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Chapter5 EfficacyofWorkingCapitalManagement&ShortTermDebt
Workingcapitalmanagementhasacrucialimpactonacompanysreturnoncapitalemployed (RoCE)andoperatingcashflowsandhenceitscreditquality.Thekeyitemsofworkingcapital, inventoryandreceivablesarepartofcurrentassetswhilesupplierpayablesarepartofcurrent liabilitiesofacompanysbalancesheet.Workingcapitalcycleismeasuredbyaddingthe numberofdaysofinventorytothenumberofdaysofcustomerreceivablesandsubtractingthe numberofdaysofpayables. Theinventorydays,asafirstapproximation,canbeobtainedbycalculatingtheratioofthe inventorytocostofproductionandmultiplyingtheratioby365,thenumberofdaysofayear. Thisfirstapproximationassumesallinventoryisfinishedgoods.Tobemoreprecise,theraw materialinventoryshouldbedividedbyannualrawmaterialpurchase,andtheresultingratio multipliedby365.Thefinishedgoodsinventorycanbecalculatedfromthefinishedgoods inventoryandtheannualcostofgoodsproduced.Theworkinprogressinventorydayscanbe calculatedbydividingtheworkinprogressinventorybytheaverageofannualrawmaterial costsandannualcostofgoodsproduced,andmultiplyingtheresultantratioby365.Thetotal inventorydaysisobtainedfromthesumoftherawmaterialinventorydays,workinprogress inventorydaysandthefinishedgoodsinventorydays.Insummary, Rawmaterialinventorydays=(Rawmaterialinventory/Annualrawmaterialconsumption)*365 Workinprogressinventorydays=(Workinprogress/0.5*(Annualrawmaterialconsumption+ annualcostofgoodsproduced))*365 Finishedgoodsinventorydays=(Finishedgoodsinventory/Annualcostofgoodsproduced)*365
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Totalinventorydays=Rawmaterialinventorydays+Workinprogressinventorydays+ Finishedgoodsinventorydays Thenumberofdaysofcustomerreceivablesiscalculatedbydividingthereceivablesamountby theannualsalesandmultiplyingtheratioby365.Thenumberofdaysofsupplierpayablesis obtainedbydividingthepayablesiteminthecurrentliabilitiessection(includingallaccrued expenses)ofthebalancesheetbyannualusageofsuppliergoodsandservices,andmultiplying theratioby365.Hence, Receivablesdays=(Receivables/Sales)*365 Payabledays=(Payables/Annualsupplierpurchases)*365 Puttingitalltogether, Numberofdaysofworkingcapital=Inventorydays+receivablesdayspayabledays Obviously,theaimofanycorporationwouldbetokeepthedaysofworkingcapitalatthe lowestpossibleleveltoreducethecostoffinancingtheworkingcapitalrequirements.Some companiesevenmanagenegativeworkingcapitaldayswhichiswonderfulifthecompanyisa profitableone.Fornonprofitmakingentities,negativeworkingcapitalleadstofearamong suppliersthattherewouldnotbeadequatecashtomeetthepayableobligationsoncethe inventoryofthecompanygetsconvertedtocash(negativeworkingcapitalcompaniestypically donothavethenormalworkingcapitalcycleofconversionofinventorytoreceivablestocashto paymentofpayables,butskipthereceivablesstage). Assupplychainsgetglobalized,thesechainscangetveryfragileonaccountofcompanies resortingtojustintimeinventorymanagementtopreventresourcesbeingstuckinworking capitalfinancing.Whentherelianceisonasinglesupplierorafewsuppliersinthesame country,anydisruptioninthesupplychaincoupledwiththecompanyhavinglowlevelsof
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ImportanceofWorkingCapitalManagementtoCreditQuality
Thecreditanalyststhoughtsareonthedriversofreturnoncapitalemployed(RoCE)(tobe discussedindetailinchapter7),forthatisthekeyfactorintheabilityofanentitytogenerate cashtopayforitsfixedobligations.Workingcapitalmanagementhasakeyroleinthis. ConsiderthebusinessatatypicallovehotelinTokyo.Guestspayrestchargesfortheusage ofaroomforafewhours.Theypayincash.Therearenoreceivables.Thereisnounsold inventory.Everymorning,finishedgoodsinventory(ofroomandservices)ismadeavailable, whichifnotsold,hastobewrittendowntozeroattheendtheday.Therearesomepayables onaccountofsalariestobepaidinarrears.So,everyday,onasustainedbasis,thecompany generatescashflowwhichcanbequicklyusedtopaydownthedebttakenforcreatingthe facility.Thereisnoneedforshorttermfundingtobuyinventoryorfinancereceivables.The numberofdaysofworkingcapitaliszeroornegativeonasustainablebasis.Andbecausethe sameroomisusedseveraltimesoverthecourseofaday,thecapitalresourcesarenotidleand hencetheRoCEshootsup. NowconsideranautomobilecompanyinDetroit,USA.Longbeforethecompanyclosesthesale ofacar,itmustbuysteel(rawmaterialinventory),bashthemetalintoacar(workin progressinventory)andstorethecar(finishedgoodsinventory)forafewdaysbeforemoving ittoitsdealersparkinglot.Thesuppliersofsteelandotherancillarieswouldgivethe automobilemakersometimetomakethepayments(creatingthenumberofdaysof payables).Inturn,theautomobilemakerprovidesthedealerssometimetopayforthe
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
finishedgoods(creatingthereceivabledays).Ateverystageintheprocess,thereisriskto thecreditworthinessoftheautomobileenterprise.Becausetheautomobilecompanymust buytherawmaterial,paywagestoconverttherawmaterialintoafinishedproductbeforeit cansellthegoodsandgetcashfromthedealer,theenterpriseneedsworkingcapitalfinancing fortheperiodbetweenprocurementofrawmaterialandrealizationofcash.True,thesupplier hasprovidedsometimetomakethepaymentfortherawmaterialsbutthisbenefitisnullified bythetimeprovidedtothedealertopayfortheinventoryofcars. Inaddition,ifthesupplierisinanotherpartoftheworld,theautomobilecompanymightwant tobuyandstoreadditionalrawmaterialinventoryinexcessofwhatheneedsforimmediate productionasabufferagainststoppageofproductionshouldtherebedisruptionatthe suppliersend.Stoppageofproductioncanbeverycostlyinsomeindustriessothepurchase andmaintenanceofadditionalrawmaterialinventoryasaninsuranceagainstdisruptionof globalsupplychainsmightbeworthit.Infact,thecreditanalystanalyzingcompanieswhere stoppagescanbecostlyshouldworryifthecompanyismaintainingultralowinventoryto releasecashandjustifiesitundersomemanagementjargon. ContractstructurescancausehighinventoryandhighworkingcapitalneedsDetroitcarmakers signedcontractswithunionsinthe1990swhichpaidworkerswhethertheyworkedornot.This ensuredthatfixedcostswerehigh.Theonlywaytoreduceunitcostwastoincreasevolumeof production.Thisincreasedproductionhadtobeoffloadedathighdiscountstorentacar companies.Highvolumeofnonprofitablesalesleadtofurtherneedforunproductiveworking capitalfinancing,besidesleadingtothedestructionofresidualvalueofthecompanysvehicles (whichthecarmakersalsoguaranteedinsomeleaseagreementsthroughtheirfinancearms).
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Itisintheareaofworkinprogressinventorythatgoodcompaniessetthemselvesapartfrom therest.In2008,HondatooklessnumberofhourstoproduceacarthanGeneralMotors.That translatestoseveraldayslowerworkinprogressinventory.Inthefinishedgoodsarena,ifthe dealersarenotabletopushcarsales,theywouldbeslowtodemandfreshfinishedgoods inventoryfromthecarmaker,translatingintohigherfinishedgoodsinventoryattheproducers end.Ofcourse,asthetechnologiesformanagingsupplychainshaveimproved,thecarmaker wouldbeawareonarealtimebasisaboutthesalesatthedealersendandhencemake adjustmentstohisproductionscheduleandpurchaseordersforfreshrawmaterialinventory, thusreducingidlerawmaterialinventorydays.So,overtime,productivityimprovement technologiescanreduceworkingcapitaldaysandleadtobettermanagementofshortterm resources.Thishowevercannotcompensateforlongertermlossofcompetitivenessofa companysproductsandassociatedlowersales. Intheearly1990sitwasfashionabletobecalledacostcutterwhowouldsqueezesuppliersto theverybonebydemandingaggressivepricingandpaymentterms.Thatwouldincreasethe numberofdaysofpayablesandreducetheshorttermdebtrequiredforworkingcapital financing.Aggressivecostcuttersdrovetheirsuppliersintobankruptcy.Japanese manufacturerswhoworkedcloselywiththeirsupplierswereabletomanagesustainable increaseinworkingcapitalefficiencies.Inthelate1990sToyotagotintotroublewhenitforgot itscorephilosophyofworkingwithsuppliersandinsteadstartedsqueezingthemforcost savingsevenifthosesavingswereachievedthroughcuttingcorners. Yes,workingcapitaldaysneedtobekepttoabareminimumtotheextentthatprevalentsupply chaintechnologycanpermit.Onceattheefficiencyfrontier,anyfurtherattempttosqueeze cashoutofthechainwouldbecounterproductiveandresultinlossoflongterm competitiveness.Attheefficientfrontier,whilekeepinganeyeonworkingcapital
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
LIFO,FIFOandvaluationofInventory
Asperaccountingstandardsofmostcountries,inventoriescanbevaluedonafirstinfirstout (FIFO)basisoronalastinfirstout(LIFO)basis.FIFOvaluationofinventoryoverstatesearnings duringperiodsofhighinflation,particularlyforcompaniesinthecommoditybusinesses, becausethecostofinventorypurchasedearlierislowerthantheinventorypurchasedlater. Thatlowersthecostofgoodsproducedandinflatestheearningsbeforeinterestandtax.LIFO accountingismoreconservativeatitreflectscurrentcosts,whetherhighorlow.Butitrequires writedowninvalueofinventoryduringperiodsoffallingprices. Overaperiodoftime,aslongasacompanyisconsistentinitsinventoryvaluationmethodology, itdoesnotreallymatter,asacreditanalystissupposedtoworryaboutreturnoncapital employedoverabusinesscycleandnotatasinglepointoftime.Butananalystshouldwonder whenacompanychangesitsaccountingpolicyfromLIFOtoFIFO.Thereasonisnotthe consequentoverstatementofearnings(thoughtheanalystshouldestimatethat),butthe
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ReceivablesManagement
Receivablesmanagementusuallytakesabackseatcomparedtoinventorymanagement.For creditandequityresearchers,twofacetsaboutreceivablesmanagementwouldbeofinterest. First,aresalesbeingachievedthroughpromisingfavorabletermsofpayment(longercredit periods)whichareoutofwhackwithindustrynorms?Second,whatisthequalityofthe receivablesaretheylikelytoberecoveredinfullaspertermsofpaymentorisonelikelyto witnesswriteoffs? ChannelStuffingandReceivablesValuationatSunbeam,CocaColaandMcAfee Companiesresorttochannelstuffingwhenrealsalesarenotgrowingandshareholdersdemand action.Marketingmanagers,whenunderintensivepressure,forcedealerstoacceptinventory higherthantheirrequirementsothatthecompanycanbookadditionalrevenueinaquarter. Thedealermightputupwiththisforcedsalebecauseheisofferedcashincentivesorsharp discountsonhispurchase.Else,hemightbearmtwistedintotakingthesupplyonaccountof lowbargainingpower.Eitherway,suchabusinesspracticeisnotsustainable.Weakeningthe financialstrengthofadealerisharmfulforlongtermsalesasthedealermightgooutof business.Andifalotofincentiveshavebeenofferedforsecuringthemovementofgoodsto thewarehouseofthedealer,itweakensthefinancialsofthecompany.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Creditanalystsshouldspotpossiblechannelstuffingearly,becausewhenthechannelstuffingis revealed,thenegativeenergyaroundthecompanysfinancialsanddoubtsabouteverythingin thereportedfinancialscancausevariousstakeholderstobackoutatthesametime,potentially causingadefault.Channelstuffingisafraudandcanexposeacompanytoregulatorysanctions andfines. Bankruptmakerofhouseholdproducts,SunbeamCorporationwasinvolvedinchannelstuffing amongotheraccountingwrongdoings.Thecompanygavefinancialincentivestodealersin 1997totakesupplyofgoodsbeforetheywereneededtomeetcustomerdemand.Its wholesalersagreedtoholdSunbeammerchandiseoveraquarterendwithoutacceptinganyof therisksofownership.Thecompanysagreementwiththewholesalerstatedthathecould returnallmerchandisetoSunbeamifhecouldnotsellitandthatSunbeamwouldreimburseto andfroshipmentexpensesandothercostssuchasinsuranceexpenses.Thewholesalers actuallyreturnedthegoodsaquarterlater.So,theincreasedrevenuedisclosedwasachieved throughwastefulcostssuchasincentivesandcostofshippingthegoods.Thesharpincreasein receivablesbeyondnormallevelsresultedinincreaseindebttofinancethosereceivablesand shouldhavebeenapointertothecreditanalystonthesuspiciousnatureofthesales. EvencompanieslikeCocaColahavebeenallegedtohavebeeninvolvedinchannelstuffing.The companywasallegedtohaveboosteditsreportedrevenuesin1999(particularlyinthe Japanesemarket)byenticingbottlerstotakeonconcentratesbeyondwhatwasrequired.In 2008thecompanysettledarelatedlawsuitfor$137.5millionwithoutadmittinganywrong doing.Andchannelstuffingcanextendbeyondphysicalgoods.Between1998and2000,IT securityvendorMcAfeeoverstatedrevenuesby$622millionandunderstatedlossesby$353 million.Thecompanyofferedsharpdiscountstothosedistributorswillingtoholdinventory. Whenthoseinventorieshadtobeultimatelyreturned,thecompanyuseditsownsubsidiary,
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
NetTools,torepurchasetheinventory(anaddedreasonwhyonehastolookatthe consolidatedfinancialsofanentity).ThecompanyhadapartnerincrimeinITdistributor IngramMicro,whoseprofitmarginswereartificiallyboostedbyitsdealingswithMcAfee.The casewassettledwithMcAfeepayingafineof$50millionandIngramMicropayingafineof$15 million.PharmaceuticalmajorBristolMyersSquibbinflatedits2001revenueby$1.5billion throughchannelstuffing. Alliedtochannelstuffingisthepracticeofbillandholdinwhichtheseller,whohasnot shippedthegoods,bookstherevenuesbecausethebuyerhasagreedtotakethegoodsbut wantstoholdoffshipping.Atleast,thispracticedoesnotresultinwastefultoandfroshipping costs.
