The Crocodile of the Moat: The Float (Part II)
In the first part we discussed the value of floats in the form of deferred taxes, profitable insurance underwriting and the benefits of a hypothetical zero coupon perpetual bond. We will now examine the float provided by negative cash conversion cycles, negative working capital, and what I will generalize as “other” revolving credit, also known as trade payables and customer advances. All of the various components are intertwined together producing a cause-and-effect relationship, which we will examine below.
Cash Conversion Cycle and Working Capital
The cash conversion cycle is one of the accounting tools one may use to evaluate management’s effectiveness relative to competitors. The cash conversion cycle can be computed using the following balance sheet items:
- Cash Conversion Cycle = DSO + DIO – DPO
- Days Sales Outstanding (DSO) is defined as Average AR/Revenue per Day
- Days Inventory Outstanding (DIO) is defined as Average Inventory/COGS per day
- Days Payable Outstanding (DPO) is defined as Average Payables/COGS per day
Albeit (CCC) should not be viewed in isolation, meaning it must be viewed over multiple years and against competitors CCC to gauge a normalized and realistic industry trend.
So what does the CCC reveal?
The cash conversion cycle reveals the time it takes the business’s cash to convert to, or “flow” through inventory and accounts payable, then through sales and accounts receivable, and finally back to cash.
The lower the CCC, generally the better. Some companies (Amazon) are even able to manage a negative cycle, settling payables (sometimes as long as a month) after inventories are sold and payment is received. Negative and very low cash conversion cycles are not always feasible (to maintain) and it can be a signal of the competitive positioning the company has over its supply chain.
The competitors that are the best at managing cash, working capital, floats and human capital will likely be the ones with the largest moat in the particular industry or niche market. Jae Jun over at OSV has a great write up (I recommend you read it) further comparing a few shoe companies CCC and market returns. The CCC may be used in combination with other metrics as a key indicator of receivable cycles lengthening or inventory bloating, as well as the inverse and more beneficial scenario of inventories shrinking/payables lengthening.
The cash conversion cycle is best used to examine businesses that are dependent on cash flow produced from inventory turns, DSO and DPO. Contrast a retailer like Wal-Mart where CCC is very important with a REIT that owns no inventory and has no turns like Riocan (but has negative working capital) and is dependent on CAP rates and interest coverage.
Forbes also found an interesting correlation (depicted in the graphic above) between the four largest U.S retailer’s stock returns and the cash conversion cycle.
The cash conversion cycle is essentially the working capital the business needs to operate, the more efficient and lower the cycle in days; the less working capital is needed. Some companies are able to extract more favorable financing terms than others due to economies of scale, industry characteristics, the individual business model, or cyclical supply/demand bursts.
In the info graphic above the typical working capital cycle is shown albeit the financing methods are missing and it assumes cash at particular points. Depending on the individual business model, competitive advantages and how the industry operates, receivables, payables and inventory may be rearranged. Take the example of Amazon. Amazon operates with a negative cash conversion cycle and negative working capital due to the economies of scale of their operations, the industry they operate within and the individual business plan.
Lets start with checking the cash received from sales versus the out lay of cash for the corresponding payables. Cash from sales are received immediately while the corresponding payable is settled at a later date. This produces a short-term float, as they are able to operate week-to-week with other people’s money. Second Amazon receives payment for Amazon Prime membership prior to providing the annual service (customer advance), again producing a float. Take a look at Amazons AR + Inventories versus AP.
And again with Wal-Mart, but not nearly as drastic.
We can see that the receivables and inventory are being easily financed by account payables, leaving a float left over in both cases. [Payables - (Inventory + AR)]
Other Revolving Credit: Customer Advances and Trade Payables
As we can see with the example above, customer advances and trade credits are usually the result of a competitive position and economies of scale, as the bigger companies are able to “muscle” suppliers into more lenient terms.
For a quick review, a cost-less and enduring float is essentially a zero-coupon perpetual bond.
The closer the duration to infinity and the lower the cost is to zero the more the float resembles a perpetual zero coupon bond. Customer advances can be classified as gift cards, traveler cheques, deposits, and subscriptions or any other service a customer pays for before receiving, diminishing the accounts receivable cycle. Trade payables are credits extended from suppliers through (lengthening) the payable cycle.
What did Buffett have to say about these types of float?
“If you get access to an enduring and free (or less-than-free) float — whether it comes from insurance underwriting, derivatives contracts, trading stamps, travelers’ cheques, stored value cards, deferred taxes or any other source — then assets financed with such a float will become “an unencumbered source of value” for your stockholders. This will happen because (1) the assets financed with such a float would still be valued on the basis of their expected future earning power; but (2) the true value of the liability represented by the float will be far lower than its carrying value, provided the float is both costless and long-enduring.”
Well we would have already likely known this to be somewhat true by analyzing other famous WB investments like American Express, Blue Chip Stamps or GEICO. Not all companies that have the ability to generate floats are large and dominant firms, but they do likely have a moat or else another company would encroach on this cost-less and enduring float. Blue Chip Stamps produced a valuable float that was recognized and utilized by Warren, as he explains below.
“An early precursor to frequent flyer miles in the 1950s and 1960s, trading stamps, such as Green Stamps, Blue and Gold, and Blue Chip, were handed out as a customer incentive by merchants. Retailers deposited money at Blue Chip in return for their stamps, then the money was used to operate the stamp company and to purchase the merchandise handed out when stamps were redeemed. Shoppers were given a certain number of stamps for each dollar spent in a store, which they pasted into books, then redeemed for prizes such as toddler toys, toasters, mixing howls, watches, and other items. Because it took time to accumulate enough stamps to redeem merchandise-and because some customers tossed the stamps in the back of a drawer, forgot them, and never did redeem them-the float built up.”
WB then used the [perpetual] float of Blue Chip Stamps to purchase another small company, See’s Candy. He also purchased American Express in 1964, producing a sizeable float through traveler cheques, which I will do a follow up case study about.
Are Floats and Moats Attached?
Free capital is a competitive advantage as it levers ROA and ROCE more efficiently than the alternatives of equity or debt financing, meaning float does not dilute shareholders to achieve this leverage.
“A good moat should produce good returns on invested capital. Anybody who says that they have a wonderful business that’s earning a lousy return on invested capital has got a different yardstick than we do.”
Float does just that, improves returns on invested capital as the denominator is lowered, because the business is able to operate (and sometimes invest) with other peoples money. Float does not dilute shareholders like equity or debt financing; it is the best capital structure choice for a business, all else equal.
It is quite possible that the float could also be used as a warning flag, prudently monitoring conversion cycles and the level of the float. If the float begins to decline in relation to operating assets, it is quite possible a competitive advantage may be eroding or a business cycle is coming to an end.
Finally, a key factor to acknowledge is that cyclical floats are hazardous and not enduring because at one point in the future the tides will turn (commodity businesses like steel production and auto manufactures). Lenient AP cycles will become more stringent and shorten, while AR cycles become more lenient (to off-set demand) and lengthens, causing a (who knows how long) needed increase in working capital. I do not want to put my business’s money up; I want to use other people’s money or......... a float.
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain