Working hard or hardly working? Capital and cash conversion in a post-covid era (Part one)

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9fin

By Ben Hoskin | ben@9fin.com

At 9fin, we’ve taken a comprehensive look into Q3 working capital dynamics across the European HY space, and will be making an abridged version of the report public across three parts. The first looks at the universe as a whole; part two will take a closer look at Retailers and Automotive Manufacturers; and part three will focus on the Energy and Gaming sectors, as well as a few other individual names

As we enter into 2021, there are myriad challenges for companies on managing their working capital. They must keep one eye on their coffers and liquidity requirements as demand is hammered by the pandemic and the other on readiness for the reopening as vaccines bring much needed relief. Working capital is a key trend that advisors, investors, management and indeed, us at 9fin are taking a particular interest in this year.

After the initial dash to cash witnessed in the first half of last year with companies drawing on their RCFs en masse, onerous maintenance covenants and costly margins meant that many were repaid as forward visibility became clearer. Liquidity therefore needed nurturing via other levers, with a common theme on Q3 earnings calls being utilisation of working capital mechanics. 

We went back to CFA basics to examine the cash conversion cycle (CCC) for a portion of the 9fin universe (n=183, with murky reporting in European HY meaning not all inputs were readily available for all). As a brief reminder, cash conversion cycle is calculated as:

CCC = DIO + DSO - DPO

Where DIO (inventory days) is average inventory over COGS (cost of goods sold) per day, DSO (receivables days) is average receivables over revenue per day, and DPO (payables days) is average payables over COGS per day.

A lower CCC is desirable, with capital tied up in assets for less time. Higher inventory days than industry norm implied inventory is on hand for longer than needed or is possibly obsolete; too low indicates sales could be compromised through inadequate stock. Higher than average receivables days suggests customers are taking too long to pay; too low could mean the company's credit policy is too stringent, again harming sales. High payables days is desirable from a liquidity standpoint but of course have to unwind at some point.

On the whole, we saw cash conversion cycles drop by an average of 1.79 days when measuring at the median between Q3 19 and Q3 20, with 57% seeing improvements. Good news. However, this is dragged up to +0.89 days measuring at the mean, implying names in the remaining 43% have struggled to a larger degree. Also, looking under the bonnet the perceived improved efficiency could, for example, be driven by DPO, with the three variables all rising but the latter doing so disproportionately, suggesting a deterioration in cash conversion across the whole cycle and calling for further inspection. Build-ups in deferred payments may also have to unwind at some point, suggesting that the liquidity runway may be shorter than appears on the surface. Furthermore, inventory impairments/write-offs would lead to a perceived improvement in inventory turnover and therefore a reduction in DIO, when in fact there could be more to the story.

Of course, different sectors operate with different working capital characteristics, so we should take a more granular look. 

Five of the nine industries sampled improved their CCC. At first glance, Communication Services (ex Media due to small sample and huge outlier) and Consumer Discretionary were the best performers; Energy, Industrials and Healthcare saw moves upwards, meaning a deterioration in their cash cycle. However, dissecting the moving parts gives us a better idea of the forces driving performance.

Payables days have a noticeable contribution by rising for the industries to the left (helping to decrease CCC) and falling for most to the right (increasing CCC). The other trend that stands out is the slowdown in inventory turnaround for those on the right hand side.   

We can see Consumer Discretionary exhibits the aforementioned illusion of improved capital efficiency, with all three variables all increasing, but payables days doing so at a rate that negated more modest slowdowns in inventory and receivables days. At the other end of the CCC spectrum, Energy, Industrials and Healthcare saw increases driven by different factors. 

Whereas Energy saw a working capital slowdown across the board (with the sum of the rise in inventory days and receivable days outpacing that of payables), Healthcare and Industrials experienced drops in receivables and payables days, with increases in inventory days. Puma Energy management summarised the difficulties the industry faced in 2020 from a working capital perspective in Q2’s earnings call, owing to 3 factors: oil price, impacting the value of working capital positions; inventory, running at higher levels than planned due to an inability to switch of supply or through buying stock for contango position; and the Covid-19 economic impact reducing demand for products overall.  

Communication Services, the “best” improver on CCC, did so from receivables and payables days that soared, suggesting potential short-term cash flow issues for the industry. Gaming was mainly to blame, with a theme of flat/decreased COGS against increased payables.          

Stay tuned for our follow up reports that will take a deeper dive into Retailing, Automotive Manufacturer, Energy and Gaming sectors.