PayablesManagementdonoharm
Creditorsshouldbewaryofcompaniesthatgetintocontinuousdisputeswiththeirsuppliers andburntheirbridgesduringsuchfights.Itisnotpossibleforcompaniestosurviveatthecost oftheirsuppliers.Becauseoftheirbargainingpower,companiesmightbetemptedtoarmtwist theirsuppliersintoacceptingunreasonablylowmargins(whichdonotgeneratetherequired returnoncapitalemployed)orextendedpaymentterms.Whenthesuppliergetsintofinancial troubleonaccountofsuchdisputes,thewholesupplychainisdrasticallyweakened.Creditors havetounderstandthatasupplychainsurvivesonthestrengthoftheconsolidatedfinancialsof thewholechainaswellashowtheprofitabilityofthesupplychainisdistributed. Understandingthecreditstoryofthewholesupplychainisfundamentaltoanalyzingitsfuture prospects.Iftheprofitabilityatthetopofthechainisachievedthroughstealingfromthe intermediatestages,itwillnotlast.Shortcutapproachestocostcuttingbytearinguplongterm suppliercontractslookimpressiveatfirstsight.Butthelongtermeffectsareseldompositive.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Howmuchbetteritisforallstakeholdersifsupplierpricesarebroughtdownbyaprocessof collaborationandsupplierinvolvementindesignsratherthanthroughdiktats.Creditorsneed tostartworryingwhenreturnsoncapitaltargetsareachievedthroughevernastierdisputes withsuppliersonoperatingmarginissuesandunwarrantedincreaseinpayableperiods. ThedifferentialsupplychainmanagementofGeneralMotorsandToyotaisagoodexample.In theearly1990s,GeneralMotorshadanaggressivepurchasingmanager,IgnazioLopez,who wouldgetintoslangingmatcheswithsuppliersbythreateningtotearexistingcontractsand demandinghugediscounts.GeneralMotorsachievednothingsubstantialorlastingthrough thoseencounters.Toyotasrelationshipwithitssupplierstookthecompanyfromstrengthto strength.LopezdefectedtoVolkswagen,butnotbeforeGMaccusedthepurchasingmanagerof givingawaytradesecretstoVolkswagen.AggressivecostcuttingbyDetroitscarmakersdrove supplierslikeVisteon,LearandDelphiintobankruptcy,whichimperiledthecompanies themselves.Toyotagotintrotroublelaterwhenitletgoofitscollaborativeapproachinits dealingswithsuppliersinmarketsoutsideJapan.Beforeitcoulddevelopacollaborative relationshipwithsuppliersincountriessuchastheUS,thecompanytookitseyeofftheballand focusedongrowthandmarketshareatallcosts. Fromacreditpointofview,onelikestoseeincreasedoperatingmarginscomingfromincreased saleprices,notbasedoneverdecreasingsuppliercosts.Andincreaseinpayableperiods,unless itisanindustrywidephenomenon,hastobelookeduponwarily.Suppliersincludelessorssuch aslessorsofcommercialpropertyaswellasequipment.
PrepaidItemsinCurrentAssetsandCurrentLiabilities
Prepaiditemsontheliabilitiessideofacompanysbalancesheetaregenerallygoodfora company.Thereverseistrueforprepaiditemsontheassetside.Thatisbecause,inthecaseof
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
HowshouldWorkingCapitalbefinanced?
Obviouslyonecannothavetheentireworkingcapitalrequirementsfinancedbyshorttermdebt. Itwouldnotgivecomforttocreditors,particularlyifthecompanyisnotfinanciallyverystrong. Forafinanciallychallengedcompany(wearenotreferringtoadistressedcompanyhere), suppliersrelyonconversionofinventorytoreceivablesintocashforpaymentoftheir obligations.Andthesuppliersandfinanciersofworkingcapitalneedadequateallowancefor slippagesuchasdestructioninvalueofinventory,eitherduetopricefallsorobsolescenceand noncollectabilityofsomeofthereceivables. Inthecaseofstrongcompanies,thoughtheoreticallythesuppliersandshorttermlendersrely onliquidationofreceivablesforpayment,moneybeingfungible,itdoesnotmatterifthe supplierandshorttermcreditorsarepaidoutofoverallcorporateprofitability(theoverall profitabilityitselfmeansthatthereiscashavailableafterpaymentstosuppliers).Insuchacase, theshorttermcreditorsandsuppliersneednotworryiftheentireworkingcapitalrequirements arefundedwithshorttermdebt.WalMartcanfinanceitsworkingcapitalthuswithoutworry
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
creasesdevelopingontheforeheadoftheshorttermcreditorsandsuppliers.In2009, Amazonssuppliersdidnothavetoworryaboutthenegativeworkingcapitallevelsofthe company(infactitisapositivebonuswhichcontributedtooverallcorporateprofitability,lower leverageratiosandlowercapitalemployed).Butadecadeago,whenAmazonwasastartup makingoperatinglosses,thecompanywasluckytohaveastockmarketbubbleon,which ensuredforbearanceofallsupplierstoitsnegativeworkingcapitalsituation. Donotdrawcomfortfromlinesofcredittheymightbepulledoutwhenyoureallyneedthem underthegarbofsomematerialadversechangeclause.Priortothecrisisintheautoindustry in2007,Forddrewitslinesofcreditandkeptitintheformofcashhenceitlivedtofight anotherday.Theonlywayforcreditorstoinvestinsuchtouchandgocompaniesisthrough convertibleinstrumentswheretheygetaportionoftheupsideifthingsturnoutalright(sothat thereisadequatecompensationfortakingonventurerisk).
InventoryManagementintheMiningandOreProcessingIndustries
Themantraforsuccessofametalproducersoperationisthemanagingofinventoryefficiently throughreductioninproductionvolumeinatimelymannerinresponsetolowerdemand.The beststudyinthisoccurredduring2008andthefirstquarterof2009.Duringthefirstthree quartersof2008,commoditypriceswerehittingalltimehighs.Duringthenexttwoquarters, demandcollapsedinresponsetotheglobalfinancialcrisisandpricesissomecasesfellbymore than50%.IntheUnitedStates,steeldemandinQ1of2009was49%belowthatinQ1of2008. Whenpricesfalldrastically,theinventoryheldbythemetalproducerssharplyloosesvalue.If youcalculatedfinishedgoodsinventorydaysatthatpoint,itwouldbemeaninglessduetothe sharpfallinvalueoftheinventory.Thecostofgoodscalculatedonatrailingbasiswouldnot bearmuchrelationshipwithwhatwillhappeninthefutureasunitcostswouldfallaswould
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
volumeofsales.Thisisparticularlytrueformetalproducersindevelopedcountries.In addition,duringtheseperiods,thequalityofthereceivablesfallssharplyasendusersretrench. Whendemandfallsandinventorygoesup,metalproducershavetocutproduction.When productionhappensatlessthanfullcapacity,thefixedcostofproductionwouldhavetobe sharedbyfewertonesofproduction,causingproductioncostperunittogoup.Howthemetal producercanrespondtothiscrisisimpactshiscreditquality.Acompanywithmultipleunits spreadacrosstheworldcanrespondtothecrisisbyoperatingsomeunitsat100%capacity whilekeepingotherunitsinhotidlecondition.Becauseofthis,thecompanysfixedcostper tonegoesupmuchlowerthanthatforasingleunitproducerwhichoperatesatlessthan100% capacity.Singleunitproducersgettremendousscaleadvantageswhentheeconomyis performingwellandarebetterforshareholdersastheycapitalizeonsharedservices.Butfor creditors,multipleunitsarebetterbecausethecreditorisinterestedinwhathappensinthe downscenarioandnotintheupscenario. Inthecaseoforeproducers,ratherthaninventoryandworkingcapital,thebiggestriskis reserveestimate,whichcanoverstateorunderstateprofitability.Actualreservesoforesmight bemuchdifferentfromestimates.Ifreservesareoverstated,thedepreciationanddepletion accountintheincomestatementmightbeunderstated,thusoverestimatingprofitability.Also, extractioncostsgoupasreservesdepleteinotherwords,lastyearscoststructuremightnot beagoodindicatorofnextyearscostsifmostoftheminesoftheproducerareageing.In addition,suchcompanieshavetobeinvolvedinexplorationtoreplenishreserves,whichisa highlyspeculativeactivity. Iftheexpensesofacompanyinexplorationactivitiesareahighpercentageoftotalcosts,the companymightnotbesuitableforcreditinvestments.Insuchcompanies,itmightbebetterto
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ringfencetheexplorationactivitiesinaseparateSPVwhosemaximumpossibleliabilitiescanbe quantifiedbytheequityinvestmentsmadebytheparentminingcompany.Theparent companycanissuelowcouponbondswhichalsoprovidepotentialupsidebygivingrightsonthe sharesoftheexplorationSPV.Iftheexplorationactivitiesaresuccessful,theinvestorgetsthe upsideifnot,hisprincipalisprotected.Amodelforthisisthesocalledshareholderdebentures issuedbyBraziliancompanyCompanhiaValeDoRoDoce(Vale).Valeisthelargestproducer ofironoreintheworldandthesecondlargestnickelproducer.Thecompanywasfoundedby theBraziliangovernmentin1942.Itwasprivatizedin1997.Whenitwasprivatized,Valeissued shareholdersdebenturetotheBraziliangovernment,whichcouldthenparticipateinthe potentialfuturebenefitsderivedfromexploitingcertainmineralresourcesthatwerenottaken intoaccountindeterminingthepurchasepriceofsharesduringprivatization.Basedonthis,the debentureholdershavetherighttoreceivesemiannualpaymentsequaltoacertain percentageofrevenuesfromidentifiedmineralresources.Thiscouldalsobeamodelthatcan befollowedbyothergovernmentsforprivatizingresourcerichcompanies/infrastructureassets, thetruepotentialofwhoseresources/assetsarenotfullyknown,soastoavoidcontroversies thatnationalresourcesweresoldforasong. AcreditinvestorinacompanylikeValeshouldlookcloselyattheheadcapitalizedmine developmentcosts.Thishastobewrittendownovertheusefullifeofthemine.Thereisalot ofuncertaintyinthelifeofamineasmentionedearlier.Socreditorswoulddowelltostress testtheusefullifeofthemineandthencheckforthecompanysabilitytoserviceitsdebt.At theendof2008,Valehad$16billionofcapitalizedminedevelopmentcostsonitsbalance sheetandrailroadstothosemineswerecapitalizedtotheextentof$5.8billion.Iftheuseful lifeofthemineislessthanprojected,thesecarryingvalueshavetobewrittendownovera shorterperiodoftime.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ArcelorMittalWellpositionedtohandledownturninSteelPricesaftertheCreditCrisis Duringthelongrallyincommoditypricestillthemiddleof2008,manycompanieswentona debtfinancedacquisitionbinge.ArcelorMittal,theworldslargestproducerofsteelcameinto existencefromthecombinationin2006ofMittalSteelandLuxemburgbasedArcelor(atthat timetheworldslargestandsecondlargeststeelcompaniesbyproductionvolume).HowMittal Steelcameintoexistence,throughtheconsolidationofdistressedsteelassetsspreadacrossthe worldoverathreedecadeperiod,isastoryinitsownright.ArcelorMittalmakesarangeofhigh qualitysteel,semifinishedcarbonsteelproductsandstainlesssteelproducts. BecauseArcelorMittalhaspredominantlybeeninvolvedinacquiringexistingassetsasan industryconsolidator,andnotasacreatorofnewassets,risksemanatenotfromproject executionbut,fromthecreditorviewpoint,overpayingforassets,thussplatteringtheasset sideofthebalancesheetwithgoodwillwhichispronetobeingwrittendown. Aswasthecasewithothermetalproducers,in2008,ArcelorMittalhadenteredintoseveral forwardpurchaseagreementsforbuyingoresatfixedpricesforafewyearsintothefuture.The companydidnotseemtobehedgingfinishedproductspricerisk.Whendemandfell precipitously,thesecontractscausedrawmaterialinventorytogoup.Becauseofthis ArcelorMittalsrawmaterialinventorywentupfrom$6.7billionattheendof2007to$9.7 billionattheendof2008.Thevolumeimpactisunderstatedbecausethepricedcrashedsothe jumpinvolumeofrawmaterialinventorywasmorethan50%.Iffinishedgoodsweresold forward,thedropindemandwouldnothavecausedfinishedgoodsinventorytogoup.The addedadvantage,fromacreditorsshoes,iswhenpricesfall,thecompanywouldhavemarked tomarketgainsonitsforwardsalecontracts,whichbecauseofproducermargin,wouldbe higherthanlossesfromforwardpurchasecontractsforores.