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Why do big comanies squeeze suppliers


ratiman
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A big company like Apple will often have negative working capital because it slow-pays suppliers. But why would it do this? Apple's cost of capital is very low. The suppliers cost of capital is very high, often because it has one customer, Apple. By forcing the suppliers to finance working capital, Apple's working capital is being financed at the supplier's COC, not Apple's. Isn't that less efficient? Shouldn't Apple be financing the working capital and in exchange negotiate better prices from the suppliers? 

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it is less of a debate than it once was, but some others may recall the discussion about whether or not Amazon's additions to negative net working capital should be part of their free cash flow calculation or not. I remember this being a big deal as late as maybe 2011/2012 in terms of discussions about Amazon's earnings power / valuation / growth etc.

 

There was a blogger / seeking alpha author named Henry Schact / Lonely Value Investor. He wrote an article where the crux of the thesis was that AMZN was overvalued and that ultimately GAAP earnings equaled earnings  power because he treated the additions to negative net working capital (or subtractions in some sense....the ever growing negative net working capital) as a loan that would "one day" come due. as a young whippersnapper who'd read Graham and Buffett and was an impressionable young fellow coming out of college, I largely agreed with him. I never shorted AMZN, but I didn't buy it because...you know it's expensive and once growth slows their true earnings power will show that it's really overvalued.

 

https://seekingalpha.com/article/200612-the-amazon-tulip-bulb

 

the stock is up 17X since that article.

 

Some comments from that article by Mr. Schact:

 

For all my readers, free cash flow is defined as:

Net Income

+ Depreciation/Amortization

- Capital Expenditures (technically only maintenance capex)

- Changes in Working Capital

= Free Cash Flow

Do this calculation and you'll see that Amazon's net income figure is a very close approximation of free cash flow. Any major deviations are the result of noise from working capital.

And yes, the company wants to claim that year-end bump in payables as free cash flow. $3 billion in fcf looks a LOT better than $1 billion when your stock is in nosebleed territory.

65x fcf may look a tad high to even the most ardent Amazon shareholder.

 

'm sorry but you need not be sarcastic about my definition for free cash flow. I haven't created something new here. Everyone knows that free cash flow is the cash available to shareholders for dividends, debt reduction, etc.

The "free" in "free cash flow" means that the cash isn't spoken for.

You have adequately defined fcf in its most basic (layman's) form. But everyone who looks at free cash flow knows that changes in working capital need to be adjusted for. And the rise (and then fall) in payables is EXACTLY that kind of adjustment.

If Amazon's payables never had to be paid, you'd have a point, but payables aren't the kind of liability that goes up and never down. It is precisely the kind of account that needs to be looked at when arriving at actual FREE cash flow.

Again, I don't know how to make this any simpler... but if money is sitting on the balance sheet this week (in late Dec) that will go to a supplier next week (early Jan), then you can't claim it as FREE CASH. It isn't available to shareholders.

But as I said, it seems you have a preconceived idea about Amazon and I'd hate to confuse that with facts.

BTW... Never said you defended Amazon's valuation, just that ALL your comments relate to Amazon... and a defense of it. Like your simplistic definition of fcf.

Time to branch out. There are other companies in the world.

 

 

I believe that I stated in both of my articles (but in case I didn't)... as long as growth continues, Amazon can continue to report fcf that is higher than earnings. Thanks to the payables at year-end. Should growth slow, it won't be possible.

The fact that the payables get run out in Q4 (and come due in Q1) doesn't mean that the level of SUSTAINABLE fcf is $3 billion a year. If anyone believes that, then they need to take Financial Statement Analysis 101.

Profits are ultimately the driver of fcf.

And anyone who thinks that the disparity between $2.9 billion in fcf and 900 million in profits is sustainable, does not understand the nature of the financial reality or financial statements.

Just curious, but (again) where is all this cash that Amazon is generating?

Cash on the balance sheet... $5 billion. Really pretty low considering the market value. That is all the money they've generated in 10 years... and then some.

Share buybacks... sure they've done some, but none of that cash has accrued to shareholders (unless they sold out.... poors saps). Ongoing shareholders have been diluted every year they've owned Amazon.

Dividend? Nope.

So if Amazon was such a cash flow machine, where is it?

 

LOL.

 

In answer to your question, I think they do it because they can. Whether it's AAPL or AMZN, isn't it the supplier who is bearing the increased costs? if someone give you an ever growing interest free loan or negative interest loan, you take it. Am I missing something?

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Companies do it because they are the dominant player in their supply chain, it has nothing to do with their size.

Want to sell product into the Apple, Amazon, Walmart supply chain? it's the cost of doing business with them. If a smaller supplier can do better elsewhere, they do so.

 

SD

 

 

 

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interesting discussion on AMZN, pupil.  you seem like a guy who tries to learn from his mistakes. bravo.

 

look at Walmart.  great American company built on the backs of small US suppliers and (ahem) low cost Chinese suppliers.  Waltons do it, Musk does it. they're a pair that wouldn't agree on much else.  economies of scale are a great thing.

