NYU’s Spring
semester MBA classes in Valuation and Corporate Finance are underway --
videos of
the individual classes of both are available at the NYU site , http://pages.stern.nyu.edu/~adamodar/ using the ‘Web Casts’ tab. Registration for the course is free and gives anyone access to Prof. Damodaran, for personal Q&A, etc. To register for the Valuation course, go to the site (http://coursekit.com/app#course/b40.3331.damodaran), registration code: EH7WZN. The Corporate Finance course is at (http://coursekit.com/finance), code RWHZYG.
Once a year Prof. Damodaran updates his series of Excel data files--this past year’s update is now available. The files include information on about 42,000 publicly traded companies (worldwide), of which about 5,900 are US-based. He uses Value Line for US listings (we’ll note his tables happen to exclude BRK) and Cap IQ and Bloomberg for the rest of the world. There’s a decade’s worth of data. See http://people.stern.nyu.edu/adamodar/New_Home_Page/data.html... , ‘Updated Data’ tab. [When using the data, see Damodaran’ s notes regarding timing lags.] He also has included some industry summaries that are interesting; some of his industry breakouts are a bit unconventional, customized for his own purposes. The table further below is just a very small example of some of the industry data included on these these files.
Working capital ratios
In a recent thread on this board we re-looked at gross margin rates. http://boards.fool.com/personally-i-dislike-shopping-and-avo... We were considering not only the conventional thinking of the benefits of high gross margin, but also the underlying drivers from the customers point of view (are they willingly paying those gross margin rates because they recognize that we are adding some value, or are we perhaps asking that they pay those rates to support our higher cost structures, hoping that customers will continue to accept those costs). We also considered whether in thinking about gross margin, ‘higher’ is always preferable to ‘lower’ to begin with.
With working capital ratios -- comparing certain short-term assets to short-term liabilities – the general assumptions are usually that assets are preferable to liabilities, and the wider the gap between assets and liabilities, the better – or at least ‘the safer’.
But how much of a relatively high quick ratio (cash plus receivables compared to payables and short-term debt) is perhaps resulting from a business model where suppliers see to it that the company pays them quickly – coercing it to be a provider of ‘float’ - while its customers are also extracting attractive terms, also pressing it into supplying free float?
Or a current ratio (which also includes ‘inventory’ in the numerator) more the result of a business model that requires heavy advance investment in materials, or entails slow inventory turn? Conventional thinking might encourage us to believe that, in general, favorable current ratios – more current assets (receivables and inventory) than current liabilities (payables) - are good things.
Are the good working capital ratios an indication of financial strength, as we often assume? Good financial health resulting from a well-managed company? Good industry economics? Or might they sometimes be a sign of a company or industry’s weakness – some burden built in its (or its industries) business model? Is the business a slave to some less-than-attractive economics of an industry?
Non-cash working capital (receivables + inventory - payables) % to revenue
Damodaran’s files include key W/C components – cash, receivables, inventory, and payables – and overall working capital rates. He shows the rates both all-inclusive, including cash, and also without cash. Along with A/R, Inventory, and A/P, these overall working capital include "other current liabilities" (which includes other non-interest bearing current liabilities like deferred taxes) and "other current assets" (which include other non-cash current assets). For purposes here, let’s set aside the ‘other’ and consider the three principal non-cash working capital categories – receivables (plus) inventory (less) payables – combined, as a percentage of revenues. We’re interested in working capital tied to growth - principally the three major working capital related components -- inventory growth and increases in payables, the higher receivables associated with increased revenues.
While managements try to optimize their individual business models and balance sheets, industries in general do often have some common characteristics and ranges of performance. When we looked at major retailers here awhile back, for example, we observed that many (with a few important exceptions) had aggregate non-cash working capital rates of about 5%. Damodaran’s recent working capital data supports that observation, with the ‘Retail Stores’ level reported at an average of 5% over the past half-dozen years. Unless some fundamental dynamics change, the sales/receivables/inventory/payables relationships often remain relatively intact as the businesses grow. This isn’t just true of the retail examples, but also of many industries – consumer products, to industrial and heavy equipment manufacturers, to services, etc.