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ArcelorMittal,fromits2008annualreport,seemedtohavehadforwardpurchaseagreements forrawmaterials,freight,energyandemissionrightsandnoforwardsaleagreementsonits products.Hencethevolumeofitsfinishedgoodsinventorysharplyrosetheinventoryfellin valuetoasmallextentfrom$8.1billionattheendof2007to$7.8billionevenasunitprices fellsharply.Theeffectisexacerbatedwhenoneconsidersthatthecompanyhadtakenawrite downinvalueofinventoryof$3.04billion.Thecompanyseemedtohavebeenconvincedthat commoditypriceswouldcontinuetogoup,hencethedesiretobenefitfromhigherfinished goodspricesandmeetingthedemandwithlowerrawmaterialsprices.Ofcourse,this calculationturnedwrongsoin2008,themarkedtomarketlossesonitsforwardpurchase agreementsofrawmaterialswas$721million.Hadthecompanyhedgedfinishedgoodsprices orsoldforwardfinishedgoods,theeffectwouldnothavebeensoprecipitous.Attheendof 2008,thecompanyhadpurchaseagreementsthatamountedto$29.7billion. Fromacreditanalystsperspective,afteraperiodofrisingcommodityprices(sayfouryears),it wouldbewisetoassesstheimpactofallforwardpurchaseandsaleagreementsshouldprices andcostsfallbyasmuchas50%.Likewiseafteraperiodoffallingprices,itmakessenseto assesstheimpactonaccountofforwardsaleandpurchaseagreementsshouldtherebea50% jumpinprices.Ofcourse,atechnicalanalyst,whobelieveswhathappenedyesterday,islikely tohappentomorrow,wouldscoffatthiscautionaryanalysis,butwecanlivewiththat. Inventoryadjustmentscanbeextremelybrutalinthecommoditiesbusiness.Inthefirstquarter of2008,ArcelorMittalhadanoperatingincomeof$3.6billion.Thisdroppedtoalossof$4.4 billioninthelastquarterof2008.Astheadjustmentswerecomingtoanend,theoperatingloss inthefirstquarterof2009wasonly$1.5billion.In2007,thecompanyproduced116MTof steel.Thisdroppedto103MTin2008.Thingswouldhavebeenfarworsehaditnotbeenfor
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
theexcellentperformanceduringthefirstthreequartersof2008.Inthefirstquarterof2009, thecompanytookafurtherwritedownofinventoryvalueof$1.2billion. Attheendof2008,ArcelorMittalhadreceivablesof$6.7billion.Thoughitwascomfortingthat nosingleentitycontributedheavilytothereceivables,thefactthat$4.3billionofthe receivableswerefromentitiesoperatingoutoftheslowmovingeconomiesofEuropewouldnot havebeencomforting. Thecompanyhadapreponderanceoffloatingratedebtoverfixedratedebt($22.6billionof floatingrateobligationsversus$6.9billionoffixedrateobligations)likemostcommodity playerswediscussinthesectiononAngloAmericanbelowwhythatisnotalwaysasound strategyfromacreditorsperspective.However,thecompanyreducedtheriskofdefaultby refinancingshortdatedobligationsinthefirsthalfof2009withlongdatedobligations.The companyalsoissuedconvertiblebondswithafacevalueof$2billionin2009.InJune2009, ArcelorMittalissued1.5billionnotesdue2013and1billionnotesdue2016.Theseliability managementmeasuresalongwithdrasticrestructuringshouldensurethatthecompanyis aroundindecentshapetotellthetalewhenthenotesduein2016mature. AngloAmericansFundingPolicyandHedgingPolicyareriskyforCreditors MininggiantAngloAmericanwasfoundedinSouthAfricaasagoldminingcompanyin1917. CurrentlyitisheadquarteredinLondon.Thecompanyisinvolvedintheextractionofbase metals,coal,diamonds(throughits45%stakeinDeBeers),ironoreandplatinum. AngloAmericanhasacoupleofpolicieswhichareworrisomeforcreditors.Firstly,thecompany doesnothedgecommoditypricerisk.Thismightbesensibleforshareholdersandevenfor creditorsprovidedthecompanyhasalowgearing.UnfortunatelythatwasnotsoforAnglo American.Attheendof2008,thecompanyhad$21.7billionequitysupporting$49.7billionof
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
assets.So,drasticfallincommoditypricescanhaveaveryprofoundimpactonthecompanys debtservicingmetrics.InadelayedactionS&PdowngradedAngloAmericanbytwonotchesin thefisthalfof2009fromAtoBBB.Definitelythedowngradeshouldhavehappenedearlier whentherewasasharprunupincommoditypricessuchsharprunupsareinevitablyfollowed bybusts. Secondly,thecompanyhasapolicyofborrowingatfloatingratesbasedonitsthesisthatthisis anaturalhedgeagainstcommoditypricemovements.Thethinkingis,ifeconomicgrowthslows down,commoditypriceswouldfall,impactingthetopline.However,theimpactwouldbe dampenedbecauseinterestratestooshouldfallinresponsetoaneconomicslowdown.The riskherecomesfromthefactthatthishypothesisisnotalwaystrue.Interestratescanfallin responsetoeconomicslowdown,butcreditspreadscangoupashappenedduringthelaterpart of2008.Floatingrateborrowingbasedonthethesisloweconomicgrowthlowinterestrates worksiftheborrowingcostsarelinkedtopolicyratesoryieldsongovernmentsecurities.Ifthe floatingratebaseisonewithcreditrisksuchasLIBOR,thethesismightfailwhencreditspreads goup.Thisisparticularlylikelyifthebankingsystemisaparticipantinthebust. In2008,AngloAmericanhadaworkingcapitalgapof$0.9billion.Yetithadshorttermdebtof $6.7billionoutofatotalnetdebtof$11.34billion.Clearlythecompanywasusingshortterm debt,notforworkingcapitalfinancing,butforprocurementoflongdatedassets.Thiswasnot aoneoffevent.In2007,despitehavinganegativeworkingcapitalgap,thecompanyhadshort termdebtof$5.9billion.Otherminingcompaniesbalancesheets,particularlythosewith fondnessforM&Atransactions,alsohadashorttermdebtflavor.Australianminingcompany RioTinto,onthebackofacquisitionsandotherfinancing,hadshorttermdebtfarinexcessof workingcapitalneedsandisveryvulnerabletoanyfallincommodityprices.Theacquisitions weremadeinthegogoyears,suchastheacquisitionofCanadianAluminummajorAlcan.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
LondonbasedminingplayerVedantahasbeenmorecircumspectinitsacquisitionsitkeptits powderdryandwassittingoncashattheendof2009,whichifusedinafewyearswouldresult insoundRoCE.ItgotoutsensiblyfromthetakeoverattemptofMexicancoppercompany Asarcofromthebankruptcycourt(inbankruptcybecauseofasbestosclaims).Asarcowasfinally takenoverbyGrupoMexico.Vedantascreditstoryisalmostentirelydependentonhow intelligently/foolishlyitdeploysitscashpile. Otherplayersintheminingsectorhadbeenmoreadeptatreducingtheirshorttermdebtin responsetofallingworkingcapitalneedsascommoditypricesanddemandcollapsedinthe thirdquarterof2008.Zug,Switzerlandheadquarteredcopper,coalandnickelproducerXstrata reduceditsshorttermdebtfrom$1.1billionin2007to$794millionin2008inresponsetoits networkingcapitalfallingfrom$3.65billionto$2.73billion.However,in2008,Xstratabecame ariskiercompanyasthecompanyslongtermdebtdrasticallyshotupanditsdebtequityratio rosefrom0.51to0.68.Still,Xstratashouldsurvivethemediumtermtoughtimesaheadfor commodities.Wedontbelongtothecampthatbelievescommoditieswillthrivethemoment westerneconomiesrecoverfromthecreditcrisis,becausefundamentaldemandwillbehit thereashouseholddebtadjuststonewnormallevels.Forinstance,theUSconsumed25%of globalcrudeoilproduction,whileChinaconsumed11%andIndia4%in2008.Asizeable fractionofChinesedemandwaslinkedtoproductionoftrinketsfortheUS.So,iftheUS demandfellby10%andthoseofIndiaandChinaeachroseby10%,(ignoringtheUScomponent ofChinesedemand),thenetresultwouldbelowerdemandforcrude.Whenonefactorsde growthinWesternEuropeandJapan,theeffectwouldbemorepronounced.Thesamewould bethestoryforbasemetals,notwithstandingtheshorttermrunupincommoditypricesin responsetothecontinuingfollyofeasymoneypoliciesinmanycountriesin20092010.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
WhereInventorygainsvaluewithTime:thebigLiquorCompanies
Theamountofinventoryofaspiritsmajorislinkedtohowmuchnonbeerrelatedproductsare partoftheproductportfolio.Forinstance,AsahiBreweries,Japansnumberonebeercompany whichsuppliesmorethan50%ofthedomesticmarket,hascomparativelylowinventory.For theyearendedMarch31st2009,thecompanyhadaninventoryof$1.06billion(oftotalassets of$14.2billion),thattoomostlyinfinishedgoodsinventoryandrawmaterialinventory.UK listedglobalspiritsmajorDiageo(theownerofbrandssuchasCaptainMorganrum,Smirnoff vodkaetc)carriedinventoryof3.16billionoutoftotalassetsof18billionattheendofJune 2009,mostlyinworkinprogressinventory.Thisworkinprogressinventory,alsoreferredtoas maturinginventoriesofwhisky,rumandwines,wasvaluedat2.27billion,whilefinishedgoods inventorywasvaluedonlyat0.5billion.Sincetheseinventoriesarecarriedatlowerofcostor realizablevalue,creditorshaveasourceofcomfort.Aslongasthebrandstrengthoftheliquor ispreserved,theactualvalueofthematuringinventoryismuchhigherthancost.Frenchspirits leaderPernodRicard(whichtookoverAlliedDomecqin2005)recordedworkinprogress inventoryof2.9billion(outoftotalinventoryof3.7billion)ason30thJune2009.The companycarriedtotalassetsof18.43billion.Thematuringinventorieswerepredominantly foruseinwhiskyandcognacproducts. Thereisastrongcorrelationbetweenbrandvalueandrealvaluation(andnotstatedvaluation) ofmaturinginventories.Thedaythebrandslosevalue,thematuringinventorieswouldhavea valueclosetocost.Andcreditorscushionwillgoforatoss.Consideringtheleveragedbalance sheetoftheleadingplayers,creditorsneedeverybitofcushiontheycanfind.Thebiggest worryisashouseholdsofcountrieslikeUSandUKrepairtheirbalancesheets,theymightbe lessandlessinclinedtopayapremiumforCaptainMorganrum.Diageocarriedthevalueofits brandsat4.6billionfortheyearended30thJune2009.Thecompanyhadanoperatingprofit
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ReceivablesarepreferabletoInventoryintheFashionRetailIndustry
Thequickertheobsolescenceinanindustry,thefastertheinventorymustbesoldofftoprevent sharpwritedowninitsvalue.Andtherearefewindustriesthatareaspronetoobsolescenceas thehighfashionindustry.Iftheinventoryisnotsoldoffbytheendoftheseason,theretailer hastotakeasharpbathintermsofrealizedvalue.Andsellingtheinventoryatsharplyreduced pricesattheendoftheseasondoesnotdothebrandanygood.Insuchindustries,itisfar bettertogettheinventoryconvertedintoreceivablesassoonaspossible,evenifthe receivablesarenotexactlyofpristinequality.FashionproductmakerLizClaiborne,supplierto luxuryretailerssuchasMacysreferredtothisinventoryvaluationinits2008Form10Kinthe followingcircumlocutoryway..maximizinginventoryproductivitybytighteningassortments todevelopSKUefficienciesandsharpeningourpricepointstomaximizeinventoryturnsfor bothwholesaleandretailoperations.Fashionhighpriest,AbercrombieandFitchputitas followsthecompanyattemptstobalanceinstocklevelsandinventoryturnoverandtotake markdownswhenrequiredtokeepmerchandisefreshandcurrentwithfashiontrends.The companycreatesaninventoryshrinkreservetotakeintoaccounttheinventorymarkdowns requiredandtreatsitasapartofthecostofdoingthisbusiness. Salesreturnscanbetreatedlikeinventorymarkdown,becausetheeffectonthecompanys profitabilityissimilar.Companiesinthisindustrytypicallycreateasalesreturnreserve.Itis