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I worked for a big company that kept significant payables once. They were willing to quick pay (15 days instead of the usual 90) for a discount to the invoice total. IIRC it was 2-2.5%. Basically offering factoring to their suppliers.

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I worked for a big company that kept significant payables once. They were willing to quick pay (15 days instead of the usual 90) for a discount to the invoice total. IIRC it was 2-2.5%. Basically offering factoring to their suppliers.

 

This is the answer.  In effect it's taking off the A/R off of the balance sheet of the supplier and creates better optics for both supplier and customer.  Banks/funding institutions are willing to take the risk b/c it's just another short term credit market (e.g., commercial paper) and counterparties are very credit worthy.  So in effect the cost isn't really cost of funds for the supplier, it's the just a small discount to the supplier, especially in these days when rates are zero...

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I worked for a big company that kept significant payables once. They were willing to quick pay (15 days instead of the usual 90) for a discount to the invoice total. IIRC it was 2-2.5%. Basically offering factoring to their suppliers.

 

This is the answer.  In effect it's taking off the A/R off of the balance sheet of the supplier and creates better optics for both supplier and customer.  Banks/funding institutions are willing to take the risk b/c it's just another short term credit market (e.g., commercial paper) and counterparties are very credit worthy.  So in effect the cost isn't really cost of funds for the supplier, it's the just a small discount to the supplier, especially in these days when rates are zero...

 

The cost is the (discount x 365)/(term - discount period) - and it is expensive financing.

The cost of (1/15, n90) is (1x365)/(90-15) - or 4.87%; the more traditional terms are  (2/10, n90) is (2x365)/(90-10) - or 9.12%.

The treasurer of an Apple, Amazon, etc. just borrows cheap on their credit line, pays the invoice early, and keeps the spread.

 

SD

 

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interesting discussion on AMZN, pupil.  you seem like a guy who tries to learn from his mistakes. bravo.

 

well, I still couldn't bring myself to buy AMZN at any point...

 

this raises for me the push/pull in investing between being flexible (which I believe to be a plus in all domains) and disciplined (sticking to what you know, in theory).

 

I think it is good to go beyond your discipline in small amounts to learn, and if you do well with it, you might be able to expand your discipline

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It's not necessarily to squeeze suppliers, but as others touched, it helps companies grow faster.

 

When they can take payment upfront, reinvest the funds to acquire growth, and pay-off their suppliers at the end of it - it makes total sense.

 

With near-zero interest rates, a supplier cost of capital is close is not huge.

 

What others may have not touched is that some suppliers love this, especially when the delivery cost of product/service is very low versus the prices they charge.

 

Hence they can acquire customers very fast, as customers do not need to pay until X amount of days later, but since their product is valuable, it is almost certain their customers will generate revenues. Worked for a company where they were the lowest cost producer, 90%+ gross margins, low-tech industry, and basically LTV/CAC of like 10, of course, you do not need these metrics to still be under this pool.

 

However, the short answer is the flexibility and opportunities to reinvest funds before paying off suppliers are a lot higher than the cost of that capital.

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I worked for a big company that kept significant payables once. They were willing to quick pay (15 days instead of the usual 90) for a discount to the invoice total. IIRC it was 2-2.5%. Basically offering factoring to their suppliers.

 

This is the answer.  In effect it's taking off the A/R off of the balance sheet of the supplier and creates better optics for both supplier and customer.  Banks/funding institutions are willing to take the risk b/c it's just another short term credit market (e.g., commercial paper) and counterparties are very credit worthy.  So in effect the cost isn't really cost of funds for the supplier, it's the just a small discount to the supplier, especially in these days when rates are zero...

 

The cost is the (discount x 365)/(term - discount period) - and it is expensive financing.

The cost of (1/15, n90) is (1x365)/(90-15) - or 4.87%; the more traditional terms are  (2/10, n90) is (2x365)/(90-10) - or 9.12%.

The treasurer of an Apple, Amazon, etc. just borrows cheap on their credit line, pays the invoice early, and keeps the spread.

 

SD

 

Not exactly.  The decision on paying early or not to get a discount is obviously based on the level of discount, so if the discount is hugely attractive then it may always be worth it.  However, for public companies at least, the optics of higher debt balance and lower AP / WC balance is worth something (sometimes a lot more than "something"), so supply chain financing can often step in when the early pay discounts are not significant enough to outweigh that. 

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I worked for a big company that kept significant payables once. They were willing to quick pay (15 days instead of the usual 90) for a discount to the invoice total. IIRC it was 2-2.5%. Basically offering factoring to their suppliers.

 

This is the answer.  In effect it's taking off the A/R off of the balance sheet of the supplier and creates better optics for both supplier and customer.  Banks/funding institutions are willing to take the risk b/c it's just another short term credit market (e.g., commercial paper) and counterparties are very credit worthy.  So in effect the cost isn't really cost of funds for the supplier, it's the just a small discount to the supplier, especially in these days when rates are zero...

 

The cost is the (discount x 365)/(term - discount period) - and it is expensive financing.

The cost of (1/15, n90) is (1x365)/(90-15) - or 4.87%; the more traditional terms are  (2/10, n90) is (2x365)/(90-10) - or 9.12%.