Now let’s think of this working capital change in terms of its impact on cash flow. In businesses with relatively low net profit margins but high incremental working capital rates, we could envision where, at least during the growth years, revenue growth could easily result in increased earnings but diminished cash flow. There have been plenty of businesses having a combination of high incremental working capital investment and low profit margins. They need continuing ‘investment’ for growth at levels that can’t be supported by the incremental earnings from that growth. These net assets – the drivers behind their (nominally) healthy ‘current ratios’- are burdens to growth.
Below is a summary combining selected industry data from a few of Damodaran’s charts, sorted ‘low to high’ by average working capital % to revenues. This list excludes financials (banks, insurance brokerages, etc). The (non-cash) working capital rates are average overall rates, not necessarily incremental -- we have to make the incremental assessment ourselves, by industry -- but these overall rates, percentages to revenues, are at least a starting point for coming up with our own reasonable assessments of incremental rates.
If we dig into the Excel files and look at Damodaran’s data by year, we see that by industry, AR+Inv-AP rates often remain fairly constant (to revenue) in good years and bad – or at least rates don’t diminish in the rebound, and that these big-three elements of working capital largely variable with revenues. In fact, looking at Damodaran’s file totals, we see that on across the industries, inventory percentages to revenues move in some direct relationship with payables percentages, with net working capital substantially driven by accounts receivable, a component that fluctuates pretty directly with revenue.
The table below also includes a ‘net capital expenditures’ column – the average annual amount that capital expenditures exceed -- or if negative, fall below -- reported depreciation( more on this further down).
Incremental rates
We have plenty of instances where, for example, an additional dollar in revenue entails funding 15 or 20 cents in additional working capital, but the sales dollar only yields a nickel or so per year in revenue. The business will eventually be cash-positive on that fifteen cent investment when growth plateaus, but not for a few years.
In a high-investment, steady-growth environment, a business can be perpetually behind on a cash-flow basis. In other words, with high enough working capital outflow and with the expected cumulative net cash flow benefits pushed out far enough into the future - it’s possible that ‘growth’ in revenue and earnings can result in little or even no improvement in intrinsic value. That’s kind of an extreme proposition, but the take-away point is that sometimes ‘growth’ may not enhance intrinsic value as much as we assume from the projected earnings.
Now, in trying to get something out of all this from an investment point of view, the key is that industry averages are just that – averages – and company performances vary. Again, we can look at those retail examples discussed recently, where we saw that most of the typical retailers – Target and such – each had working capital rates right around the industry’s 5% average; some department stores were as high as 15%; Costco was at ‘zero’, and Walmart less than zero. Some companies had substantially lower investment requirements for growth than others – giving them a significant long-term growth advantage.
Along those same lines, within industries, company capitalizations vary. We may see businesses -- especially outside the S&P500 -- that ‘can’t afford’ to take on much new business now. In another board thread here (“The 400% man”), there was a linked article that mentioned air-conditioning equipment supplier Watsco. Watsco is a large, comparatively well capitalized participant in a working-capital-intensive industry. Other large participants, significant or even dominant in their own regions, are finding that they are having difficulty financing post-recession growth.
In this segment there is historically high pent-up demand (nationally the average age of installed air conditioning units, which typically have about a decade of useful life, is about at an all-time high). There should be plenty of capacity – there probably is -- but the industry has high working capital requirements for doing business, and many of the regional participants are struggling to fund that required 'investment'. At least some have been, or are, even quietly looking to the larger Watsco-types as possible candidates to buy them out. [This isn’t news any more, and it’s not a suggestion to buy Watsco at its currently rich levels – but it is a convenient recent example of some post-recession business dynamics].
Without specifics at hand, we might suspect that Illinois Tool Works is finding itself in a similar situation, with plenty of businesses in which it might naturally have an interest now needing financing – or lacking that, a well-financed home in order to get on track for handling new orders.