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
bettertoenticethebuyertobuytheproductsevenifthereisnocertaintythatthecustomer willbesatisfiedandnotreturnthatproduct.Perhapsoncethegoodissold,sheerlethargy mightinducethecustomernottoreturntheproductafarbetterthingtohopeforthanwaittill theendoftheseasonandtakeamarkdowninvalueoftheunsoldinventory.Inbeauty products,salesreturnscanbehigher.EsteeLauder,oneofthemorefamousplayersinthe spacehadsalesreturnsaround4.5%inthethreeyearsupto2009. Becauseofthesharpspeedatwhichthingscanchangeinthisbusiness,itmakessensetohave aslittledebtaspossiblesoastohavethemaximumfinancialflexibilityduringhardtimes,when discretionarybusinessessuchasthisaremostaffected.AbercombieandFitchhasoneofthe fewrightcapitalstructuresforthebusinessithasafairlylowlevelofdebtasdoestheother biggieinthefashionbusinessPoloRalphLauren. MostplayersusetheFIFOmethodofaccountingforvaluinginventory.Mostoftheinventoryis finishedgoodsinventory.Sincethefirstcreatedinventoryislosingvaluerapidlycomparedto laterinventory,inthisindustrythatistherightwaytovalueinventories.Theoptimalmethodis tovaluerawmaterialinventoryusingtheLIFOmethodandfinishedgoodsusingtheFIFO method.Sincefinishedgoodsdominate,acreditanalystneedstofocusonlyonthat.For example,SpanishluxurydressmakerGrupoInditex,theownerofbrandssuchasZara,hadat theendof2008,991millioninfinishedgoodsinventoryoutofatotalinventoryof1.05 billion.Becausethisismeasuredatlowerofcost(FIFO)andrealizablevalue,therecouldbe delaysinmanagementrecognizinglowerrealizablevalues.Inditexhashadahugelysuccessful modelofquickinventoryturnsthishasresultedinthecompany,unlikeitsothercounterparts, havingnegativeworkingcapitalrequirementsrecently.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
UnredeemedGiftVouchersavaluableRevenueStream Aninterestingsourceofrevenueforthefashionretailindustryisunredeemedgiftvouchers. Uponthepurchaseofagiftvoucher,theretailerestablishesaliabilityforitscashvalue.The vouchersthatarelikelytoberedeemedwithinayeararerecordedascurrentliabilities.The liabilityisremovedandincomeearnedasnetsalesuponredemptionbyacustomer.Notall vouchersareredeemedbytheownersofthosevouchersitisafunctionofthestateofthe economy.Thisnonredemptionofvouchersisreferredtoasbreakage.Usually,thecertificates haveanexpirydateiftheyarenotredeemedbythen,theretailercanbookitasother income.Unredeemedgiftsvoucherscanbeasubstantialamountforleadingfashionretailer GAP,itfellfrom$319millionfortheyearendingJanuary2008to$255millionfortheyear endingJanuary2009,inkeepingwiththedeterioratingeconomywhichwouldhavecaused lessergiftgivingandquickerredemption.In2008,redemptionwashigherthanissuanceof freshgiftcardsasopposedto2007whenthereversesituationprevailed.Evenifallthe vouchersweretoberedeemed,itisanexcellentsourceofshorttermfinancingwhichcutsthe needforshorttermborrowings. MarketingCostscannotbesacrificed Thecreditstoryoffashionretailersiscloselylinkedtopeopleplayingaoneupmanshipgamein theirsocialcircle.Itistellingtheiracquaintancesthattheycanaffordtopayforthosegoods andlesslinkedtotheintrinsicvalueofthosegoods.Insuchastateofaffairs,marketing expensesarepivotalforaretailertokeepuptheillusionofdesirabilityofhisproducts.Ifyour neighbordoesnotknowaboutVersace,theconsensusrealityvalueofitsproducts,irrespective ofqualityandintrinsicmerit,falls.IftheneighbordoesnotknowVersace,hedoesnotknow thatthecompanyproducesexpensiveaccoutrementandthewholepurposeofbuyingthe
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Versacedressgoesforatoss.So,theonusisonthehighfashionretailertomarkettheproduct inappropriateforums,notaccessedbytheaverageperson,toletpeopleknowthattheproduct exists,thatitisexclusiveandthatitisnotcheap(everydaylowpricescannotbethemarketing sloganhere).Obviously,marketingisthekeytothecompaniescreditstoryasmuchasresearch anddevelopmentarepartofIntelsinvestmentstory.Youcantcutmarketingexpensesin timesofeconomicslowdowntoboostshorttermprofitability.Anyfashionretailercuttinghis marketingcostsissignalingtocreditorstogetout. GAPreduceditsmarketingexpensesby$97millionin2007andby$41millionin2008.Liz Claibornecutitsmarketingexpensesfrom$205millionin2007to$135millionin2008. AbercombieandFitch,sensibly,basedonaclearunderstandingofwhatitwasselling,cutits marketingexpensesbyonly2%.EsteeLauderactuallyincreaseditssalesandpromotion expensesduringthetoughtimes. Oneshouldbeworriedaboutthefutureoffashionretailers,asconspicuousconsumption,not onlybecomeslessaffordableinanenvironmentofhighhouseholddebt,ititselfmightbecome lessfashionable.Whatif,afterthetwodecadeconsumptionbinge,thriftbecomesthenewchic? Whatifsomeveryrichpeoplestartflyingeconomyclassonairplanesinsteadofcharteringthem? WhatifAngelinaJolieannouncestotheworldthatsheshopsforherlingerieatWalMart? WhatwouldthatdotothecreditqualityofLimitedBrands,themakeroftheVictoriaSecret brandoflingerie?Inaflash,theconsensusrealityonthevalueofitsproductswouldshiftto resetmode.Andcreditorsmightnothavethetimetogetoutintheensuingstampede.Already astringofluxuryretailerssuchasChristianLacroixandEscadaAGhavefiledforbankruptcyand otherssuchasSaksareperilouslyclose.Despitetheflightawayfromconspicuousconsumption, retailerssuchasFrenchcompanyLVMH,whoseproductsalsorepresentvalueanddurability shouldsurvive.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
LimitedBrands,attheendof2008,hadinventoriesworth$1.2billionanditcarriedgoodwillof $1.4billionfromacquisitions,particularlyfromtheacquisitionofCanadianlingeriemakerLa Senza(the$1.4billiongoodwillcarriedispostthe$215milliongoodwillimpairmentchargethat thecompanytookontheLaSenzaacquisitionin2008).Thetotalassetsofthecompanywere $7billionandshareholderequitywas$1.87billion.Thecorrelationbetweentheinventory valuationandthevaluationofgoodwillinthiscaseisparticularlypotentandcanleadtothe wipeoutofasubstantialportionofshareholdersequity.Andthefashionbusinessisliterallya graveyardforgoodwillemanatingfromacquisitionsmadeinrosytimes.Privateequityshop PermiraboughtfashionhouseValentinofor5.3billionin2007attheheightofthebubble.By mid2009thevalueoftheinvestmentwaswrittendownbyhalf.LizClaibornehad shareholdersequityof$2.1billionattheendof2006.Bytheendof2008,theshareholder equityhadplungedto$503milliononthebackof,amongotherthings,writedownofgoodwill andtrademarkof$487millionin2007and$693millionin2008.Thedebtequityratiowas racingtowards1.5andhigher.Attheendof2008,thedressmakerfortheprofessional woman,AnnTaylor,wroteofftheentire$286milliongoodwillonitsbalancesheet.Becauseit didnothavealeveragedbalancesheet,thecompanycouldfaceuptothenewrealityfaster thanotherswithmoreindebtedbooksofaccounts.
FranchiseModeldrivesWorkingCapitalneedsintheRestaurantBusiness
Typicallyrestaurantchainsgettheirrevenuesfromthreesourcescompanyownedrestaurants, franchiserevenues(royaltyasapercentageofsalesandfees)andpropertyincomefromspace leasedtofranchisees.Thenatureofthebusinessmixdeterminesthenatureofworkingcapital requirements.Acompanythatownsallitsrestaurantsisrequiredtoemployconsiderablymore capital(morecapitalexpenditure)butitusuallyenjoysnegativeworkingcapitalrequirements. Customersusuallypaybycash.Suppliersextendcreditperiods.Inventorycannotbetoohighin
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
thebusinessasthefoodneedstobefresh.However,ifacompanygetsthebulkofitsrevenues fromfranchisees,thatisnotlikelytobethecaseasfranchiseesshipapercentageofsalesas royaltytothecompanyafteracertainperiod.Ifpropertyrentalsarepaidinadvanceby franchisees,itreducesworkingcapitalrequirements. Anyway,companieswiththefranchiseebasedbusinessmodelarelikelytohavereceivables closetotheirpayablesandtheinventoryrequirementspushtheworkingcapitalneedsintothe positivezone.Forinstance,attheendof2008,BurgerKingHoldings,theownerofthecompany thatsellstheWhopper,had90%ofitsrestaurantsfranchised.Thecompanyhadreceivablesof $130millionandpayables$127million.Inventory,showninthebalancesheetasprepaidand othercurrentassets,showedabalanceof$86million.Thefranchiseemodelhasthe disadvantagethatifaparticularfranchiseedoesnothavethefinancialresourcesforremodeling therestaurantandforotheressentialexpenses,itcanhurtthebrandasawhole.Ifacustomer hashadabadexperienceatoneBurgerKingjoint,heislikelytorefrainfromvisitinga restaurantofthatchainanywhereintheworld.So,franchiseesindistressneedtobesupported topreventthemfromkillingthevalueofthebrand.Ason30thofJune2009,thecompanys potentialexposurefromhavingtosupportsuchfranchiseesstoodat$9.9millionafigurethat islikelytogoupuntilUShouseholddebtlevelscomesbacktoreasonablelevels.Inaddition, thecompanyhadguaranteed$74millionofleaserentalpaymentsoffranchisees,effectively reducingthebenefitfromthefranchiseemodeloflowercapitaldeploymentrequirements. RestaurantchainYumBrandsoperatesorlicensesunderfamousbrandssuchasTacoBell (Mexicanfood),KFC(earlierknownasKentuckyFriedChicken),PizzaHut,LongJohnSilverand otherrestaurantsworldwide.Forsheernumberofrestaurantsownedorfranchised,Yum Brandsisthelargestrestaurantoperator.Becausethecompanyrelieslessonfranchiseesthan BurgerKing,thecompanyhadnegativeworkingcapitalrequirements.Attheendof2008,the
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
companyhadpayablesof$1.47billionwhilethesumofitsinventoriesandreceivableswas$ 664million. TheWendysArbysgroupwasformedin2008throughthemergeroftworestaurantchains WendysandArbys.Inthatyearitself,thecompanytookagoodwillimpairmentchargeof$ 460millioninconnectionwiththeacquisitionofArbys.Thegrouphadafairlyhighproportion ofownedrestaurants(particularlytheArbysbitofthebusiness).Currentliabilitiesintheform ofpayablesandaccruedexpensesweremuchhigherthanthecurrentassetsfrominventories, prepaidassetsaswellasreceivables. ManilaheadquarteredrestaurantchainJollibeeFoodsCorporationisthelargestFilipinofast foodcompanywithseveralbranchesintheUSandotherpartsoftheworld.Thecompany operatesitschainsthroughbrandssuchasJollibeeandChowking.Becauseofitsfranchisee model,thecompanyhadpositiveworkingcapitalrequirementsthecompanyhad,fortheyear endedDecember2008,inventoriesof2.5billionpesos,receivablesof1.9billionpesosandother prepaiditemstosuppliersof1.5billionpesos.Itspayablesamountedto3.6billionpesos. Ultimately,acompanyanditsfranchiseesarepartofthesameconsolidatedchainitisnot possibleforonetoprosperatthecostoftheotheroverextendedperiodsoftime.So,ifthe workingcapitalfinancingcostisbornebythefranchisor,thefacthastobefactoredinthe royaltypaymentsduetothefranchisor.
