Industry Profiles

Covid Cash Surge in Wholesale Distribution

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Reliance Steel photo
Metals distributor Reliance Steel & Aluminum, based in Los Angeles, maintained strong cash flow during the global pandemic.

Wholesale distributors experienced a rare surge in operating cash flow during the coronavirus pandemic even as sales and net profit declined.

An industry normally starved for operating cash saw an upsurge of the precious business commodity during the coronavirus pandemic to cap a surprising three year trend of higher operating cash flows even as profitability, typically the main driver of cash, went in the opposite direction declining for three consecutive years, according to an analysis of newly released benchmark data from CreditPulse.

The unusual development is an indicator that wholesale distributors, long accustomed to operating on razor thin margins with very little excess cash, may finally be gaining the upper hand in maximizing working capital and operating cash flows in order to offset chronic industry deficiences in profitability and market value.  However, industry credit risk as measured by the bad debt allowance benchmark jumped to its highest level since 2010 (see accompanying chart). 

The wholesale distribution industry includes a diverse mix of very large companies with a global reach and smaller companies that serve mostly domestic and regional markets.  These companies combine scale and purchasing power with a direct sales business model that enables them to offer multiple product lines at competitive prices in a variety of specialized industries such as pharmaceuticals, electronics, food, computers, building materials, chemicals, industrial machinery and others.

The sales-oriented business model, however, exerts added pressure on profitability and operating cash flow--two major reasons that many companies in the industry have chosen to remain private and those that are publicly-traded have low market valuations.  The average market capitalization compared to revenue, or maket cap to revenue ratio, per company is a dismal 0.60, the lowest of any other industry. 

"The surge in operating cash was a welcome sight to an industry that has historically struggled in that critical area," said John Bassford, senior credit analyst at CreditPlulse.  "But, the surge was largely due to a drop in inventories caused by supply shortages during the pandemic, which is not a sustainable source of cash.  The profit trend is a concern and shows there are still liquidity challenges in this industry going forward particularly among the largest companies."

Sales Pandemic

Increasing sales became an ongoing challenge during the Covid pandemic as average annual revenue for the industry fell 0.3% from the 2019 level--a dramatic development for an industry that was in the midst of a sales boom with average annual sales growth of 9.8% from 2017 to 2019, according to CreditPulse data.  Although severe, the Covid impact on sales was mild compared to the 6.3% decline during the recession of 2009.

The decline in sales placed even more pressure on profitability as the average net profit for the industry declined for the third straight year to 2.1%, a 22% reduction from the 2.7% profit benchmark for 2019 (see nearby chart).  Only two companies, out of an industry group of 60, reported double-digit profit margins while 16 experienced net losses.

Fastenal Company, a building materials supplier based in Winona, Minnesota, continues to be the most profitable publicly-traded distributor in the world with a profit margin of 15.2% in 2020 up from the industry-leading 14.8% margin the previous year.  Meanwhile, SIG plc, a $2.4 billion British supplier of insulation and roofing materials was the least profitable with a net loss of 7.4%. 

New Found Cash

The industry's operating cash flow benchmark, which represents the average net operating cash flow for the 60 distribution companies in the Credit Standards Index (CSI), surged to 6.5%, a sizable 35% increase from the 4.8% level the previous year and a huge improvement over the 3.5% benchmark in 2018.   The increase in operating cash came even as the industry's net profit declined for the third straight year, an unusual occurrence.

Declines in inventory, accounts receivable, sales and a sudden rise in bad debt all combined to form a perfect storm that vaulted the industry's operating cash flow to its highest level since 2009 when the benchmark reached 7.4% paced by companies such as Digital River and Sigma Aldrich Corp, two companies that are no longer in the CSI. 

Operating cash flow is so scarce among wholesale distributors that only 18 of the 60 companies, a mere 30%,  reported operating cash as a percent of revenue of 10% or more.  Meanwhile, 20 of 60, or 33%, had operating cash of 4% or less, the danger zone in the world of cash flow.

Weyco Group Inc, an apparel and footwear distributor based in Milwaukee, Wisconsin was the industry leader in generating operating cash at 20.5% of revenue in 2020 just edging out highly-rated Fastenal Co, which came in at 19.5%.  Meanwhile, the company that generated the least amount of operating cash was ePlus Inc, a computer and IT services distributor, based in Herndon, Virginia with annual revenue of $1.6 billion.

Working Capital

With slim profit margins and low market value, 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 measurments associated with working capital and cash management are bad debt allowance and days' sales outstanding (DSO). 

Bad debt allowance, or BDA, a key credit risk benchmark, rose sharply in 2020 to 2.9% as the result of a pandemic-induced rise in credit risk following steady improvements in recent years that culminated in a 2.1% BDA in 2018, according to CSI data. Three companies raised their bad debt allownces to 10% or more last year, the first time since 2016 that any company had a BDA in double-digits.  The company with the highest amount of credit risk was Now Inc, a global oil and gas industrial products distributor based in Houston, with a BDA of 12.4%.

The DSO benchmark, a frequently monitored measure of receivables integrity and efficiency, rose slightly to 43.71 days from the 42.55 day benchmark in 2019.  DSO numbers vary widely among all industries, particularly wholesale distribution.  Core Mark Holding Company, a wholesale grocery distributor, had the lowest DSO at 7.80 days, while Insight Enterprises Inc, a $8.3 billion IT products and services distributor based in Tempe, Arizona, had the highest DSO of 117.52 days, narrowly edging out the perennial leader Arrow Electronics also at 117 days.

The DSO benchmark is influenced to some degree 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, or SPEs, and, in some cases, a portion of the company's receivables are removed from the balance sheet, thus artifically lowering the DSO. 

Of the 14 wholesale distributors that reported using such facilities in 2020, nine appeared to have SPEs that qualified for removal from the company's balance sheet, based on disclosed information and previous DSO figures.  When excluding the DSO results for those nine companies, the DSO benchmark edges higher to 46.65 days in 2020 and 44.66 days in 2019.  Genuine Parts Company and Patterson Companies just began using A/R securitization in the past two years.

Liquidity and Solvency

Liquidity, as measured by current ratio, has remained steady over the past few years clinging to a seemingly comfortable 2.25 level, but, not surprisingly, even it took a hit during the pandemic falling to 2.17.  The most liquid company in the industry remains Universal Corp, a tobacco distributor based in Richmond, Virginia, with a ratio of 5.53 current assets over current liabilities. 

Meanwhile, in a potentially ominous sign, three companies dipped below the 1.00 current ratio mark for the first time, according to CSI data, with two of the three among the industry's largest companies.  UGI Corp, a $6.5 billion natural gas distributor based in King of Prussia, Pennsylvania hit the basement in industry liquidity at 0.88 followed closely by two industry giants, AmerisourceBergen Corp and McKesson Corp at 0.98 and 0.99 respectively.

The debts-to-assets ratio, a key solvency benchmark, remained steady at 0.66, but the long-term solvency of some companies could be in jeopardy as three wholesale distributors are now over the critical 1.00 solvency mark.  Pyxus International Inc, formerly Alliance One International, filed for Chapter 11 bankrupcty on June 15, 2020 with a debts-to-assets ratio of only 1.04 and two well-known distributors Wesco Aircraft Holdings and Tech Data Corp were recently acquired by private-equity firms, the first PE acquisition since the aforementioned Digital River was aquired in February 2015.

Look for more on the liquidity and solvency of the industry in the subsequent industry rankings article.
Written by John Bassford, CreditPulse senior credit analyst