ITW’s ‘AR+Inv-AP’ rate is currently something like 22% of revenues, with earnings at 11%. If that’s representative of its various industries, less well capitalized companies in its segments having similar dynamics might not be currently able to ramp up their own businesses so easily. Again, this is just some speculation, only using ITW as an example because it was just mentioed. But ITW happens to operate in working-capital-intensive industry segments, and the dynamics may help us understand both its acquisitions and its (and its competitors) cash-flow challenges to internal growth.
With all this let’s keep in mind that the ‘inversion’ of working capital ratios is just one ancillary aspect to analysis; it’s not something to overplay or go too far with on its own – it’s just one more tool for our analysis kit. The point of mentioning it at all is that it often seems to be overlooked.
Moving on… Recessions are nothing new – and these types of working-capital-intensive businesses have been always been around. So what’s ‘different this time’? What has changed during this recession?
Collateral-based debt
From a practical point of view – unless the variable-working-capital intensive business is exceptionally well capitalized, it will likely borrow to fund revenue growth. We’re used to discussing S&P500 companies-- the top 10% or so of the companies represented in the data above—that typically have access to bond markets and such, and are able to secure longer-term fixed debt. The large majority of smaller-cap, W/C-intensive companies, however – the 90%-plus – don’t have the same access. These companies often end up financing working capital through some kind of asset-based borrowing facility– through the Wells Fargo’s or BofA’s, or other commercial lenders, such as GE Capital and such. [This short-term borrowing is also why some of these ‘incremental working capital’ discussions stayed under the ROE radar – the poor ROE dynamics were masked by this related leverage.]
Businesses in all sorts of industries -- transportation; metal fabrication; dealers of equipment and vehicles; you name it -- use working-capital-based debt. The borrowing is typically collateralized by receivables based on perhaps 80% or 85% (historically) of ‘eligible’ receivables. Sometimes a small fraction of inventory--typically less than 50%, often significantly less--can serve as collateral. There will be some kind of overall loan cap, but the actual borrowing limitations will be dependent on the 'advance rates,' and on eligible collateral at any moment. Ask the bankers, and they’ll say that their authorized credit limits are generous. Ask the businesses, and they’ll often say they can only borrow a fraction of that limit under the loan’s formula.
With the recession, advance rates on receivables were frequently cranked down – and in many cases, the inventory-secured portions were yanked altogether. Borrowers who hit potholes in performance – who came up short in meeting financial performance requirements ('covenants'), were more likely this time to find themselves dropped altogether, rather than just getting hit with the usual prescribed financial penalties.
Unlike home mortgages, these loans come up for periodic renewal, and in the interim they have those continuing performance covenants. And being collateralized by liquid assets, the lender can often exit fully paid. Over the past several years, whenever a business privately mentioned that Wells Fargo was the lender, we could pretty much guess that the next sentence included something like ‘reduced our advance rate’ or something along those lines -- though this was by no means limited to just them. Well's point of view of course was that they were helping keeping their customers avoid getting over their heads.
From the business’ point of view, if the company survived, it found itself stuck in a no-growth situation. It became common for working-capital-intensive businesses to find themselves unable to take new orders because they couldn’t come up with the money they needed in advance to fulfill the orders, because they didn’t already have the receivables (the collateral) to borrow against....because they couldn’t take the new business....trapped in a kind of ‘reduced borrowing base’ spiral.
One reason for the relative silence on this whole subject has probably been that companies with financing or refinancing pressure can never let their suppliers, their customers, or their competitors see them sweat. Just the hint of a credit problem can itself cause a collapse; nobody wants to be part of the chain with the leper.
On a related tangent -- we see a lot of commentary about excess cash build-up now. Among the S&P500, the reasons for both the build-up and retention are widely discussed. For the other 90%, the build-up has been at least a defensive action to this kind of situation, having recently been through an environment where banks pulled out with little notice, or where their borrowing limits have been reduced by a tighter formula.