WorkingCapitalManagement:thekeytoSurvivalintheConstructionIndustry
Workingcapitalmanagementisthecornerstoneoftheconstructionindustry.This,asdiscussed inchapter3,isalowmarginbusiness,wherethemarginscangetwipedoutfairlyfastifthe projectsarenotexecutedontimeandtorequisitequality.Theworkingcapitalrequirements flowfromthefactthatthecontractorhastoshowconsiderableprogressinprojectexecution
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
beforehecanbillhisclient.Andoncethebillisraised,theclientdoesgetsometimebeforehe hastopayup. Constructioncontractsareoftwotypescostpluscontractandfixedpricecontract.Inacost pluscontract,thecontractorisreimbursedforpermittedcosts(permittedasperthe constructioncontract)plusapercentageofthosecostsorafixedfee.Thesecontractsare typicallyawardedforprojectsinwhichitisverydifficultfortheowneroftheprojectaswellas thecontractortoestimateprojectcostsupfront.Thisistypicallythecaseforoneoffprojectsor projectswherethescopeofworkcannotbedefinedclearlyupfront.Inafixedpricecontract, thecontractoragreestoafixedcontractpriceandbearstheriskofcostoverruns.Typically, theseprojectsareawardedbytheownerbyinvitingafewchosencontractorstobidfor constructingtheproject,afterclearlydescribingthescopeofwork,theexpectedperformance ofthecompletedprojectetc.Usuallytheownerawardstheprojectforexecutiontothe contractorwhobidsthelowestprice.Needlesstosay,consideringthehigherriskstothe contractorthanfromfixedpricecontracts,theyyieldhighermarginsiftheprojectisexecuted flawlessly. Inafixedpricecontract,oncethecontractisawarded,thecontractpricebecomessacrosanct andfewescalationsareallowed.Thecontractoragreestopayliquidateddamagestothe ownerforanydelayinprojectexecution.Thesedamagescouldbestructuredaspenaltyper daysdelay,withorwithoutanuppercapontheextentofdamages.Damageswouldalsohave tobepaidshouldthedeliveredprojectfallshortonperformancegrounds.Evenatthebidding stageforaproject,thebidderswouldhavetopostbidbondsintheformofbankguaranteesin favoroftheprojectowner.Thisistoassuretheownerthatthebidderisseriousinhisbid.Ifa contractorisawardedtheproject,buttriestobackoutofenteringintoafirmcontract,the projectownercancashinthebidbond.Onceaprojectiscompleted,beforethecontractorgets
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
hisfinalpayment,hehastopostaperformanceguaranteebondinfavoroftheowner,which theownercancashiniftheprojectdoesnotperformtorequisitespecifications.Asapartof theirbusiness,contractorshavetofactorinbankguaranteeexpensesforbidbondsand performancebonds.Liquidateddamagesandperformancebondscreatecontingentliabilities whichwillbediscussedinalaterchapter. Contractorstypicallyhavemorereceivablesthaninventory(asworkinprogressprojectsare referredtoinsomepartsoftheworld).Basically,theworkinprogressbitistherevenuethe companyhasbookedinitsincomestatementalongwithassociatedcosts,buthasnotbilledthe clientfor.Themomentthecontractorbillstheclient,theworkinprogressheadgetsconverted intoreceivables.Becauseofthewaythecontractorsbookrevenueonmultiyearprojects(see AccountingBox:TheQuirksofthePercentageofCompletionMethodAccounting),credit analystsshouldbewarywhentheworkinprogressheadgetslarge,andpossiblybiggerthanthe receivableshead.Itcouldimplythatthecompanyisoverbookingrevenue,whichitisinno positiontobillonaccountofslowexecution.Ofcourse,itcouldbelegitimatetooifthebilling milestonesofthecontractsundertakenbythecontractorarefewandfarbetween,itcauses considerableaccrualoftheworkinprogressheadinthebalancesheet.Inthatcase,the contractorwouldrequireconsiderableamountofshorttermdebttofundthebigworking capitalgap.Thatwouldcauseexpendingfundsforshortterminterestpayment,whichshould befineaslongasitispricedintothecontract. Themomentaprojectownerawardsaprojecttoacontractor,hepaysthecontractoracertain amountascustomeradvance.Thisisrecognizedasacurrentliabilityundertheheadcustomer advances.Asthecontractorstartsexecutingtheprojectandrecognizingrevenue,hewrites downthecustomeradvance.Thiscanbeanexcellentsourceoffinancingforthecontractorsat theearlystageofaproject.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
AccountingBox:TheQuirksofPercentageofCompletionMethodAccounting
Constructioncompanies,shipbuildersandhomebuildersusethepercentagecompletion methodofaccountingtorecognizerevenues,costsandprofits.Whilethisisasensiblemethod ofcontractaccounting,thedifferentialknowledgeandinformationbetweenthecontractorand anauditorcanmakethismethodvulnerabletobeingabused.Thatisparticularlytruewhena contractorexecutesanumberoffixedpricecontractsandasmalloverstatementofrevenueson eachcontractcouldtranslateintoalargesum. Thepercentagecompletionmethodworksasfollows:Acontractoragreestocompleteabig project(sayapowerstation)foranownerfor$300million.Whilebiddingfortheproject,the contractorestimatedhiscosttobe$270million.So,thecontractorsestimateofprojectprofits atthebeginningoftheprojectwas$30million.Letussay,theprojectisexpectedtobe completedin3years.Letusfurtherassume,inthefirstyear,thecompanyhasspent$90 millionontheprojectthatisonethirdoftheestimatedtotalprojectcost.So,thecontractor booksasrevenueonethirdofthetotalprojectrevenue$100millionandtheexpenditureof $90million.Thisresultsinthecontractorbooking$10millionofprofitbeforetaxfromthe projectinthefirstyear.Thisisperfectlytherightwayofbookingrevenuesandcostsprovided thecontractorisexecutingtheprojectwithoutanycostoverrun.Whatiftheprojectcontractor hasincurredacostof$90millionattheendofthefirstyear,butduetocostandtimeoverrun hascompletedonly25%oftheproject? IAS11,whichdealswithcontractaccounting,isveryclearwhatthecontractorshoulddo.The contractor,onceheknowsthatthecontractcostislikelytoexceedrevenue,isrequiredto recognizetheexpectedlossfromthecontractimmediatelyasanexpense.So,ifittookthe contractor$90milliontofinishaquarterofproject,thefullprojectcostcanbeexpectedtobe
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
$360million.Sinceonly$300canbebilledtotheclient,thecontractormustrecognizealossof $60millionimmediately.Butthecontractorcangetawayifhebooks$100millioninrevenues and$90incosts.Itisnotpossibleforananalysttoknowwhatishappeningineachproject.In severalcountries,particularlythosewherecontractorsgetmostoftheirrevenuesfromfixed pricecontracts,manycontractorstakeadvantageofthistooverstaterevenues.Itworksinthe shortrunandhasthepotentialtotrapacreditortothecontractor. Ascontractingisgettingmoreandmorecompetitive,contractorsarebiddingatwaferthin marginstowinbids.Thesecontractscanbeexecutedoncostandontimeonlyiftheexecution isabsolutelyflawless.Butseveraleventshappentomilitateagainsteverythinggoingasplanned. Thereishoweverawayforanalyststocatchanyoverbookingofrevenueandunderbookingof costs.Intheexamplegivenearlier,ifacontractorhascompletedonly25%oftheproject,he cannotbillmorethan$75million,asaknowledgeableclientislikelytoobject.So,acontractor bentonoverbookingrevenues(thatis$90million)willshow$15millioninthecurrentassets undertheheadworkinprogressinventory.Nowthereisagenuinereasonforhavingworkin progressinventoryacontractorcannotbillaclienteverydayforprogressinconstruction. Perhapshebillstheclientonceamonthoronattainmentofkeymilestones.Butheisentitled tobookrevenuesontheprogresshehasmade.However,whenthenumberofdaysofworkin progressinventorystartshittinglevelsnotnormallyencounteredinthecontractingbusinessof acountry,onehastosuspecthankypanky. Agenuineprogressinaprojectresultsinworkinprogressinventorygettingconvertedinto receivables.Ananalystneedstokeeptrackofreceivablesfrombigprojectsincasetheytake toolongingettingconvertedintocash.Butthebiggestworryisworkinprogressinventory. Whenacontractorisonahighgrowthpath,theactivitiesonthenewprojectscanmask problemsinprojectshavingexecutionproblemsforquiteawhile.Andforsometime,customer
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
advancesfromnewprojectscanfundtheworkinprogressinventorywithoutcreatingliquidity problems.Butthesolvencyissueisjustaroundthecornerwhenworkinprogressinventory pilesuponaccountofpoorprojectexecution. Inmanycountries,realestatedevelopersandhomebuildersuse(orratherabuse)the percentagecompletionmethodofaccountingforbookingrevenues.Theyusethismethodfor bookingrevenuesondevelopmentprojectsevenwhentheyhavenotyetsoldtheresidential apartmentstheyhaveconstructed.Therearemanyknownunknownshere.Willthedeveloper beabletofindbuyersatthepriceheisbookingrevenues?Willhebeabletocompletethe projecttocost?Thefirstobjectionisthemostcriticalone.In2008,mostrealestatedevelopers inIndiawerereportinghugeprofitsusingthepercentagecompletionmethodofaccountingfor revenuesevenastheyweredefaultingontheirdebtobligations.Theprojectsfromwhich revenueswerebeingbookedhadnotbeensoldtohomebuyersyetthustheyweresucking liquidityandneededaddeddebtforprojectcompletioninanticipationofsalespostcompletion. Theygotintoaterriblesolvencycrisis(notaliquidityonebecausetherewasuncertaintyinthe valueatwhichtheapartmentswouldbesold).Thebalancesheetofmostdeveloperscame undercontrolbymid2009throughnewequityissues.ButanalystsinIndiaatthattimedidnot findtheuseofthepercentagecompletionmethodofaccountingodd. IntheUS,asperSFAS66,AccountingforSalesofRealEstaterevenueandcostscanbe recognizedusingthepercentagecompletionmethodofaccountingonlywhentheconstruction isbeyondearlystages,thebuyeroftheprojectiscommittedtotheextentofbeingunableto askforarefund(exceptinthecaseoffailureofthedevelopertodeliver),sufficientunitsofthe projecthavebeensold,thesalesproceedsarecollectibleandtheaggregatesalesproceedsand thetotalprojectcostscanbereasonablybeestimated.So,formostprojects,homebuildersin theUSusethecompletedcontractmethodofaccounting.Revenue,expensesandprofitare
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
deferreduntilthecompletionofthecontract.Norevenueisrecognizedintheincome statementallcostsandbillingsarerecognizedinthebalancesheet. IndiasConstructionCompanyLarsen&Toubro:GreatCompanybutnotatopnotchCredit Larsen&Toubro(referredtolocallyasL&T)isIndiastopengineeringandconstructioncompany. ThecompanyhasbeenresponsibleforbuildingprominentinfrastructureprojectsinIndia.Itis alsoaplayerintheconstructionsectoroftheMiddleEast.Inthefirsthalfoffinancialyear 2010(yearendingMarch312010),thecompanysecured85%ofitsrevenuesfromthe engineeringandconstructionsector.AlocalcreditratingagencyinIndiaratesL&TtripleAfor localcurrencydebt.ThecompanyisgraduallygoingthewayofEuropeanBOToperatorssuchas VinciandFerrovialbytakingbigstakesininfrastructureprojectsthatitexecutes.Thathas causedthecompanysdebtequityratiotoincreaseoverthelastfewyears.That,ifnothingelse, shouldimplythatL&TisnotatripleAcompanydespiteitsengineeringprowess.Attheendof financialyear2009,thecompanyhadshareholdersequityofIndianRupees(INR)139billion anddebtofINR184billion.Bytheendoffinancialyear2010,thedebtequityratioislikelytobe skewedfurthertowardsdebt.Thedebtequityratiowaslessthan1in2007. Whenacontractorisonahighgrowthpath,itisverydifficultforthecreditanalysttotellif projectsarebeingexecutedwellonaccountofthepercentageofcompletionmethod accounting.L&Tstoplinein2009wasalmost250%ofthatin2006anamazinggrowthasthe companyisbestpositionedtotakeadvantageoftheIndiainfrastructurestory(theconstruction sectorhasbeengrowing1.5timestheGDPgrowth).Ifahighgrowthcontractorisexperiencing delaysandcostoverrunsonhisprojects,itisverydifficultforanauditortospotiftherevenues thatarebeingbookedhavereallyaccruedandthatthecostsdonothaveacostoverrun component.Iftheaveragetenureofexecutionofprojectsis3yearsandthecontractorstop
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
linegrowthisgreaterthan33%,itispracticallyimpossibletoassureoneselfthatthereisno overbookingofrevenue.Someanalystsrelyonfaithtodotheircreditassessmentinthose cases(suchasthefaithbasedvaluationofLevel3assetsofbanksintheprecreditcrisisera) definitelynotahappyplacetobein.Theanalystcangetaroundthisbyaskingthecontractor whatthefrequencyofbillingfortypicalprojectsis.Whiletheremightbedifferencebetween workinprogressandreceivablesonindividualprojects,whenagglomeratedovermanyprojects underexecution,thenumberofdaysofworkinprogressinventoryshouldnotbemorethanthe averagenumberofdaysbetweenbilling.Iftheworkinprogressinventoryistoohigh,growth couldbemaskingcostoverrunsandoverbookingofprofits.Evenincostpluscontracts,the projectownerisnotresponsibleforcostoverrunsduetopoorexecution. Ason31stMarch2009,L&Thadabout49daysofworkinprogressinventoryonitsconstruction projects.Typically,thisshouldnotbemorethan30days.Thatexcess19daystranslatesto almostINR18billioninrevenues.Anaddedpointthatmustbekeptinmindbycreditorsof constructioncompaniesistotakeacloselookatreceivablesgreaterthan90days.Itcouldbe becausethecustomershavenotacknowledgedthatworkhasbeencompletedonthegroundto justifythebillingwhichmeansthattherevenuesbookedaresuspect.Itisnoonescasethat theprojectownerisalwaysright.Butacreditanalystwoulddowelltoassumethatisindeed thecase.Itcouldalsobebecausetheprojectownerisexperiencingfinancialstressandwants todelaypaymentwhichisnotgoodnewsforthecontractorscreditors.Unfortunately,Indian contractorsdonotreportintheirannualreportsreceivablesmorethan90days.Theyreport receivableswhichhavebeendueformorethan180days.L&ThadINR24billionofreceivables morethan180dayswhichitconsideredcollectible.Whenoneaddstheexcessworkin progressinventorytoreceivablesdueformorethan180days(90daysshouldbethecorrect metric,butthatnumberisnotdisclosed),onegetsINR42billion.L&Tsoperatingprofitin
