified as return of capital, not as profit.  (I think this make sense, but I’ve been analyzing companies for over 30 years.  Don’t worry if it doesn’t to you.  Fodder for another post on cash flow vs. profits, and why it makes a difference to investors.)

In the case of Project 2, the actual cash inflow is probably 6/year (depreciation and amortization of 5 + profit of 1).  That’s a 6% yield.  But it’s also a millstone around the neck of the company that launched the project.  It’s return on equity–a key stock market screening factor–will be depressed for as long as it owns the project. On the other hand, to an income-oriented buyer a yield of 6 units/year for the next 20 years is nothing to sneeze at.  At a price of 85, the yield would be an eye-popping 7%.

this has happened before

In the early 1980s, T Boone Pickens, a brilliant financial engineer if no great shakes as an oilman, wildly overpaid for a number of oil and gas leases in the Gulf of Mexico.  Once he realized these properties would struggle to make back his initial lease payment and would never make money, he repackaged them as a limited partnership and spun it off. Around the same time, Marriott did the same thing.  It made a similarly unwise decision to build a number of very expensive luxury hotels.  When bookings started to come in, the company saw the properties would provide large cash flow–but never any profits.  So it rolled them all up into a limited partnership, which it sold to retail investors. In both cases, management “repurposed” assets to emphasize their cash generation characteristics rather than their lack of profitability.  Both also used a tax-minimization structure to enhance the assets’ attractiveness to income-oriented individual investors. REITS do the same thing. More tomorrow.