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Ben Hoskin

We return with the latest edition looking into working capital trends and dynamics within European High Yield. Previous editions have focused on companies going cap-in-hand to suppliers in order to extend payables terms and keep cash in the business as the pandemic took hold in 2020, and the implications supply chain financing (aka reverse factoring) on the cash conversion cycle in the wake of the Greensill insolvency scandal in March 2021.

As activity returns, most companies have seen sales soar compared to last year, but inflation in raw materials, and supply chain issues have hit several sectors hard. Two companies that stood out in our analysis are Takko and Boporan, with Takko’s cash conversion metrics plunging despite strong improvements in its retailer peers, and Boporan’s tiny cash position vulnerable as inventory effects roll off. A monster payables outflow due to production slowdowns at Jaguar Land Rover courtesy of the global semiconductor chip shortage was also of note.

Looking into the Q2 dynamics, there were two clear themes across the dataset that we analysed (n=149; removing outliers of +/-100 day delta in the cash conversion cycle):

A strong snapback in sales in many sectors 

Inflation and supply chain issues are flowing through to working capital

Between Q2 20 and Q2 21, net working capital (defined as inventory plus receivables less payables) as a percentage of sales fell from 65% to 49% on average across the dataset.

Intuitively, this makes sense for two main reasons:

Firstly, Q2 21 revenues were far larger than Q2 20, with a lot of companies able to trade for most or all of the quarter compared to 2020 when draconian lockdowns were still very much the order of the day, meaning that comparables are distorted.

A second, less pronounced factor was working capital management. Businesses hit by very uncertain demand landscapes and in need of cash used working capital as a mitigant, through disciplined inventory management and/or reducing the time and amount of receivables outstanding, so cash isn’t tied up in these two assets for as long. A corresponding increase in payables to keep cash in the coffers offset this slightly.

Consumer Discretionary, Communication Services, Healthcare and Industrials all hovered around that average decline of ~15%, with Materials and IT experiencing a slightly larger contraction.

Sales at Materials companies were up on average ~40%, likely due to the depressed prices of raw materials in the prior year against this year's transitory (or perhaps not?) inflation bonanza. Inventories were largely flat, with increased prices combined with a snapback in sales leading to a ~20% rise in receivables. Payables rose by a similar magnitude.

This was the story for many sectors; Consumer Discretionary and Materials had increased sales of 75% and 33% respectively versus prior year, with inventories flat, and receivables and payables rising in the range of 10%-20%.

But working capital as a percentage of sales doesn’t tell the whole story, especially when prior year sales figures are so low. So we return to the cash conversion cycle for a more granular look at working capital trends and dynamics we’ve seen over the last twelve months.

As a reminder, the cash conversion cycle is calculated as:

Where DIO (inventory days) is average inventory over COGS (cost of goods sold) per day, DSO (receivables days) is average receivables over revenue per day, and DPO (payables days) is average payables over COGS per day.

A lower CCC is desirable, showing capital tied up in assets for less time. Higher inventory days than industry norm imply inventory is on hand for longer than needed or is possibly obsolete; however, too low indicates sales could be compromised through inadequate stock. Higher than average receivables days suggests customers are taking too long to pay; too low could mean the company's credit policy is too stringent, again harming sales. High payables days are desirable from a liquidity standpoint but of course, have to unwind at some point.

Interestingly, this was the biggest reduction in cash conversion cycles across the analysed dataset we’ve seen since looking at this, declining at a similar magnitude at the mean (-14.7 days) and the median (-14.8 days). The split was roughly 70/30 in favour of companies reducing their cash conversion against those experiencing increases.

Among sectors, Utilities saw the biggest slowdown in the cash conversion cycle, with IT and Materials improving the most, similar to the previous chart looking at working capital as a percentage of sales. But there are some differences too.

Healthcare went from a ~17% decrease in working capital as a % of sales to a modest increase in the cash conversion cycle. The reason for this is where net working capital rose ~1% for the sector, sales grew ~20%, thus lowering working capital as a % of sales. The culprit for the difference was inventories growing at a quicker rate than payables, and with both metrics relative to COGS, the reduction in payables days outpaced inventory days, thus having the effect of increasing the CCC.

As always, we took a look at the underlying components driving the cash conversion cycle, showing a reduction in all three components for every sector other than Consumer Staples, where there was a tiny uptick in inventory days.

Of the four sectors on the right of the chart which experienced a reduction in the CCC by >10 days, the drop in inventory days and receivables days was large enough to offset the drop in payables days. Similarly, the two sectors which experienced increases in CCC (Utilities and Healthcare) experienced drops in all three components, with the magnitude of a reduction in payables days eclipsing the combined effect of inventory and receivables days falling.