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Net Capital Expenditures
Since we’re looking at balance sheet items as ‘costs’ -- cash outflow required to support the business -- we might also want to look at capital expenditures. For most businesses – most industries – we think of capital expenditures as ‘investment’. But that’s an accounting definition, and not always an economic distinction. For some industries, even heavy capital expenditures can really be considered ‘expenses’ of the business.
To some extent – and in most industries – depreciation expense in the P&L reflects capital spending (we saw in the chart above that for most industries, the ‘net’ of capex and depreciation is about ‘zero’ over time). But for some industries, the participants are consistently spending above depreciation levels – and sometimes this excess capex is at remarkably consistent levels (see Damodaran’s files).
In some industries capital ‘investment’ is a requirement just to stay in business – sometimes just to stay competitive with the industry. That’s especially true where competitive pricing is such that the entire industry is passing efficiencies of collective new investment on to customers, or where there’s ongoing obsolescence, whether textile looms or fuel-inefficient aircraft.
Similarly, some of this positive ‘net capex’ represents capacity replacement, new mines replacing old; new railroad spurs replacing recent abandonments, etc. - where we have defensive spending, sometimes at highly inflated costs vs the replaced assets. We’ll have to determine for ourselves, case by case, how much is embedded in the business model, and how much I really elective.
Where this type of spending is necessary to remain competitive, we may want to re-think our interpretation of P&L results to include these costs. In any event, we’ll want to factor these costs into our discounted cash flow analyses in assessing intrinsic value.
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Again, the point of this is not to take away from any of the analytical tools we are using or change our fundamental approaches to analysis, but to add some perspectives. When we see P&L-based projections, and particularly when we’re taking stabs at what they might mean for intrinsic value – the value of future cash flows -- we might keep the working capital (and net capex) elements in mind.
the individual classes of both are available at the NYU site , http://pages.stern.nyu.edu/~adamodar/ using the ‘Web Casts’ tab. Registration for the course is free and gives anyone access to Prof. Damodaran, for personal Q&A, etc. To register for the Valuation course, go to the site (http://coursekit.com/app#course/b40.3331.damodaran), registration code: EH7WZN. The Corporate Finance course is at (http://coursekit.com/finance), code RWHZYG.
Once a year Prof. Damodaran updates his series of Excel data files--this past year’s update is now available. The files include information on about 42,000 publicly traded companies (worldwide), of which about 5,900 are US-based. He uses Value Line for US listings (we’ll note his tables happen to exclude BRK) and Cap IQ and Bloomberg for the rest of the world. There’s a decade’s worth of data. See http://people.stern.nyu.edu/adamodar/New_Home_Page/data.html... , ‘Updated Data’ tab. [When using the data, see Damodaran’ s notes regarding timing lags.] He also has included some industry summaries that are interesting; some of his industry breakouts are a bit unconventional, customized for his own purposes. The table further below is just a very small example of some of the industry data included on these these files.
Working capital ratios
In a recent thread on this board we re-looked at gross margin rates. http://boards.fool.com/personally-i-dislike-shopping-and-avo... We were considering not only the conventional thinking of the benefits of high gross margin, but also the underlying drivers from the customers point of view (are they willingly paying those gross margin rates because they recognize that we are adding some value, or are we perhaps asking that they pay those rates to support our higher cost structures, hoping that customers will continue to accept those costs). We also considered whether in thinking about gross margin, ‘higher’ is always preferable to ‘lower’ to begin with.
With working capital ratios -- comparing certain short-term assets to short-term liabilities – the general assumptions are usually that assets are preferable to liabilities, and the wider the gap between assets and liabilities, the better – or at least ‘the safer’.
But how much of a relatively high quick ratio (cash plus receivables compared to payables and short-term debt) is perhaps resulting from a business model where suppliers see to it that the company pays them quickly – coercing it to be a provider of ‘float’ - while its customers are also extracting attractive terms, also pressing it into supplying free float?
