Investing in Retail: Understanding the Cash Conversion Cycle (CCC)
One of the best ways to
distinguish excellent retailers from average or below average ones is to look at their
cash conversion cycles.
The CCC tells us
how quickly a firm sells its goods (inventory),
how fast it collects payments for the goods (receivables), and
how long it can hold on to the goods itself before it has to pay suppliers (payables).
Naturally, a retailer wants to sell its products as fast as possible (
high inventory turns), collect payments from customers as fast as possible (
high receivables turns), but pay suppliers as slowly as possible (
low payables turns).
The best case scenario for a retailer is to sell its goods and collect from customers before it even has to pay the supplier.
Wal-mart is one of the best in the business at this:
70% of its sales are rung up and paid for
before the firm even pays its suppliers.
COMPONENTS OF CCC
INVENTORY TURNS
Looking at the
components of a retailer's cash cycle
tells us a great deal.
A retailer with
increasing days in inventory (and decreasing inventory turns) is likely stocking its shelves with merchandise that is out of favour.
This leads to
excess inventory,
clearance sales, and usually
declining sales and stock prices.
RECEIVABLES TURNS
Days in receivables is the
least important part of the CCC
for retailers because most stores either
collect cash directly from customers at the time of the sale or
sell off their credit card receivables to banks and other finance companies for a price.
Retailers don't really control this part of the cycle too much.
However, some stores, have brought attention to the receivables line because they've opted to offer customers
credit and
manage the receivables themselves.
The credit card business is a profitable way to make a buck, but it is also
very complicated, and it is a completely
different business from retail.
Be wary of retailers that try to boost profits by taking on risk in their credit card business because it is generally
not something they are good at.
PAYABLES TURNS
If days in inventory and days in receivables illustrate how well a retailer interacts with customers,
days payable outstanding shows how well a retailer negotiates with suppliers.
It is also a great gauge for the strength of a retailer.
Wide-moat retailers such as Wal-Mart, Home Depot, and Walgreen
optimize credit terms with suppliers because they are one of the few (if not the only) games in town.
The fortunes of many consumer product firms depend on sales to Wal-Mart, so the king of retail has a huge advantage when ordering inventory: It can push for
low prices and
extended payment terms.
Extending payment terms to their suppliers allow the retailers to hold on to its cash
longer and to
reduce short-term borrowing needs; effectively increasing the retailers' operating cash flows .
Additional Notes:
In retail and consumer services, most economic moats for the sector are
extremely narrow, if they exist at all.
Therefore, not surprisingly, you
don't find a ton of great
long-term stock ideas in retail and consumer services.
The only way a retailer can earn a wide economic moat is by doing something that
keeps consumers shopping at its stores rather than at competitors'.
It can do this by offering
unique products or
low prices.
Although you can do well buying high quality specialty and clothing retailers when the industry sees one of its
periodic sell-offs,
very few of these kinds of firms make great
long-term holdings.