Next, we’ll dive into some of the more interesting pockets of the market to take a closer look at the moving parts. If you interested analysis on a specific industry that isn’t covered here, please contact team@9fin.com.

The cash conversion cycle slowed ~70 days at German value fashion retailer Takko with the management conversion cycle falling drastically, as multiple changes occurred in the c-suite during the last 18 months. The combined effect of cash tied up in inventories for longer and less time spent owed to trade creditors pushed up the cycle by ~70 days during the three months to April. Average inventories rose €23m (~12%) despite flat COGS, which the company attributes to lower sales in Winter 2020/21 thanks to the second lockdown.

There is some seasonality in the business — sales are higher in the spring (March to May) and lower in the winter (December to February), we expect to see some inventory unwind when the company reports numbers for its second quarter (ending July), particularly if the business experiences any pent-up demand. However, the Q1 report does touch on some supply chain disruptions in the form of partner factory and port closures that will cause production and delivery delays, which, if commentary from peers for the quarter ending in June is anything to go by, may have worsened during Takko’s Q2.

A vast recovery in sales at New Look meant revenue and COGS both more than doubled, which explains the move down in all three of the CCC components. Gross margin expanded from 30.6% to 45.5%, as the prior period - when the UK was in full lockdown for the majority of the quarter - saw mostly lower margin online sales as a result of higher distribution costs and more promotional activity. There was a cash outflow as inventories in the quarter increased to ensure an appealing stock package for customers returning to in-store shopping, versus prior year when the brakes were put on stock purchases as the pandemic took hold.

It was a similar story at Matalan, where a near tripling in topline complemented lower average inventories and receivables and higher payables - a perfect storm for driving down the CCC. Matalan management told investors on the Q1 call that there is still ~£80m of deferrals (tax, rent, suppliers), much of which will unwind in the second quarter, although the majority of this won’t show up in the CCC. Supply chain disruptions were likely to continue into early autumn, with three to four week delays from Asian suppliers.

Another interesting pocket of the market was manufacturing, where surging raw material prices flowed through to the working capital account.

PVC window and door profile manufacturer Profine’s net working capital increased 3.9% y-o-y, attributed to “fast increasing raw material prices and the favourable sales performance”. A PVC price increase is reflected in inventory levels, whilst a €22.3m rise in payables is further enhanced through acquisitions. COGS rose at a faster rate (~90%) during the quarter than sales did (~61%), compressing margins and explaining the divergence in inventory and payables days against receivables days (with the former two using COGS as the denominator and the latter using sales). The company only implemented material surcharges in June meaning they were playing catch up against the inflationary effects (PVC prices increased 36% between March and June), but signaled that it will further increase surcharges into July and August to claw back gross margins.

Supply chain bottlenecks were evident in Thyssenkrupp’s Q3 21 (end-June) results. Higher input costs and a slowdown in orders in the forgings business from automotive customers (due to the semiconductor shortage) temporarily pushed up net working capital.

Norican bucked an industry trend with much lower average inventories. Of the inventory components, raw materials were roughly flat year-on-year, with the decline coming in work-in-process and finished goods. Sales rose 8% for the quarter with COGS roughly flat, leading to a gross margin expansion of 5% for the quarter. Looking at this, one might conclude disciplined inventory management against a backdrop of rising input prices, however, the company expects the price escalations to dissipate throughout H2, potentially giving up the gains seen in the first six months.

Not shown in the graph due to the size of the component changes is Aston Martin, where cash was tied up in inventories and receivables for 184 and 256 days less, respectively. However, this was more than offset by a 497-day reduction in payables days, pushing the cash conversion cycle up 56 days in total. There was a sizable £62m inflow from working capital for the first half of 2021, in stark contrast to last year's £86m outflow, where a £110m payables unwind was mainly to blame as plants were closed for production. Inventories in H1 20 also caused a £30m outflow to support the production of DBX models at the St Athan site.

This unwound through H1 21, with a £40m receivables inflow the most significant contributor as the “build to order strategy normalised delivery cadence” (£31m came during Q1 21, so the Q2 contribution was less pronounced). The company claims its limited edition vehicles help to control working capital swings, with deposits for the vehicles required up front to generate a favourable working capital profile, which can then be maintained at a stable level.

Aston utilises a £150m receivables finance facility (which replaced the previous Wholesale Finance Facility), whereby the company sells “rights” in certain receivables to a counterparty for a discount (effectively factoring).

Jaguar Land Rover is another in the sector utilising a similar facility, incorporating receivables days into the operational covenants. Plant shutdowns during April and May in 2020 at the onset of Covid-19 led to a monster £1.2bn outflow from working capital, reflecting the runoff of payments to suppliers for vehicles built before the shutdowns, and highlighting the pain the industry faces during periods of production issues with supplier payment terms often lagging the immediate receipt of payment from retailers.