Or a current ratio (which also includes ‘inventory’ in the numerator) more the result of a business model that requires heavy advance investment in materials, or entails slow inventory turn? Conventional thinking might encourage us to believe that, in general, favorable current ratios – more current assets (receivables and inventory) than current liabilities (payables) - are good things.
Are the good working capital ratios an indication of financial strength, as we often assume? Good financial health resulting from a well-managed company? Good industry economics? Or might they sometimes be a sign of a company or industry’s weakness – some burden built in its (or its industries) business model? Is the business a slave to some less-than-attractive economics of an industry?
Non-cash working capital (receivables + inventory - payables) % to revenue
Damodaran’s files include key W/C components – cash, receivables, inventory, and payables – and overall working capital rates. He shows the rates both all-inclusive, including cash, and also without cash. Along with A/R, Inventory, and A/P, these overall working capital include "other current liabilities" (which includes other non-interest bearing current liabilities like deferred taxes) and "other current assets" (which include other non-cash current assets). For purposes here, let’s set aside the ‘other’ and consider the three principal non-cash working capital categories – receivables (plus) inventory (less) payables – combined, as a percentage of revenues. We’re interested in working capital tied to growth - principally the three major working capital related components -- inventory growth and increases in payables, the higher receivables associated with increased revenues.
While managements try to optimize their individual business models and balance sheets, industries in general do often have some common characteristics and ranges of performance. When we looked at major retailers here awhile back, for example, we observed that many (with a few important exceptions) had aggregate non-cash working capital rates of about 5%. Damodaran’s recent working capital data supports that observation, with the ‘Retail Stores’ level reported at an average of 5% over the past half-dozen years. Unless some fundamental dynamics change, the sales/receivables/inventory/payables relationships often remain relatively intact as the businesses grow. This isn’t just true of the retail examples, but also of many industries – consumer products, to industrial and heavy equipment manufacturers, to services, etc.
Now let’s think of this working capital change in terms of its impact on cash flow. In businesses with relatively low net profit margins but high incremental working capital rates, we could envision where, at least during the growth years, revenue growth could easily result in increased earnings but diminished cash flow. There have been plenty of businesses having a combination of high incremental working capital investment and low profit margins. They need continuing ‘investment’ for growth at levels that can’t be supported by the incremental earnings from that growth. These net assets – the drivers behind their (nominally) healthy ‘current ratios’- are burdens to growth.
Below is a summary combining selected industry data from a few of Damodaran’s charts, sorted ‘low to high’ by average working capital % to revenues. This list excludes financials (banks, insurance brokerages, etc). The (non-cash) working capital rates are average overall rates, not necessarily incremental -- we have to make the incremental assessment ourselves, by industry -- but these overall rates, percentages to revenues, are at least a starting point for coming up with our own reasonable assessments of incremental rates.
If we dig into the Excel files and look at Damodaran’s data by year, we see that by industry, AR+Inv-AP rates often remain fairly constant (to revenue) in good years and bad – or at least rates don’t diminish in the rebound, and that these big-three elements of working capital largely variable with revenues. In fact, looking at Damodaran’s file totals, we see that on across the industries, inventory percentages to revenues move in some direct relationship with payables percentages, with net working capital substantially driven by accounts receivable, a component that fluctuates pretty directly with revenue.
The table below also includes a ‘net capital expenditures’ column – the average annual amount that capital expenditures exceed -- or if negative, fall below -- reported depreciation( more on this further down).
