Are Big Corporations Manipulating Their Cash Flows?

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Includes: DEO, KMB, LOW, NSRGY, PG
by: Joseph Harry

Summary

"Stretching" payables boosts short term liquidity.

Operating cash flow may be overstated as a result.

Where does it end? How long can you take to pay suppliers before you pressure them too much?

After analyzing some consumer staples names lately, I've noticed that many have been increasing their days payables outstanding, or effectively taking longer to pay their suppliers. Few seem to announce this openly, but The Wall Street Journal recently published a piece on Lowe's (NYSE:LOW) that caught my attention. In effect, Lowe's has enough power over its suppliers to dictate payment terms, and can take longer to pay, which can immediately improve its working capital, increase its operating cash, and subsequently, its free cash flow.

Is this a "win-win"? Everyone else is doing it, right?

Here's the thing though, Lowe's suppliers may actually be paid just as quick as before, if not quicker. This is possible because Lowe's banks basically pay its vendors on time, and then Lowe's pays the banks the full invoice amount when it wants/needs to.

Here's how Lowe's stacks up to some of its similar big-box retail peers:

LOW Days Payables Outstanding (Annual) Chart

LOW Days Payables Outstanding (Annual) data by YCharts

Now putting consumer staples back in the spotlight, Procter & Gamble (NYSE:PG) started stretching its payables in 2013. It began offering financing terms through banks to smaller vendors, allowing them to hopefully cope with the increased payment terms. Procter & Gamble stated that it would offer cash to suppliers after 15 days from delivery, for a fee of course. At the time, P&G was looking to implement its policies over a three year period, freeing up around $2 billion in cash by increasing the time it took to pay suppliers by as much as 30 days.

In other words, it aimed to stretch its payment time from around 45 days to 75 days. A Wall Street Journal article published around the time of the announcement pointed out that:

P&G is actually late to this game. It currently pays its bills on average within 45 days, faster than the 60 to 100 days that other consumer products makers and large companies in other industries generally take, according to industry experts.

P&G pretty much pitched this idea as a "win-win" in 2013, insinuating that it would not only benefit them by freeing up working capital and operating cash (leading to higher free cash flow), but also by helping its suppliers who often had higher borrowing costs. Competitors such as Kimberley-Clark (NYSE:KMB) have participated in this practice, too.

PG Days Payables Outstanding (Annual) Chart

PG Days Payables Outstanding (Annual) data by YCharts

The practice of extending payments seems to have largely started during the financial crisis, which makes sense. It also seems like it's a continuing trend, however, and it's not just happening with American companies, either.

Backlash is the U.K.

Diageo (NYSE:DEO) also announced that it would be extending the time it takes to pay vendors earlier this year. It sent out a letter to suppliers on February 1st saying that it would start to extend the number of days it takes to make payments from 60 days to 90 days. This policy would begin with all of its new contracts going forward, and the company itself stated that the move was much needed to cut costs and "improve its cash flow". The company doubled its payment time from 30 days to 60 days back in 2009 as well, so this is not the first time it's done this.

While I haven't noticed any complaints surrounding P&G or Lowe's, in regards to Diageo, the Forum for Private Business struck out at them rather quickly, saying that its policies threatened "to break the backbone of the British economy - small businesses". Diageo (not unsurprisingly) fired back, and said its announced policies would protect the long-term sustainability of not just its own business, but that of its suppliers as well. How nice of them, right? In all fairness, the company did make the announcement publicly, informing its suppliers ahead of time.

What it means

I've found that the phenomenon of extending payables usually occurs in the consumer staples industry, or any other industry that is consolidated enough that it can wield power over its suppliers --whether they like it or not. Who's going to say "no" to Diageo -- the maker of Smirnoff, Guiness, Ketel One, Tanquerey, and many more essential brands? How is a small supplier going to make up lost business if it tells Procter & Gamble "sorry, we don't accept your new terms"?

Most suppliers probably won't or can't, and many might not even care that much if they get paid on time through the buyer's supply chain financing scheme. It seems that the banks are wedging themselves in between buyer and seller, taking a fee for easing cash constraints and helping big-time buyers keep their cash longer. I don't see this as a major issue now, but if I see a company I'm invested in burning through cash and running working capital deficits, I think there would be some concern.

Procter & Gamble currently has a working capital deficit (more current liabilities than current assets), even after stretching its payables over the years. So what makes it different than a firm that's extending its payables out of desperation?

P&G has a fat cash pile and generates solid free cash flow even adjusting for the extra operating cash its kept from taking longer to pay, so in their case, I think it's just matching "industry practice" as an efficiency measure in regards to their cash management policies. They still have a strong, flexible balance sheet in other words, so I'm not as concerned about their payment extension policies as I would be if they had no cash on the books and were saddled with a massive debt pile.

I think a red flag would arise if a debt-laden company with little cash was running out of options (due to limited financial flexibility) and decided to extend its payables period rapidly and in a short amount of time, without any public disclosure. If a company starts sending checks out after 45 days (as opposed to say the 30 days it usually does) without telling its vendors, that's way more concerning than what Diageo or Procter & Gamble are doing, in my opinion.

Conclusion

The bigger the company and more consolidated the industry, the more power a firm has over its suppliers. This is undeniable it seems, and it makes sense for these giants (financially in the short-term, at least) to squeeze some extra cash flow out of them, especially in tougher times like the financial crisis. If you can hold on to your own cash longer and goose liquidity by pushing out the pain to your suppliers, why not right?

What happens, though, if you push them too far, and your liquidity needs are still unmet? I doubt this is really a concerning issue as of now with strong companies like Procter & Gamble, but later on down the road I think it might increase overall costs. The banks are usually getting their cut through fees and vendors might raise prices to cover any payment shortfalls.

What happens if we get another downturn, then what's left to stretch if your payment terms are already at 90 days or more? Gigantic, multinational juggernauts like Nestle (OTCPK:NSRGY) have payables periods over 100 days. I don't think any of the above mentioned companies are in any serious financial trouble, I just think that they're flexing their size-and-scale muscles to squeeze out more cash flow at the expense of their smaller vendors.

The thing that concerns me most as an investor is the potential distortion of the cash flow statement. Higher operating cash derived from extending payables isn't exactly encouraging to me. It's similar to manipulating net income to goose earnings per share, and I think that investors should pay more attention to payment policies going forward when analyzing current and prospective investments. It may be harder to manipulate operating cash, but it's obviously not impossible.

To sum things up, in my personal opinion the practice of extending payment periods should be used as an emergency source of funding, not a long-term tactic. Supply chain financing might look attractive now in the short-term, but let's also consider the low interest rate environment we're currently in. Will this practice be as attractive to these corporations if/when we enter a normalized rate environment and it costs more than 1% or 2% for a bank to bridge the gap between payments to suppliers?

Disclosure: I am/we are long PG, NSRGY, DEO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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