The treasurer of an Apple, Amazon, etc. just borrows cheap on their credit line, pays the invoice early, and keeps the spread.

 

SD

 

Not exactly.  The decision on paying early or not to get a discount is obviously based on the level of discount, so if the discount is hugely attractive then it may always be worth it.  However, for public companies at least, the optics of higher debt balance and lower AP / WC balance is worth something (sometimes a lot more than "something"), so supply chain financing can often step in when the early pay discounts are not significant enough to outweigh that.

 

This is zero-risk arbitrage, and what the treasurer is incentivized to do.

Typically, the capital invested is not large enough to affect optics.

 

In most cases, bad optics will raise the cost of FR debt by no more than 10-25 bp before tax.

As long as the treasurer can earn more than that, risk free, it's really a non-issue. The higher EPS, from the risk free spread, more than offsets P/E multiple compression arising from risk related concerns.

 

When the optics are big enough to matter, the treasurer has other, and more pressing concerns.

More usually, can he/she continue to roll the debt long enough, until the company can either 'grow' into it - or pay it down? If growth is 'interrupted', and the debt cannot be rolled without difficulty, the company risks BK. As a great many companies are discovering , in this time of Covid-19.

 

SD

 

 

 

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This is zero-risk arbitrage, and what the treasurer is incentivized to do.

Typically, the capital invested is not large enough to affect optics.

 

In most cases, bad optics will raise the cost of FR debt by no more than 10-25 bp before tax.

As long as the treasurer can earn more than that, risk free, it's really a non-issue. The higher EPS, from the risk free spread, more than offsets P/E multiple compression arising from risk related concerns.

 

When the optics are big enough to matter, the treasurer has other, and more pressing concerns.

More usually, can he/she continue to roll the debt long enough, until the company can either 'grow' into it - or pay it down? If growth is 'interrupted', and the debt cannot be rolled without difficulty, the company risks BK. As a great many companies are discovering , in this time of Covid-19.

 

SD

 

SD - with due respect -- and I do mean it, as I've found your comments elsewhere to be generally insightful -- while I agree with you on the concept, the real world companies that I've worked for do not work this way.  SC financing are **generally** not done out of a cohesive logic regarding shareholder returns or value maximization in the long run, but rather incentives at the micro level.  A couple of examples that I've witnessed:

 

1) The CEO/COO are told they need to lower working capital by the Board b/c McKinsey did some work and shows your Shitco is 4th quartile on W/C.  Reducing inventory is really hard work without taking on operational risk, and it's much easier to negotiate with suppliers for better terms.  That work is further reduced when the customer asking is offering an easy out - e.g., supplier financing that's relatively cheap.  For the supplier many get to receive cash faster with some financing cost, and many do take it.  The treasury group does not get a say in this - they are the intermediary that facilitates the interactions with the banks, assuming they're asked to do so at all (they are on the sidelines occasionally too).

2) The company has made some promises to the street to do a stock buyback on a leverage neutral / friendly basis.  TO fulfill that promise it's going to pull an easy lever - financial engineering.  SC fulfills that promise, and does not show up anywhere.  It's not a required disclosure (vs. something like AR securitization).  Little by little W/C comes down, and analysts cheer the operational improvements that the mgmt team is achieving. 

3) The company promised the rating agencies of a certain operational plan, and are told that if they continue the progress they'd be very close to an upgrade (worth 20-50bps across the entire stack when refinanced).  However, the easy fruits are gone, and SC financing looks very appealing... For a treasurer whose career track would be dramatically helped with a ratings upgrade, it's a pretty good carrot.

 

Point is - across various constituencies within a public co the SC financing option is just the easy button, and nobody needs to know about it, which is why it's so damn attractive. 

 

A few other comments:

1) Not all suppliers offer early pay discounts (currently working for a company that doesn't offer it at all - like never.  We'll negotiate on the days, but no discount for paying early).  The % that do this is higher than I thought.

2) This game is being played by both customers and suppliers, so unless a company is in a business that sells to consumers it's just as likely to be on the receiving end of it.

3) I'm not sure I quite get your calcs on the increase in cost of debt, but if it's 10-25bps in as total incremental cost of funding, then that's a really significant amount.  It's really not trivial when companies are looking for bps in terms of funding cost improvements...

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No worries.

 

Agreed on the number of supplier early payment discounts. For the most part it's only going to be the less solvent suppliers, and because the cost of the discount is less than their cost of financing. A robust supply chain is not going to have many of these.

 

Agreed on the w/c waterfall. Early payment discounts are typically an A/P manager responsibility

Treasury just sets the internal rate and maximum capital allocation. Often as a training tool.

 

Different industries, different practices. In the vehicle leasing industry it's not unusual to see supplier end-of-period 'channel stuffing'. Buyers offered very attractive volume and early payment discounts, to 'move the metal', for maybe a 2-3 week period at best. But often it means the treasurer having to temporarily finance 2-3 months of purchases up-front, by going into the CP market. If the raise is large, and the firm is near its borrow capacity, expect to pay a premium.

 

SD

 

 

 

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