%’s are to Revenues ‘NCapex’ = annual capital expenditures in excess of (or “-“ below) depreciation Averages are 2006-2011, unless denoted by ‘*’ Industry………….. 6 year average …………………Net Profit Margin Name AR+Inv-AP NCapEx 2011 2006 Med Svcs -3% 0% 5% 6% Cable TV -2% -1% 9% 4% TelecomSvcs -2% -2% 5% 10% Advertising -1% -2% 4% 5% TelecomUtil* 0% -4% 9% *** Restaurant 1% 2% 11% 7% Beverage 2% 0% 14% 11% Ret/WhFood* 2% 1% 4% *** ElecUtilWest 3% 11% 9% 6% NatGas-Div 3% 28% 13% 12% Railroad 4% 7% 18% 14% AirTransp 4% 2% 4% 3% Oil/GasDistr* 4% 13% 10% *** Petrolm-Integ 5% 4% 8% 8% FuneralSvcs* 5% 0% 7% *** EducSvcs 5% 1% 12% 8% RetailStore 5% 1% 3% 4% Petrolm-Prod 6% 16% 11% 16% Maritime 6% 29% 1% 15% Util(Forgn) 7% 16% 1% 8% WaterUtil 7% 19% 12% 11% Hotel/Gam 7% 8% 6% 8% Power 7% 6% 1% -3% Internet 8% 1% 16% 11% Trucking 8% 14% 3% 5% Coal 8% 3% 12% 12% PharmSvcs 8% 1% 3% 3% Newspaper 8% -2% 3% 10% Comp/Periph 9% 0% 11% 4% PipelneMLP* 9% 4% 7% *** InfoSvcs 9% -2% 12% 12% PreciousMet 9% 17% 30% 16% EntertnTech 9% -2% 10% -10% ElecUtil-East 9% 8% 10% 8% RetBldgSup 10% 2% 5% 7% ElecUtil-Centr 10% 8% 9% 8% Retail-Soft 10% 1% 6% 5% MedSupNonInv 10% 0% 5% 7% Engin&Const* 10% 0% 3% *** FoodProc 10% 1% 5% 5% Aero/Def 11% 0% 7% 6% ECommerce 11% 1% 11% 6% Environmtl 11% 0% 8% 5% Entertain 11% -1% 10% 9% IndustSvcs 12% 0% 3% 3% Tobacco 12% 0% 8% 9% Publishing 12% -1% 6% 4% Pack&Cont 12% -1% 13% 3% NatGasUtil 12% 3% 5% 4% HshldProd 12% 0% 12% 11% Recreation 13% 5% 7% 10% HumRes 13% 0% 2% 2% IT Svcs* 13% -1% 11% *** Retail-Hard* 13% 4% 4% *** BldgMatrl 14% -1% -4% 4% WirelessNet 14% -1% 8% 2% Metl&MinDiv 14% 7% 7% 8% OffEquipSup 14% -1% 4% 5% RetailAuto 14% 1% 4% 3% Paper/ForProd 15% -2% 5% 3% Toil/Cosmetics 15% 0% 7% 4% CompSoft 15% -1% 25% 13% Semicond 15% 0% 18% 13% ChemBasic 16% 1% 12% 7% Electronics 16% 0% 5% 3% Furn/HomeF 16% -1% 4% 5% TelecomEqu 16% -1% 7% 11% ForElectrncs 17% 0% 2% 2% HealthcrInfo 17% -2% 9% 4% ChemicalSpclty 17% 0% 8% 5% Steel 17% 0% 4% 9% MetalFabric 18% 2% 8% 6% HvyTruck&Equ* 18% 0% 8% *** AutoParts 19% 0% 5% 0% OilSvcs/Equ. 19% 7% 11% 12% Chem-Divers 19% 1% 9% 8% Shoe 20% 0% 8% 8% Automotive 20% 0% 3% 3% SemicondEquip 20% -1% 16% 18% Apparel 21% 0% 7% 5% Biotechnology 22% 1% 9% 16% PrecisionInstr 23% -3% 10% 7% Drug 23% -4% 18% 16% Machinery 24% 0% 7% 7% MedSupInvsv* 25% -1% 17% *** ElecEquip 60% 1% 12% 12% Homebuildg 75% 0% -6% 9% ______________________________ *** Indicates that there was no directly comparable industry classification for 2006
Incremental rates
We have plenty of instances where, for example, an additional dollar in revenue entails funding 15 or 20 cents in additional working capital, but the sales dollar only yields a nickel or so per year in revenue. The business will eventually be cash-positive on that fifteen cent investment when growth plateaus, but not for a few years.