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
financialyear2009wasINR55.5billion,whileitsshareholderequitywasINR139billion. Becausethesecontractspertaintomultiyeartransactions,oneshouldnotdeductthepossible excessiverevenuebookingfromtheoperatingprofitbutfromshareholderequity.Whenone reworksthedebtequityratiopostthisadjustment,thedebtequityratio,alreadyunflattering, looksevenuglier.ThisdoesnotmeanL&Tisindangerofdefaultingonitsdebt.Thecompany doeshaveanimpressivetrackrecordofprojectexecutiononscheduleandwithoutcost overruns.Butanalysts,overthenextfewyears,shouldpaycloseattentiontothecompanys revenuebookingandburgeoningleverage.ThebusinessinIndiaforcontractingwillgetmore competitiveintheyearstocome,aswesterncontractors,withverylittlebusinessopportunities intheirhometerrainswillcrowdin.Beingleveraged,andhencehavinglowfinancialflexibility mightnotbethebestplacetobeintomeetthiscomingchallenge. ThescaleofoverbookingofrevenuesintheIndianconstructionindustryamonglesser contractors,overthelastfewyears,seemshigh.Creditanalystsshouldcloselyquestionthe managementsofconstructioncompaniessuchasHindustanConstruction(HCC),PunjLloydand NagarjunaConstructionontheirworkinprogressinventory,billingcyclesandreceivables greaterthan90days.AuditorshavealreadypassedqualifyingremarksonPunjLloydsearnings. Thesituationgetsevenmurkieronaccountofthefactthatmanycontractorshaverealestate arms,wheretheopacityofaccountinggetsworse. FloursrelianceonCostplusContractsimpactsMarginsbutisgoodfortheCredit USbasedFluorCorporationisoneoftheworldslargestengineering,procurementand construction(EPC)companies.Ittracesitsoriginsto1912.Thecompanygetsachunkofits revenuesfromprojectsintheoilandgassectoraswellastheindustrialandinfrastructure sectors.TheonlyareaofconcernregardingthecompanyisitslowpresenceintheAsiaPacific
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
regionwhichwouldbetheregionwheremostoftheconstructioncontractsaregoingtobe awardedinthemediumterm.ItsbiggestcompetitorsintheUSmarketformegaprojects includeprivatelyheldBechtel,FosterWheeler,JacobsEngineeringandBlack&Veatch. Fluorisoneofthestrongestconstructioncompaniesfinancially.Itcarrieslowdebtonits balancesheet.Becauseofthewaythecompanyhasbeenmanagingitsworkingcapital,ithas noneedforshorttermfunds.Theadvancesthatthecompanyreceivesfromcustomersand othercurrentliabilitiesexceedthesumofworkinprogressinventoryandreceivables. Additionally,thecompanyhasahealthycashbalanceformanagingshorttermcontingencies. Thecompanyscontractworkinprogressinventoryhasbeenfluctuatingbetween16to20days recently.Italsocollectsitsreceivablesfairlysoonafterbillingin2008,thecompanycollected itsbillswithin20daysofbilling.Thisrulesoutthepossibilitythatthecompanyisoverbooking revenues. Whataretherisksinthiscompanyoverthemediumterm?76%ofthecompanyscontractsare costreimbursable,while24%arefixedpricecontracts.Intheformercontracts,paymentsare madetothecontractoronachievingmilestones.Aslongastheexecutionofthecontractis alright,therearenorisksfrommiscalculatingcontractcosts.Manycontracts,particularly governmentcontractsareindefinitedelivery,indefinitequantity(IDIQ)contractswherethe contractorworkscloselywiththeprojectownertoscopethecontract.Costpluscontracts havelowermarginsthanfixedpriceones,buttheriskstooarefarlower.Fromacreditor standpoint,theyaresuperior.TheonlyunknowninFluoriscontingentliabilitiesfromposting performanceguaranteesoncompletedprojects.ContingentliabilitiestomanyUScontractors havecomefromviolatingtheUSForeignCorruptPracticesAct,1977.Houstonbasedcontractor Kellog,Brown&Roothadtopaya$403millioncriminalfineforbribingNigerianauthoritiesto secureanEPCcontract.Fluorhasneverhadsuchaproblem.Asmalladdedriskisonaccount
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ofthecompanysprofessionalliabilityinsurancecoveragebeingonaclaimsmadebasiswhich coversonlyclaimsmadeduringtheinsurancecontractperiodandnoteventswhichoccur duringtheperiod.ExtendedperiodofslowgrowthindevelopedcountrieswillnotaffectFluor toomuchonaccountofthecompanyslowdebtservicingrequirementsandflexiblecost structure(asizeableportionofemployeesworkonanhourlybasis). CorrectInventoryvaluationdeterminesShareholdersEquityatTollBothers&KBHomes ThebiggestriskcarriedbyUShomebuilderslikeTollBrothersandKBHomesistheinventoryof homescarriedontheirbalancesheet.Intimesofrisinghomeprices,theriskisusually underestimatedbyallmarketplayers.Likewise,afteraperiodoffallinghomeprices,theriskis overestimated.Inreality,theriskismisstatedinbothcases.Acreditanalystshouldbemore comfortablewithinventoryvaluationafterafewyearsofhomepricecorrectionthanafterafew yearsintoaperiodofsharplyrisinghomeprices.Agazeatsocietaldebtratiowouldprovide somewarningsignsonhomepriceshittingdangerouslevels.Itisnotforacreditortobeton homeprices,sowhenthewarningsignsarethere,itisbetterforthecreditortoparehis exposuresratherthantrytopredictwhenthedownturninhomepriceswillarrive. Postaperiodofsharplyrisingprices,homepricesintheUSstartedstabilizingin2006andfalling from2007.Acreditorshouldfeelmorecomfortablewithstatedinventoryvalueinthe2011 annualreportthanthevaluestatedinthe2009annualreport.Ahomeownerwhohasboughta homeinaprojectofluxuryhomebuilderTollBrotherspaysonlyafractionoftheprojectcostat thebeginning.Thecustomerretainstherighttocancelthebookingforthehome.The customermighthavetoforfeithisinitialdeposit(whichisgoodforcreditorsbecauseitcanbe usedforassetimpairmentchargesifthehomeissoldlateratalowerprice),butinmanycases, thecustomercansecurearefundofthedepositsbasedonstatelawsorbecauseoffailureto
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
securefinancing.Whenhomecancellationratesriseandinventoryofunsoldhomesgoesup,it putsfurtherpressureonhomeprices. TollBrothersdesigns,buildsandsellssinglefamilyluxuryhomes.Inventoryofhomesisthe biggestitemontheassetsideofitsbalancesheet.In2007,inventorywascarriedat$5.57 billionwhentotalassetswere$7.2billion.In2008,theinventoryvalueandtotalassetsfell respectivelyto$4.13billionand$6.6billion.Thecompanytookinventoryimpairmentcharges of$688millionin2007and$849millionin2008.Thesensitivityofthecompanysbusinessto homepricesisevidentontheearningsandbusinessfrontaswell.Thevalueofnewcontracts signedin2008declinedby47%versus2007onaccountofa34%decreaseinnumberof contractsanda19%decreaseintheaveragevalueofthecontractssigned.So,notonlydoes thebalancesheetweaken,theearningsprofilealsodeterioratesatthesametime.Acomforting featureoftheaccountingofrealestateplayersintheUnitedStatesisthattheypredominantly usethecompletedcontractmethodofaccountingasopposedtothepercentagecompletion methodprevailinginmanycountries(seetheAccountingBox:TheQuirksofPercentageof CompletionMethodAccounting).Thecreditanalystneedstofocusonlyontheinventorycarried valueandnotworryaboutadjustmentsintheincomestatement. TollBrothersbacklogofordersfellfrom$2.85billionin2007to$1.33billionin2008.Between 2005and2007,thecancellationofthebacklogwasaround20%.ThegoodthingabouttheToll Brothersbalancesheetisthatitisnottooleveragedattheendof2008,thecompanyhad$3.3 billionofequitysupporting$6.6billioninassets.So,thecompanydidhavesomeheadroomfor furtherinventorywritedown.Also,thecompanyhadroomtoadjustitscoststructureinline withlikelyfarlowerrevenuesinthenextmanyyears.CustomizedhomebuilderKBHomesdoes nothavesuchaluxury.Attheendof2008,postassetimpairmentcharges,thecompanyhad $830millionofequitysupportinga$4billionbalancesheet.Inventories,whichwerearound
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
KoreanShipBuildersandtheArtofmanagingWorkingCapital
Shipbuildingislikeconstructioncontractinginsomerespects.Theprojectsgetexecutedover severalyears.So,shipbuilders,likecontractors,bookrevenueusingthepercentageof completionmethodaccounting.However,therearesomecriticaldifferencesaswell.Sincethe lastdownturnintheindustrybeginningin2003,whencancellationsofordersunderexecution puttheshipbuildersinapickle,shipbuildersnowinsistonsubstantialadvancepaymentsand paymentsinfewerinstallments.Moreover,ifshipownerscanceltheirordersinbetween, vesselssuchasVLCC,Aframax,Panamax,arefungibleandcanbesoldeasilytoathirdparty.Ifa contractorisbuildingarefineryforaownerinagodforsakenplaceinthemiddleofnowhere andtheprojectownergoesbust,andisunabletopayforpastexecution,thehalfbuiltproject cannotbesoldtoathirdpartyreadily. TheshipbuildingindustryisgraduallybecominganAsiacentricindustry,withSouthKorea, JapanandChinadominatingthefield.Attheverylowendoftheshipbuildingindustry,cheap laboristheonlythingthatmattershenceitwillbedifficultforothercountriestocompetewith China.AccordingtoleadingshippingservicescompanyClarksons,fortheperiodending September2008,Chinahadamarketshareof48%intheconstructionoflowendbulkcarriers. KoreaandJapaneachhadamarketshareof22%.Asperthesamesource,intheareaoftankers, SouthKoreahada51%sharewhileChinahadashareof27%.Intheareaofcontainervessels, SouthKoreawasoverwhelminglydominantwitha60%globalmarketshare.Europeanship
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
builderssuchasGermanshipbuilderHDWcancompeteonlybybeingtheBMWsegmentofthe businessbyproducinginnovativehighqualityproducts.Thisoccursintheareasofluxurycruise linersandvesselsusedbythedefenseindustrysuchassubmarines.Buttheymustcontinuously watchoutforshipbuildersfromKoreaattackingthemfromthebottomup. InthemidsegmentitisverydifficulttoseeadisciplinedpeopleliketheKoreans,whoworklong shifts,thusdrivingdownprojectexecutiontimes(whichisakeybenefitforcustomerswhocan quicklytakeadvantagewhentheBalticdryindexgoesup)facingcompetitionfromcountries wherepeopleclamorfor35hourworkweeks.Also,sincetheskillsrequiredaresubstantial,it cantbesupplantedbyaprisonworkforceonlowwages. Attheotherendofthespectrum,itseemsthatJapaneseshipbuilders,witharichandillustrious pastaregoingtofadeintothesunset,squeezedfromallsides.KawasakiHeavyIndustries, foundedin1878isinaparlouscondition.Becauseshipbuildingconstitutesasmallerpercentage ofsales,theydonothavethetrimcapitalstructuresoftheKoreanshipbuilders.Kawasakis debtequityratiowas119%infinancialyearendedApril2006.Duringthenextfewyears,dueto theglobalbubbleeconomy,Kawasakiwasabletogeneratefreecashflowstobringdownits debtequityratioto75%fortheyearendedApril2008.Atthefirstwhiffoftrouble,the companysoperatingcashflowsdisappearedandthedebtequityratioclimbedto123%forthe yearendedApril2009.HitachiZosensensiblysolditsshipbuildingoperationstoajointventure withNKKCorporationcalledUniversalShippingCorporation.MitsubishiHeavyIndustriesisalso notlikelytolastinthisbusinessformuchlonger.Thecompany,whichhasbeenbuildingships since1884inapreviousavatar,isplaguedbydeterioratingfinancials.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
WouldHyundaiHeavyIndustriesbeaffectedbytheslowdowninDemand? HyundaiHeavyIndustrieswasestablishedin1973.Atthebeginningof2009,shipbuilding,along withitsalliedindustry,offshoreengineering,contributed62%ofthetotalsalesofthecompany. Thecompanyhasauniquecapitalstructure.Attheendofthefirstquarterof2009,the companyhadadebtequityratioofonly9.5%.Butithadaliabilitytoequityratioof354%. Thesehugeliabilitieswerenotsomehorridstufflikepensionliabilitiesthatplaguealotoffirms, butgoodliabilityintheformofcustomeradvances,whichoverwhelminglydominatesthe balancesheet.Ofthetotalassetsof27trillionKoreanWon(KRW),thecompanyscurrent assetsat13.7trillionKRWwerealmost50%ofthebalancesheet.Thecompanyscurrent liabilitiesamountedto17.8trillionKRWonaccountofcustomeradvancesof10.2trillionKRW. ReceivablesandInventoryamountedto6.7trillionwonsothecashflowgeneratedfromthis negativeworkingcapitalcanbedeployedproductively.Ofcourse,ifnewordersslacken,the customeradvanceswouldslackenmorethanslackeningofinventoriesandreceivablescreating theneedfordebt. Becauseofthefloatgeneratedbycustomeradvances,thecompanysdebtequityratiofellfrom 4.3%in2006to0.1%in2008.Theliabilityratioontheotherhandjumpedfrom200%in2006to 352%in2008,onthebackofincreasedordersandcustomeradvancesaswellas,in2008,dueto thesharpdeteriorationinthevalueoftheKRW. Clearly,inthisbusiness,cashflowsimproveanddebtgoesdowninanupturn(oppositeof normalindustriesintheirexpansioncycleduetothenegativeworkingcapitalintensityofthe business).Operatingmarginsfellfrom11.2%inQ12008to8.6%inQ12009.SamsungHeavy Industrieshadasimilaralbeitslightlyinferiorcreditprofile.Onthebackofcustomeradvances, thecompanysdebtequityratioremainedlowaround7%from2006to2008.Attheendof
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
2008,itscustomeradvanceswere8.6trillionKRWasagainstinventoriesandreceivablesof around5trillionKRW.HanjinHeavyIndustries,becauseofthefactthecompanygetsachunkof itsrevenuesfromconstruction,hadapositiveworkingcapitalgap.Shipbuildersgetspeculative ordersduringupturnswhichgetcancelledduringthedownturn,thusincreasingliabilitiesfrom hedgingcontractssuchasforeignexchangeforwardliabilities. Onaseparatematter,theshipbreakingindustry,unliketheshipbuildingindustry,iscompletely drivenbytwofactorsabundanceofcheaplaborwhichisindifferenttoitshealth,andpoor implementationofenvironmentalstandards.BoththesefactorsaremetintheIndianstateof Gujarat,thelocationofseveralhazardouschemicalindustriesandthelocationofsomeofthe mostpollutedspotsonthefaceoftheearth.Itishencenosurprisethatthelargestship breakingyardintheworldislocatedatAlanginGujarat.
