Credit Risk Management
Wholesalers Thirst for Cash While Eyeing Debt
Industry trends toward lower cash flow and higher debt are raising red flags with some of the world's largest wholesale distributors.
With slim profit magins and low asset bases, few companies depend on efficiencies in operating cash flow and working capital more than wholesale distributors. But, improvements in working capital aren't necessarily translating into improved cash flow, according to newly released benchmark data from the Credit Standards Index (CSI), an index of credit data published by CreditPulse.
Wholesale distribution companies follow a sales-oriented business model in which they buy products from manufacturers and then resell those products to end users in a variety of industries. Companies in this industry serve as a sales distribution channel for many of the world's most important and widely-used products in areas such as pharmaceuticals, electronics, food, computers, building materials, chemicals, industrial machinery and others.
"Wholesale distributors have a done a good job of managing credit risk in recent years, but, unfortunately, that has not translated into improved operating cash flow even though net profit improved slightly," said John Bassford, senior credit analyst at CreditPulse. "For some large publicly-traded distributors this poses a problem because their market valuations remain anemic even in an inflated equity market."
Investment capital has long eluded the industry due to factors such as low profitability, slow revenue growth and very little free cash flow, which is why the industry group has the lowest market capitalization compared with annual revenue of any industry in the 76-industry CSI at 0.66. Market capitalization, or the market value of a company, is found by multiplying a company's total outstanding shares by its stock price. Generally, in healthy companies, market value should always exceed annual revenue.
One glaring example of how the strain on profit and cash flow affects the market value of the industry can be found in one of its largest companies, World Fuel Services Corp, based in Miami, Florida. In 2018, the annual revenue for World Fuel was $39.7 billion, yet its market cap in June of that same year was only $1.37 billion for a market cap-to-revenue ratio of 0.03, the worst in the industry. Scant interest from investors is a major reason why many distributors in the U.S. and around the world forgo the capital markets and choose to remain private. (See separate article on market valuations.)
Less Operating Cash
In 2018, the last year before the Covid pandemic that CSI data is available, the industry's operating cash flow benchmark, which represents the average net operating cash flow for 70 publicly-traded wholesale distribution companies, fell to a dangerously low 3.8%, a 1.2% decline from the 5.0% figure registered in 2016 (see accompanying graph). The decline in operating cash came even as the industry's net profit average edged up to 3.5% from the 2.2% average in 2016.
Cash flow is so scarce among wholesale distributors that an amazing 60% of the 72 companies in the 2018 CSI industry group reported operating cash flow of 4% or less compared with revenue, one of the lowest of any industry.
UGI Corp, a natural gas and electric power distributor based in King of Prussia, Pennsylvania had the highest operating cash flow in the industry at 14.2% in 2018 just edging out highly-rated Fastenal Co, which reported operating cash flow of 13.6%. It's no coincidence that both companies also have healthy market values well above their annual revenues.
Meanwhile, the company with the least amount of operating cash flow in the industry at minus 13.8% was Pyxus International Inc, formerly known as Alliance One International, a $1.8 billion tobacco leaf distributor based in Morrisville, North Carolina. Pyxus filed chapter 11 bankruptcy on June 15, 2020, but in June 2018 the company's market value was only $190 million for a market cap to revenue ratio of 0.11. The deadly combination of low market value and low operating cash flow is rapidly becoming a near-certain path to bankruptcy.
Working Capital
With tight margins and little equity capital, working capital and cash management are critical to wholesale distributors. Deficiencies in managing working capital may lead to a significant increase in debt, thereby reducing funding headroom and liquidity. Two key measurements associated with working capital and cash management are bad debt allowance and days' sales outstanding (DSO).
Bad debt allowance, a key credit risk benchmark, has steadily improved among wholesale distributors in the past eight years (see nearby chart) falling to 2.3% in 2018, according to CSI data, a positive sign for an industry with little margin for error in credit risk. In all, 63% of the companies had bad debt allowances of 2% or less. The company with the highest amount of credit risk was SIG plc, a British-based international supplier of insulation and roofing materials, with a BDA of 7.6%.
The DSO benchmark, a frequently monitored measure of receivables efficiency, fell to 45.84 days in 2018 an improvement from the 47.42 day benchmark in 2017. DSO numbers vary widely among all industries, particularly wholesale. Core Mark Holding, a wholesale grocery distributor, had the lowest DSO at 8.98 days, while Arrow Electronics Inc, one of the world's largest distributors with annual revenue of $30 billion, had the highest at 110.02.
The DSO benchmark is influenced somewhat by some companies use of a form of receivables lending known as receivables securitization. In A/R securitization programs, loans are made to the company through bankruptcy-remote, special purpose entities (SPE) and, in some cases, a portion of the company's receivables are removed from the balance sheet, thus artificially lowering the DSO.
Of the 15 wholesale distributors that reported using such facilities, six required enough funding whereby signficant portions of their accounts receivable were consolidated into SPEs and qualifed for removal from the company's balance sheet. When excluding the DSO results for those six companies, the DSO benchmark edges higher to 47.74 for 2018 and 49.33 for 2017.
Liquidity and Solvency
Liquidity, as measured by current ratio, is the one benchmark that has remained steady over the past few years clinging to a seemingly comfortable 2.25 level (see chart). However, in 2018, the majority of the industry's current assets were inventory at 42% while accounts receivable, a more liquid asset, particularly with lower credit risk allowances, represented 40% with cash and cash equivalents representing approximately 18%.
The most liquid company in the industry in 2018 was Universal Corp, a tobacco distributor based in Richmond, Virginia, which reported current assets of 6.26 over current liabilities with 44% coming from inventory and 23% from accounts receivable. Meanwhile, the industry's most illiquid company and the only one with a current ratio of under 1.00 was AmerisourceBergen Corp, the world's second largest wholesale drug distributor, with a liquidity ratio of 0.91.
The solvency of some companies in this industry is starting to become a concern as the all-important debts-to-assets ratio, a key solvency metric, rose to 0.66 in 2018 from the 0.63 mark in 2016. Three of the industry's largest companies by revenue, AmerisourceBergen Corp, Cardinal Health Inc and McKesson Corp, all have debts-to-assets ratios over 0.84. Total long-term debt for the three companies alone totaled $19.78 billion in 2018, a 25% increase from the 2016 combined figure.
Written by John Bassford, Senior Credit Analyst