This was again present in the corresponding quarter of this year, but for different reasons. Highlighting the sensitivity and magnitude of JLR’s working capital swings, this time it was the semiconductor shortage that led to production slowdowns, and contributed to a ~£1.4bn payables outflow in Q122 (end Jun-21). Faurecia reduced guidance on September 23 because of the shortage, while consultancy Alixpartners estimates an enormous $210bn revenue hit for global automakers in 2020, highlighting the severity of the crisis for the industry.

Aptiv, Tenneco, Goodyear and Gestamp all complained in Q2 results of adverse effects from the chip shortage, with many expecting the situation to deteriorate in Q3 before recovering in Q4.

Similarly to manufacturing companies, raw material prices have a big impact on the working capital requirement of those in the Chemicals space.

INEOS reported a ~€413m outflow in working capital during Q221, primarily reflecting higher raw material prices, and consequently product prices, coupled with increased sales volumes compared to the prior year; the effect of these was a big jump up in inventories and receivables. This did not offset the near doubling in sales (with a corresponding increase in COGS), pushing the CCC down. The company also has access to a receivables securitisation program and an inventory financing facility, used to help fund working capital.

Working capital management is cited as a high priority and focus at Ashland, where a 16% reduction in inventories complemented a 16% increase in COGS, improving inventory turnover by ~40% and thus meaning cash was tied up in inventories for less time (i.e. lower inventory days).

However, other factors than disciplined inventory management may be at play here. Inventories are primarily stated at cost using the weighted-average cost method, although the company does value certain (undisclosed) stock using the last-in, first out (LIFO) method. The US firm reports under US GAAP, with LIFO prohibited under IFRS, thus requiring care when comparing against European peers. In an inflationary environment, gross margins and inventories will be lower, due to the most recent (expensive) inventory purchases being used in COGS, and the old (cheaper) stock used in the valuation of inventories. The overall effect acts as a double-edged sword in pushing down inventory days.

Lower volume of trade receivables sold under a securitisation and reverse factoring programme at CABB contributed towards a working capital outflow for the quarter. Average inventories, receivables and payables were largely flat against ~25% increases in sales and COGS, pushing all three of the CCC components down.

Solvay management revealed on their Q2 call that “renegotiating credits with key suppliers has improved our average DPOs, days payable outstanding”. This, coupled with inventory and receivable days decreases pushed CCC down.

Boparan’s inventory stockpiling in the face of the Brexit transition gave the company a nice boost to free cash flow when it unwound in Q3 21 (end-May), although working capital now presents a risk to the flimsy £26.9m cash position. One distressed debt analyst cautioned on the accompanying earnings call that it could unwind in coming quarters, however the extent of this isn’t particularly clear with granularity and visibility on working capital being difficult to gauge for the company.

Management mentioned they expect ~£10m more of poultry stock to unwind over the next twelve months, although with inventory at the lowest it’s ever been - albeit distorted through the Fox’s biscuits disposal - questions remain around how much more slack the company actually has here. The cash position could be exacerbated by £12m owed in PAYE payments at the end of May, and the impact of limited labour availability in the UK.

Despite higher sales in 2021, there was an operating cash outflow at Lycra driven by working capital flows. Higher polytetramethylene ether glycol costs (a chemical compound used in products) increased inventories, increased sales drove higher receivables, and other asset increases due to increased advanced payments for raw materials.

Balta warned of a difficult H2 in light of raw material cost increases, which had already made their way into a working capital outflow for H1. There was seasonal inventory build that, coupled with the rising input costs, increased inventories by €31.3m. Cash sat at €87.5m at June-21, down from €106.3m at the end of 2021, despite posting a €41.2m EBITDA figure for the first half (H120: €18.3). Availability under the €61m RCF, extended to June-24 in February’s A&E, was just €10.8m, although net leverage at 3x is “well inside the covenant”.

Inventory unwind during the H2 will help to reduce net debt further, but it could be worth keeping an eye on how much input costs impact margins, considering much of the inventory build during the first half was at favourable prices to the company.

Puma Energy pointed to a reduction in DSO and DIO as a demonstration of working capital improvements, however, they omitted the ~70-day reduction in DPO, leading the CCC to rise ~35 days. This was due to average payables actually falling slightly, despite COGS more than doubling, although the main culprit for the lower average payables was a monster unwind in Q2 20, and payables are now trending back to historical levels.

You can read previous editions of our Working Capital report here. 

Q2 working capital - Cash conversion cycles working out in an economic boom

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