InventoryManagementinIndustrieswithshortInventoryShelfLife
Ahotelroomandanairlineseatarefastperishableinventoryifnotconvertedinto receivables/cashduringthecourseofaday,theyloosealltheirvalue.Inresponsetolow demand,airlinescancancelflightsbuthotelsdonothavetheluxuryofmothballingtheir operationsforaday.Flightscanbecancelledtoremoveinventorywithoutincurringvariable costsfixedcostsremain.Inthecaseofahotelnothingcanberemovedcapacitycannotbe temporarilykilled. Theownersofhighendhotelchainsfaceagreatdilemmaiftheydonotgenerateanyrevenue fromahotelroombytheevening,thepotentialrevenuewouldbelostforever.Fromashort termperspective,thehotelownersmightbebetteroffresortingtosharpdiscounting,asany revenuegeneratedabovethenegligiblevariablecostswouldbeusefulbutthatcanhurtlong
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
termbrandequity.Theownersofbudgethotels,whodonothavetogiveanarmoralegto protecttheirbrand,canresorttosuchlastminutediscounting. Sincemanyofthehighendhotelchainsareresortingtoanassetlightstrategy,whereinthey relymoreonbrandvalueandfeesgeneratedthereof,theycannotaffordtohaveindiscriminate pricereductionstooffloadinventoryatsharplyreducedprices.ForHotelIntercontinental,the ownerofbrandssuchasIntercontinental,CrownePlaza,HolidayInnetc,atendof2008,75%of thegroupsroomswerefranchises,24%weremanagedandpropertiesownedorleased amountedtoonly1%.Sothevalueofthecompanytoshareholdersrestedstronglyonitsbrand valuation,whichhelpstogeneratefranchisefeesandmanagementfees.Starwood,ownerof luxurybrandssuchasSt.RegisandupperscalehotelbrandssuchasSheratonandLeMeridienis alsomovinginthedirectionofanassetlightstrategy.Attheendof2004,thecompanyowned 56%ofitshotels.By2008,thepercentageofownedhotelsdroppedto33%.Thecompanys visionwastogetthisnumbertolessthan20%. Doestheassetlightstrategymakesense?Gradualcommoditizationofroomsthroughinternet bookingandincreaseintherelativeimportanceofpersonaltravelasopposedtobusinesstravel mightseeforcedcorrectioninaverageroomrentsintheyearstocome.Thevalueofthebrands, undersuchascenario,wouldcomeunderstress. TheImpactoftheVacationTimeshareBusinessInventoryonHotelIndustryCreditQuality Inthehotelindustry,whileconsiderableattentionispaidtotheinventoryofhotelrooms availabledaily,sufficientattentionisnotpaidtothetimesharing/fractionalownership businessofthehotelchains.Thishasgrowntobefairlyimportantforhotelchainfinancial analysisoverthelasttwodecades.Becauseaconsiderableamountofdebtfinancingisinvolved inthetimesharebusiness,itisnosurprisethatthebusinessprosperityintheUnitedStates
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
coincidedwiththesharpincreaseinhouseholddebt.In1983,UShouseholddebtwas46%of GDPthisjumpedtomorethan100%aquarterofcenturylater.Thenumberoftimeshare resortsoftheMarriotgroupjumpedfromoneresortin1984to67resortsoverthenext25 years. Thetimesharebusinessmodelconferspartownershiporrighttotheuseofaproperty,typically avacationhomeorafacilityinaresort.InthecaseofStarwoodsvacationownershipbusiness, abuyeristypicallyentitledtobuyownershipofafullyfurnishedresortunitforaoneweek periodannually,andinthecaseoffractionalownershipinterests,forthreeormoreweeks. Multiplepartiesholdrightstousethepropertyandeachpartownerisallottedaperiodoftime duringtheyearinwhichhemayusetheproperty.Thetimesharerightscanberesold.Overa periodoftime,thebighotelchainssuchasStarwood,HiltonandMarriottbecamebigplayersin thetimesharebusiness.Becausethebigchainshaveadoptedanassetlightstrategybynot owningthehotelpropertiesthattheymanage,timesharepropertybuildingconstitutesabig chunkoftheircapitalinvested.Forinstance,Marriottownedlessthan1%ofthehotelsit managesorfranchises.Marriottrecordedtimeshareassetsonitsbalancesheetof$3.6billion outoftotalassetsof$8.9billionin2009aroundthesameasthepreviousyear.AtStarwood, vacationownershipinventorywascarriedat$729millionoutoftotalassetsof$9.7billion. Sincethesaleoftimeshareandfractionalownershipfollowsthepercentagecompletionmethod ofaccounting,softdemandanddelinquenciesarenotreflectedinthebusinessresultsofthis segmentuntillateraccountingperiods.Intimesofeconomicstress,therearedelaysinprojects hittingrevenuerecognitionthresholdsonaccountofthelowcustomerinterestorslowdown anddelaysinconstruction.Mosttimeshareoperatorsrecognizesaleswhentheyhavereceived acertainminimumamountofthepurchaseprice(usually10%),thepurchasersrighttorefund hasexpired(thoughthepurchasersrighttodefaultontheloanhehastakenfromthetime
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
shareoperatordoesnotexpiretheriskmerelybecomessmallerovertimeasthetimeshare ownerbuildsequityintheasset)andtheprojecthasreachedacertainminimum implementationlevel.Marriottin2008recorded$324millionlesstimesharerevenuethan2007 inadeterioratingeconomicenvironment(in2008,outofthecompanysapproximately$12.9 billioninrevenues,$1.75billioncamefromtimeshareoptions.AtStarwood,thefractionwas $749millionoutof$5.9billion).Thisinventorystandstheriskofloosingvalueandfacingwrite down.Therecouldalsobeachargeonaccountofreducedvaluationofresidualinterestsinsold timeshareprojects.Additionally,duringstressperiods,eveninprojectsthathavecrossed revenuethresholds,thereislowerrevenuebecauseofclientcancellations.Decreaseinreal estateandvacationhomepricesreducesprofitsonsales(therecouldevenbealoss).During slowdowns,theinventorydoesnotmovefastandincreasescarryingcostsforthetimeshare operator.Inventoryofunsoldtimesharepropertiesdragdownearningsanotherwaythey continuetoconsumecashformaintenance.Atimeshareoperatoralsorecordsacontract cancellationallowanceinanticipationthataportionofcontractrevenuebookedunderthe percentagecompletionmethodaccountingwouldnotberealizedduetocontractcancellations beforeclosing.Anddecisionsnottodevelopplannedtimeshareprojectscouldalsobecostly Starwoodtookanimpairmentchargeof$75millionin2008becauseofitsdecisionnotto developtwotimeshareprojectsinaworseningeconomicenvironment. Timeshareoperatorsincurconsiderablemarketingcoststoselltimeshares,aportionofwhichis expensedasincurredandanotherportionisdeferred.Marriotthaddeferredcostsof$7million attheendof2008,whichitrecordedaspartofcurrentassets.Starwoodcapitalizesdirectcosts attributabletothesaleofitstimeshareassetsuntilthesalesarerecognized.Ifacontractis cancelled,thecompanychargestheunrecoverabledirectsellingandmarketingcoststo expensesandrecordstheforfeiteddepositsforthepurchaseasincome.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Thetimesharebusinessinvolvesprovidingfinancingtocustomers.Loansoutstandingto timeshareownersatMarriottamountedto$607millionin2008,upfrom$408millionin2007. Thatiswhatgeneratesthesales.Marriotthadestimatedthelossesonsuchloansat$35million and$19millionrespectivelyin2008and2007.Thisnumberisexpectedtogoupinthecoming yearsashouseholdscleanuptheirbalancesheetsandcreditorswritedownreceivables. Starwoodestimatedadefaultrateof7.9%onitsvacationownershipassetsattheendof2008. Thecompanyestimatedthata0.1%changeinthisestimatewouldhavea$3millionimpact.So theoutcomemightnotbeahappypictureifthereisaprecipitousincreaseindelinquencies.At theendof2008,thecompanyhadreceivablesof$581million,ofwhich$91millionwasdeemed unrecoverable. Companiesaresupposedtodeductfromtheirrevenueanyuncollectibleloansthattheyhad giventobuyersoftimesharefacilitiesthemomenttheystartrecognizingrevenues.The companiessellthetimeshareloansinthesecuritizationmarket.Whenthesecuritization marketsfreeze,itinhibitsthefinancingofthetimeshareownership,whichinturnimpactssales. Additionally,companiesuseinterestratederivativestohedgetheriskfromtheresidual interests(Marriottrecordedthefairvaleofitsretainedinterestsattheendof2008at$221 million)retainedbythetimeshareoriginator,whichaddstotheriskoftheproductifthe hedginghasnotbeendonecorrectly.In2008,Starwoodrecordedanimpairmentchargeof$22 millionrelatedtothefallinthevalueofretainedinterests. Ashoteloperatorsadopttheassetlightstrategyofnotowningthehotelstheymanageor franchise,assetcreationhasrecentlyhappenedintheareaoftimeshares.Theseassetsinclude loanstocustomersforbuyingtimeshareproperties.Becausetheseassetsarebecominga biggerandbiggerportionofthebalancesheetofthosecompanies,anychangeinthevaluation ofunsoldinventoryoftimesharepropertyaswellasanyincreaseintimeshareloanwritedown
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
cancausesuddenjumpinthedebtequityratiosofthosecompaniesonaccountofthethin sliverofshareholdersequitypresentinmosthotelcompanybalancesheets. LiabilitiesfromCustomerProgramsshouldbeviewedasCurrentLiabilitiesforCreditAnalysis Almostalltheleadinghotelchainshaveloyaltyprogramsthroughwhichcustomersearnloyalty pointseverytimetheystayatthehotel.Theconditionsattachedtoredemptionofthesepoints varyfromhotelchaintochain.Insomecases,thepointsareredeemablewhileusingservicesof thirdpartiessuchasairlines.Irrespectiveofthetermsandconditionsofloyaltyprograms,they createliabilitiesonahotelchainsbalancesheet. Theliabilitiesfromtheloyaltyprogramisrecognized,throughactuarialestimate,bytakinginto accountfactorssuchastimingofredemption(basedonpastredemptionpattern)andbreakage (i.e.pointsthatareneverredeemedthankstocustomerlaxity).Aportionoftheseliabilitiessits underthecurrentliabilitiessection(basically,thecoststhatarelikelytobeincurreddueto redemptionofpointswithinayearofthedateofthefinancialstatement)andthebalanceunder theheadNoncurrentliabilities. Loyaltyprogramshavethesameeffectasofferingadiscountonroomtariffsbuttheyhavea fewadvantagesoverroomtariffdiscounting.Theywouldusuallyachievetheaimofthe programbybindingacustomertoaparticularhotelchain.Secondly,offeringdiscountsonroom tariff,tocleartheunsoldinventoryofvacantroomscandestroythebrandvalueofleading chains. Sincemanyofthehotelchainsarenotexactlyinprimecreditcondition,frequenttravelers shouldbeawarethatthereisagoodishchancethatabankruptcycourtinfuturecouldcancel theseliabilities.Butfromtheperspectiveofacreditanalyst,theseliabilitiesthemselvescanbe quiteonerousandcandriveachainintofiscaltrouble.Evenshorttermcreditorsneedtolook
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
attheliabilitiesfromthisprogramwholly,andshouldnotthinkthattheycangetawaywith lookingatthecurrentliabilitiesportion.Thereisalwaystheriskthatshouldahotelchain displaysignsoffinancialstress,thecustomersholdingloyaltypointswhichwouldnormallyhave beenredeemedoveraperiodoftime,rushingtocashout,thusprecipitatingadownwardspiral earlierthanexpected.So,whatwasactuariallydeemedtobeanoncurrentliabilitymightend upbecomingone.Shouldcreditorsdrawcomfortfromtheairlineindustrywheretherewasno madrushtoredeemfrequentflierpointsastheairlineswereheadingtobankruptcy?Itishard tosay. ConsiderStarwoodhotelsattheendof2008,thetotalliabilitiesfromtheloyaltyprogram amountedto$662million.Ofthis,$232millionwereincludedincurrentliabilities.Thiswasa fairlysizeableportionofshareholderequitywhichamountedto$1.6billion.Hotel Intercontinentalhadpracticallywipedoutitsshareholderequitybytheendof2008.Butitstill had$471millionofloyaltyliabilities.Marriottsbalancesheetwasmoreinteresting.Itjust had$1.4billioninequitysupportingabalancesheetof$8.9billion.Liabilitiesfromtheguest loyaltyprogramamountedtomorethan$1.5billion.