In a high-investment, steady-growth environment, a business can be perpetually behind on a cash-flow basis. In other words, with high enough working capital outflow and with the expected cumulative net cash flow benefits pushed out far enough into the future - it’s possible that ‘growth’ in revenue and earnings can result in little or even no improvement in intrinsic value. That’s kind of an extreme proposition, but the take-away point is that sometimes ‘growth’ may not enhance intrinsic value as much as we assume from the projected earnings.
Now, in trying to get something out of all this from an investment point of view, the key is that industry averages are just that – averages – and company performances vary. Again, we can look at those retail examples discussed recently, where we saw that most of the typical retailers – Target and such – each had working capital rates right around the industry’s 5% average; some department stores were as high as 15%; Costco was at ‘zero’, and Walmart less than zero. Some companies had substantially lower investment requirements for growth than others – giving them a significant long-term growth advantage.
Along those same lines, within industries, company capitalizations vary. We may see businesses -- especially outside the S&P500 -- that ‘can’t afford’ to take on much new business now. In another board thread here (“The 400% man”), there was a linked article that mentioned air-conditioning equipment supplier Watsco. Watsco is a large, comparatively well capitalized participant in a working-capital-intensive industry. Other large participants, significant or even dominant in their own regions, are finding that they are having difficulty financing post-recession growth.
In this segment there is historically high pent-up demand (nationally the average age of installed air conditioning units, which typically have about a decade of useful life, is about at an all-time high). There should be plenty of capacity – there probably is -- but the industry has high working capital requirements for doing business, and many of the regional participants are struggling to fund that required 'investment'. At least some have been, or are, even quietly looking to the larger Watsco-types as possible candidates to buy them out. [This isn’t news any more, and it’s not a suggestion to buy Watsco at its currently rich levels – but it is a convenient recent example of some post-recession business dynamics].
Without specifics at hand, we might suspect that Illinois Tool Works is finding itself in a similar situation, with plenty of businesses in which it might naturally have an interest now needing financing – or lacking that, a well-financed home in order to get on track for handling new orders.
ITW’s ‘AR+Inv-AP’ rate is currently something like 22% of revenues, with earnings at 11%. If that’s representative of its various industries, less well capitalized companies in its segments having similar dynamics might not be currently able to ramp up their own businesses so easily. Again, this is just some speculation, only using ITW as an example because it was just mentioed. But ITW happens to operate in working-capital-intensive industry segments, and the dynamics may help us understand both its acquisitions and its (and its competitors) cash-flow challenges to internal growth.
With all this let’s keep in mind that the ‘inversion’ of working capital ratios is just one ancillary aspect to analysis; it’s not something to overplay or go too far with on its own – it’s just one more tool for our analysis kit. The point of mentioning it at all is that it often seems to be overlooked.
Moving on… Recessions are nothing new – and these types of working-capital-intensive businesses have been always been around. So what’s ‘different this time’? What has changed during this recession?
Collateral-based debt
From a practical point of view – unless the variable-working-capital intensive business is exceptionally well capitalized, it will likely borrow to fund revenue growth. We’re used to discussing S&P500 companies-- the top 10% or so of the companies represented in the data above—that typically have access to bond markets and such, and are able to secure longer-term fixed debt. The large majority of smaller-cap, W/C-intensive companies, however – the 90%-plus – don’t have the same access. These companies often end up financing working capital through some kind of asset-based borrowing facility– through the Wells Fargo’s or BofA’s, or other commercial lenders, such as GE Capital and such. [This short-term borrowing is also why some of these ‘incremental working capital’ discussions stayed under the ROE radar – the poor ROE dynamics were masked by this related leverage.]
