Increased Payables as a Percentage of Inventory
Some management teams wisely attempt to reduce the level of assets tied up in working capital – things like cash on hand and inventory on store shelves. The reason is straightforward: each dollar freed is a dollar that can be used to pay down long-term debt, repurchase shares, or open new stores. At the same time, it is necessary to have sufficient products on the shelf to satisfy demand. Otherwise, potential customers won’t waste a trip!A solution to this dilemma is a form of vendor financing known as pay-on-scan(“POS”). Here’s how it works: one of the executives at Seattle Enterprises (“SE”) will approach its vendors – the manufacturers and wholesalers of the products stocked on store shelves. Traditionally, SE selects the products they want to carry, orders them from the vendors, pays the bill, and sticks them on the shelf. Instead, the executive will propose that SE does not actually purchase the product until the customer has picked it up, walked to a cash register, and paid for it; the vendors, in other words, still own the products sitting on the shelves in SE stores. In exchange, SE might give the vendors volume rebates, special placement in stores, or other incentives.
The result is a drastic reduction of working capital risk and the ability to expand much, much more rapidly. Why? When a retail company opens new stores, one of the biggest startup costs is the purchase of the initial inventory. Now that the inventory is being provided on a pay-on-scan system, all Seattle has to do is sign a lease, improve the property to match its other store designs, and hire new employees. The lower upfront costs will allow it to open two or three stores for every one store it could afford prior to the POD system implementation!
The only apparent drawback of this arrangement is a dramatic increase in accounts payable account, which shows up on the balance sheet as a short-term liability. Despite the fact that the business doesn’t really have any additional risk – the product, remember, can be returned to the vendor if it is not sold – some investors and analysts treat this debt as an obligation that could threaten liquidity! This is clearly a case of accounting not representing economic reality. The shareholders are infinitely better off despite the apparent rise in the debt to equity ratio.
Case Study
A perfect example of this phenomenon is AutoZone. (Let me say up front that at the time this article was published, I owned shares of the company. Please remember, however, that all investment decision should be driven by your estimate of intrinsic value. Over the past several years, the stock has traded in a range from around $25 to over $100; it may be a wonderful investment at one price, a terrible investment at another. Therefore, it is inappropriate for you to consider purchasing a stock, bond, mutual fund, or other asset simply because you know someone else has a position in it.)The number-one retailer of automotive parts and accessories has seen net income increase from $245 million in 1999 to $566 million in 2004. At the same time, earnings per share have risen from $1.63 to $6.40. Common equity, on the other hand, has fallen from $1.3 billion to $171 million while the debt to equity ratio has skyrocketed from around 40% to over 90%. There are two primary reasons:
- AZO has repurchased nearly half of its outstanding shares over the past five to ten years, decimating common equity while providing a nice boost to EPS.
- The management team has successfully migrated over 90% of vendors to a pay-on-demand arrangement, increasing the accounts payable balance substantially while reducing the investment in working capital.
These moves were tremendously beneficial for shareholders, yet the apparent risk appeared to increase due to the limitations of accounting rules. The moral of the story? Always look deeper; focus on economic reality, not merely reported earnings and ratios.