TheRealInventoryoftheAirlineIndustry
Everyday,atmidnight,anairlinehasthecapacity(fromownedandleasedaircraft)toflya certainnumberofpassengersforacertainnumberofkilometerswithoutcompromising customersafetyorcustomerexperience.Bymidnightnextday,anyplanethatdidnotflyan optimalnumberofhours,or,forthehoursitflew,didnothaveaplaneloadofpassengers, wouldhaveforeverseenawritedownofinventoryfromthepreviousmidnight.Atmidnighton thepreviousday,theairlinehadacertainnumberofseatkilometersavailable(numberof passengerseatsavailablemultipliedbythemaximumpossiblekilometerstheplanescouldhave
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
flownontheirroutes).Thisisreferredtoasavailableseatkilometerstherealinventorythat anairlinehasnotthesundrydetailsitrevealsinitsbalancesheetintheformofairplane spares,fuelinventoryetc.Bymidnightthefollowingday,thisavailableseatkilometers(ASM) perdayneedstobeconvertedintohardrevenue.Else,theavailablepassengerseatkilometers wouldhavetobewrittenoffforgood. Ofcourse,ifdemandisabundant,theairlinecanloaduptheplanestothemaximumextentand chargethecustomerwhatthemarketcanbear.Whatifdemandislessthanabundant? Decisionsonwhethertocancelflightswillhavetobetaken.Thedecisionisgovernedby whetherthroughflyingthepassengerswhoarewillingtofly,theairlinecancoveritsvariable costsfuelcosts,variableportionofcrewpayetc.Iftheairlinecutstheticketprice,more peoplewouldbewillingtofly,causingtherevenue,theproductofpassengerticketandnumber ofpassengerstogoup.Thereisacertainpricelevelatwhichtherevenuescanbeoptimized. Theairline,ifworriedaboutlongtermbrandvalue,mightchoosenottomaximizeshortterm revenue.Whethertheairlinefliesanairplaneonagivendayornot,fixedpricesconnectedwith theairplanesuchascapitalcostswouldcontinuetobeincurred.So,theaimofairline managementisnotonlytoincreasepassengerloadfactor,butalsorevenue.Inthemedium term,capacitiesmighthavetobepermanentlywithdrawnbyreturningairplanesonoperating lease.Forinstance,initsannualreportof2008,SouthwestAirlines,theonlyinvestmentgrade USairline,planneda4%reductioninaveragepassengermileduring2009.Thatwouldresultin aconcomitantreductioninfixedcostsandagreaterlikelihoodthattheairlinewouldmake betteruseofitsdailyavailableseatmileinventory.Asoperatingexpensesperseatmilegoup, theminimumrevenuerequiredfrompassengersforaflighttobeviablegoesup,i.e.breakeven passengerloadfactorgoesup.Ultimatelyoptimaluseoftheairlineseatmileinventoryover timeiswhatoptimizesthereturnoncapitalemployedforanairline.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
SingaporeAirlinessuperbWorkingCapitalmanagementbringsdownitsGearing ItiswellknownthatSingaporeAirlinesisoneofthebestrunairlinesintheworld.Inanindustry inhabitedbycompanieswhicheitherhavenoclueaboutoperationalexcellenceorravagedby unionintransigenceormanagementsconfusedabouttheirbusinessmodels,SingaporeAirlines comesoutasashiningbeacon. Thecompanysoperationalexcellencetranslatesintohighprofitability.Whenthisprofitabilityis combinedwithitsnegativeworkingcapitalrequirements,itisarecipeforeverloweramountof capitaltobedeployedvisvisthescaleofoperations.Airlinestypicallyhavenegativeworking capitalrequirementsbecausecustomerspayfortheirtravelbeforefuelsuppliershavetobe paid.Butthisbenefitdoesnotaccruetoairlineswhicharenotprofitable.Theygetintoa viciouscycle.Theseairlineshavetoservicetheirairplaneleaserentals(becauseoftheirweak profitability,noonewouldprovidefinancingtotheseairlinesforbuyingplanes)andotherfixed expensesbeforeresourcesareavailabletoensurecustomersatisfaction.Suppliersoffuel wouldbewaryofprovidingcredittothoseairlinesforextendedperiods.Intheextremecase, fuelsupplierswouldrequirelettersofcreditorotherriskmitigantsbeforetheysupplyfuel. Thatresultsinaddedcostsandforgoingofthebenefitthataccruesfromhavingtopayforfuel later.Thisinturnrequiresshorttermfinancing(ineverincreasingamounts)untilbankruptcy putsthosecompaniesoutoftheirmisery. SingaporeAirlinesdoesnothaveanyshorttermdebt.AttheendofMarch31st2004,the companyhadadebtequityratioof0.2.AttheendofMarch31st2008,thisratiohadfallento almost0.1.ThecompanyhadcurrentliabilitiesofSingaporeDollar(SGD)5.96billion.Ithad currentassetsofSGD8.3billion,butwhencashandmarketablesecuritiesweredeductedfrom thoseassets,theeffectivecurrentassetswereonlySGD2.7billion.FuelsupplierstoSingapore
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
AccountingBox:DoestheCashFlowStatementtelltheAnalystanythingnew?
Thefetishforthecashflowstatementdisplayedbyanumberofcreditanalystsisdifficultto comprehend.Itmightbeusefultotheequityresearcherforhisdiscountedcashflowanalysis (DCF),ifyoubelieveDCFisameaningfulpursuit.Sustainablecompetitiveadvantagecanbe gleanedfromthecredit/equitystoryandtheincomestatementandbalancesheet(intermsof returnoncapitalemployed).Thecashflowseemslikeanentertainingdiversion.Wewonder ifequityanalystseverrevisittheircashflowforecastsforDCFanalysisayearlatertocheckifthe actualfreecashflowhadanysemblancetotheirprojectedfreecashflow.Andthefurtherout intothefuturethesecashflowsareprojected(totheendoftime,orsothetheorygoes),the morestarkthedeparturefromreality. Anyway,foracreditanalyst,thecashflowdoesnottellhimanythingnewifhehasgraspedthe incomestatement,thebalancesheetandhastiedthetwostatementstothecreditstory.Andif hehasnotgraspedthemessagefromthosestatements,hewillnotbeabletogleanmuchfrom thecashflowstatement.Afterall,thecashflowisderivedfrombalancesheetandtheincome statement,andisareconciliationstatementbetweenofcashinabalancesheetattheendof thepreviousyeartothecashattheendofthecurrentyear.Theoperatingmargins,gleaned fromtheincomestatement,giveoneanideaofthecompetitivenessofthecompanyvisvisits competitors.Thebalancesheetletsananalystknowofthecapitalefficiencyinsecuringthe returns.Capitalefficiencymeansusingaslittlelongtermsourcesofcapital(implyingefficiency
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
ofcapitalexpenditure)andaslittleshorttermdebtaspossible(implyingefficientworking capitalmanagement). Thetheorythatthecashflowstatementisusefulbecauseitpermitscomparabilityofthe reportingofoperatingperformancebydifferententitiesbecauseiteliminatestheeffectsof usingdifferentaccountingtreatmentsforthesametransactionsandeventsisdubious.An analystwhohasunderstoodtheunderlyingcreditstorywouldautomaticallybeabletohandle thedifferentaccountingtreatments(anyway,theworldisgraduallymovingtowardsreconciling thedifferentaccountingstandards).Andifyouarejustgoingtolookatthefinancialstatements withouthavingunderstoodtheproseandpoetryofthecreditstory,thereisarealdanger,at somepointintimeinthenearfuture,yourjobmightbetakenoverbyatrainedmonkeyora computerprogram. However,thereisnoharminhavingaquickglanceatthecashflowstatement,particularlyifthe cashflowstatementhasbeenpresentedusingthedirectmethod.BothIAS7andSFAS95 encouragetheusageofthedirectmethod,whereinmajorclassesofgrosscashreceiptsand grosscashpaymentsaredisclosed.Unfortunately,mostcompaniesreporttheircashflows usingtheindirectmethodwhichmerelyadjuststheincomestatementfornoncashtransactions. Whenpresentedusingthedirectmethod,allananalystneedstodotogetoperationalcash flowsistosubtractfromcashreceivedfromcustomersthesumofcashpaidtosuppliersandthe interestpaidonworkingcapitalloans.Theinterestpaidonlongtermloansshouldbe consideredinfinancingcashflows,unlesstheinterestispaidbythefinancingarmofa manufacturingcompany.Thentheinterestpaidonlongtermdebtisalsopartofoperational cashflows.Theinvestingcashflowsarebasicallyincrease/decreaseinnoncurrentassetsand thefinancingcashflowsaretheincrease/decreaseinnoncurrentliabilities.
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
Anotherdangerousnotionoftentalkedaboutis,ifoperationalcashflowsaregood,alliswell. Inindustrieswherehighcapitalspendingisinitiallydone,theyearaftercapitalexpenditureis completed,highoperatingcashflowsmightoccurbecauseofhighersales.Salesmightnot coverfullcosts(depreciationcostsetc).Whensalesdonotresultinfullreturnoncapital,debt servicingoveraperiodoftimeisnotassured,despiteoperationalcashflows. Insomecircles,particularlywherealotoffeebasedincomesareatstakebasedonfructifying lendingtransactions,EarningsbeforeInterestTaxandDepreciation(EBITDA)isconsideredasa proxyforoperationalcashflows.Ifthismetricisusedbyanyoneotherthanrascalstryingto makeaquickbuck,onehastowonderiftheuserofsuchmetrichasanyideaaboutfundamental businessrealities.Itignoresthefundamentaltenetthatacompanycanearnitswayto bankruptcyifitdoesnotcollectitsreceivables,replacedepreciatedassetsorpaythepayables beforecashisavailableforinterestservicing.IfEBITDAisnonsense,soisanyratioderived usingitsuchasDebttoEBITDA.Thislessonhasnotbeenlearnteventhoughithasbeenalmost fourdecadessincethebankruptcyofUSrailroadcompanyPennCentral.PennCentral conservedcashbynotdoingthenecessarycapitalexpenditure.Becauseofthis,itstracks deterioratedandthetrainshadtorunatreducedspeeds.Thisdelayedshipmentsandcaused personneltoworkovertimefurtherbloatingcosts.Derailmentsandtrainwrecksoccurred frequently.PennCentralalsousedshorttermdebttofinancelongtermassets.Butthanksto lowcapitalexpenditure,forawhile,itsEBITDAwasstrong.
KeyTakeawaysfromthisChapter
Ahighreturnoncapitalemployedisanillusionifitisaccompaniedbyinefficientorfraudulent workingcapitalmanagement.Ifreceivablesorinventorykeepgoingupdisproportionatelywith growthinsales,everincreasingamountofcapitalwouldhavetobedeployedforfinancingthis
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
workingcapitalrequirement.Whentheincreasedcapitalrequirementcomesfromhigherand higheramountsofshorttermdebt,troublecouldloominthehorizon. Ifreceivablesofacompanyaregoinguprelativetosales,itcouldimplyoneofthreethings. Firstly,itcouldbebecausethecompanyisextendinglongerperiodsofcredittoitscustomersin ordertosecuresales.Thatcouldbeonaccountofthecompanysproductsnotbeingthat excitingvisvistheproductsofcompetitorsandhenceneedstoextendlongerperiodsofcredit topushsales.Inthatcaseacreditanalystneedstoaskhimselfifthecompanyscreditstoryis over.Secondly,itcouldbebecausethecompanyscustomersareexperiencingfinancialstress andareunabletopayupontime.Thatisalsonotgoodnewsbecauseitcouldrequirewrite downofreceivablesandfallinfuturesales.Finally,theriseinreceivablescouldonaccountof fraudulentsalesbeingbookedtooverstatereportedrevenuesandearnings,eithertokeep financialmarketshappyortosatisfysomeloancovenantlinkedtoEBITDA(whylenderslink theircovenantstoaneminentlymalleablenumbersuchastheEBITDAisaseparatetale). Rawmaterialinventorylevelsarecomingdownacrossindustriesonaccountofefficientsupply chainmanagement.However,thecreditanalystshouldcheckandconvincehimselfthatthe supplychainisnottoostretched.Also,itneedstobeverifiedthatthecompanysprofitability hasnotbeensecuredbyarmtwistingsuppliers,whosefallingintobadtimesdueofthiscanput thecompanyatperil.LIFOaccountingofrawmaterialinventoryismoreconservativethanFIFO accountingintimesofhighinflation.Asmanufacturingprocessesgetmoreefficient,theworkin progressinventoryhasbeencomingdown.Ananalystshouldverifythatworkinprogress inventoryinindustriesusingthepercentagecompletionmethodaccountingisnotanartificefor overstatingrevenues.Finishedgoodsinventoryshouldbelow,particularlyinindustriessuchas fashionretailingbecausetheinventorycanloosevaluefairlysharplyinresponsetochanging
StoriesinCreditAnalysisEfficacyofWorkingCapitalManagement
fashiontastes.Inthoseindustries,itmightbebettertoconvertinventoryintoreceivablesof questionablequalityratherthancarryitasinventory. Inthecaseofpayablesmanagement,thecardinalruleisdonoharm.Delayingorstretching paymentstosuppliersisnotasustainablewaytomanagecashflows.Payabledaysoutofsync withindustrynormsshouldbeclearlyexplained.Inindustrieswithnegativeworkingcapital days,thecreditanalystshouldunderstandthatwhilethisisagoodpositiontobein,itmightnot besustainableforalossmakingcompany.Inthecaseofnegativeworkingcapitalindustries,the cycleofconversionofinventorytoreceivablestocashforpayingthesupplierdoesnotexist.The supplierdrawscomfortfromtheoverallprofitabilityofthecompanyheisasupplierto.The momentthatiscalledtoquestion,supplierforbearancecannotbetakenforgranted.