Businesses in all sorts of industries -- transportation; metal fabrication; dealers of equipment and vehicles; you name it -- use working-capital-based debt. The borrowing is typically collateralized by receivables based on perhaps 80% or 85% (historically) of ‘eligible’ receivables. Sometimes a small fraction of inventory--typically less than 50%, often significantly less--can serve as collateral. There will be some kind of overall loan cap, but the actual borrowing limitations will be dependent on the 'advance rates,' and on eligible collateral at any moment. Ask the bankers, and they’ll say that their authorized credit limits are generous. Ask the businesses, and they’ll often say they can only borrow a fraction of that limit under the loan’s formula.
With the recession, advance rates on receivables were frequently cranked down – and in many cases, the inventory-secured portions were yanked altogether. Borrowers who hit potholes in performance – who came up short in meeting financial performance requirements ('covenants'), were more likely this time to find themselves dropped altogether, rather than just getting hit with the usual prescribed financial penalties.
Unlike home mortgages, these loans come up for periodic renewal, and in the interim they have those continuing performance covenants. And being collateralized by liquid assets, the lender can often exit fully paid. Over the past several years, whenever a business privately mentioned that Wells Fargo was the lender, we could pretty much guess that the next sentence included something like ‘reduced our advance rate’ or something along those lines -- though this was by no means limited to just them. Well's point of view of course was that they were helping keeping their customers avoid getting over their heads.
From the business’ point of view, if the company survived, it found itself stuck in a no-growth situation. It became common for working-capital-intensive businesses to find themselves unable to take new orders because they couldn’t come up with the money they needed in advance to fulfill the orders, because they didn’t already have the receivables (the collateral) to borrow against....because they couldn’t take the new business....trapped in a kind of ‘reduced borrowing base’ spiral.
One reason for the relative silence on this whole subject has probably been that companies with financing or refinancing pressure can never let their suppliers, their customers, or their competitors see them sweat. Just the hint of a credit problem can itself cause a collapse; nobody wants to be part of the chain with the leper.
On a related tangent -- we see a lot of commentary about excess cash build-up now. Among the S&P500, the reasons for both the build-up and retention are widely discussed. For the other 90%, the build-up has been at least a defensive action to this kind of situation, having recently been through an environment where banks pulled out with little notice, or where their borrowing limits have been reduced by a tighter formula.
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Net Capital Expenditures
Since we’re looking at balance sheet items as ‘costs’ -- cash outflow required to support the business -- we might also want to look at capital expenditures. For most businesses – most industries – we think of capital expenditures as ‘investment’. But that’s an accounting definition, and not always an economic distinction. For some industries, even heavy capital expenditures can really be considered ‘expenses’ of the business.
To some extent – and in most industries – depreciation expense in the P&L reflects capital spending (we saw in the chart above that for most industries, the ‘net’ of capex and depreciation is about ‘zero’ over time). But for some industries, the participants are consistently spending above depreciation levels – and sometimes this excess capex is at remarkably consistent levels (see Damodaran’s files).
In some industries capital ‘investment’ is a requirement just to stay in business – sometimes just to stay competitive with the industry. That’s especially true where competitive pricing is such that the entire industry is passing efficiencies of collective new investment on to customers, or where there’s ongoing obsolescence, whether textile looms or fuel-inefficient aircraft.
Similarly, some of this positive ‘net capex’ represents capacity replacement, new mines replacing old; new railroad spurs replacing recent abandonments, etc. - where we have defensive spending, sometimes at highly inflated costs vs the replaced assets. We’ll have to determine for ourselves, case by case, how much is embedded in the business model, and how much I really elective.
Where this type of spending is necessary to remain competitive, we may want to re-think our interpretation of P&L results to include these costs. In any event, we’ll want to factor these costs into our discounted cash flow analyses in assessing intrinsic value.
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Again, the point of this is not to take away from any of the analytical tools we are using or change our fundamental approaches to analysis, but to add some perspectives. When we see P&L-based projections, and particularly when we’re taking stabs at what they might mean for intrinsic value – the value of future cash flows -- we might keep the working capital (and net capex) elements in mind.
