U.S. corporate bankruptcies thus far in 2023 are their highest since 2010, according to a new report from S&P Global Market Intelligence. S&P 500 earnings were down year over year in Q1 and are expected to continue falling in Q2. Financial conditions are tightening, in the form of higher interest rates and more stringent lending standards. U.S. economic fundamentals are likely to deteriorate further in the months ahead as student loan payments resume and higher auto loan rates eventually adversely affect borrowers. And already-high corporate debt levels are arguably understated. As evidenced by elevated corporate bankruptcies as well as recent dividend cuts and share repurchase freezes, liquidity risks are rising.
U.S. corporate debt excludes a widely used tool called supply chain financing (SCF) that’s come to light thanks to a recent rule from the Financial Accounting Standards Board (FASB) effective in the first quarter of this year. The more familiar one becomes with SCF, the more it resembles debt; buyers are effectively borrowing from their suppliers on a short-term basis, pulling forward free cash flow in the process. As The Wall Street Journal recently wrote, SCF is “essentially a form of short-term borrowing to pay for goods and services from suppliers.”
A FreightWaves analysis of S&P 500 companies’ Q1 filings with the Securities and Exchange Commission revealed about $80 billion of obligations associated with SCF programs concentrated among 84 companies, and that figure excludes several prominent companies (including Procter & Gamble) that haven’t yet been required to disclose any such programs owing to the timing of their fiscal year.
Furthermore, the $80 billion is understated because some companies disclosed a different (read: lower) number than what FASB required. FASB wrote that “a buyer is required to disclose the amount of [SCF] obligations that it had confirmed as valid to a finance provider or an intermediary that is outstanding at the end of a period (the outstanding confirmed amount) …” Instead, several companies disclosed the amount of their outstanding payment obligations that their suppliers had elected to sell; we assume that in almost all cases, the number that FASB required is larger than what these companies chose to disclose.
Consequently, we think the amount of SCF outstanding among S&P 500 companies likely exceeds $80 billion, and perhaps is comfortably north of $100 billion.
Why does this issue matter to investors?
Corporate leverage is high even excluding SCF, and corporate profitability is declining owing to the deteriorating global economy as the positive effects of the massive global government stimulus have worn off. Furthermore, the cost of SCF programs has risen sharply owing to the Federal Reserve’s interest rate hikes over the past year and a half, and the availability of these programs could diminish as banks are under increasing stress. Importantly, supply chain financing is an uncommitted line of credit, which means banks can withdraw it at any time (unlike other types of bank financing). What would happen if companies lost access to SCF? Some would likely have to draw on their revolving lines of credit or issue bonds, such that investors ought to be aware of how much undrawn credit exists relative to the size of the SCF outstanding in many cases.
How much more expensive are SCF programs becoming?
The AES Corp., a power company that had $645 million of SCF outstanding at the end of Q1, indicated in its 10-Q filing in early May that the weighted average interest rate on its SCF programs rose from 4.32% as of Dec. 31 to 6.58% as of March 31, a 225-basis-point increase in just three months. And with respect to the future availability of these programs, The Wall Street Journal reported on Monday that U.S. regulators could force large banks to hold up to 20% more capital following three of the four largest bank failures in U.S. history earlier this year; higher bank capital requirements are potentially problematic for the availability and cost of credit.
Where is SCF usage most pronounced among S&P 500 companies?
Retailers, consumer packaged goods (CPG) companies, packaging companies and telecommunications companies. Retailers, CPG companies and telecom companies account for fully two-thirds of SCF outstanding, and SCF as a percentage of accounts payable is particularly high among CPG companies and packaging companies (along with auto parts retailers).
Why might that be? Retailers, CPG companies and packaging companies are all part of the same supply chain: The retailers decide to take longer to pay their suppliers (among them the CPG companies); the CPG companies decide to take longer to pay their suppliers (among them the packaging companies); and the packaging companies decide to take longer to pay their suppliers. In other words, the pressure cascades down the supply chain, until and unless something breaks somewhere in the chain.
How does SCF work in practice?
Once a buyer decides to take longer to pay its suppliers, it arranges for a bank to pay them on its behalf. As The Wall Street Journal put it last year, “A third party, often a bank, pays a vendor’s invoices but takes a cut. The company pays the bank the amount that was due under the invoice, though at a later date than originally required. The bank’s cut is determined by the company’s credit rating.” Regarding the latter, the higher the buyer’s credit rating, the more economical the transaction; the prevailing interest rate is based on the buyer’s credit rating rather than on the supplier’s. If the supplier has a better credit rating than the buyer, the supplier may choose not to participate in the program.
In that context, how creditworthy are the companies that are engaging in SCF programs?
Their credit ratings run the gamut. Some are large, stable companies with good credit ratings (Procter & Gamble and Walmart are prominent examples), whereas others are far smaller and less stable. Advance Auto Parts, which had $3.1 billion of SCF outstanding as of April 22 (which accounted for a substantial 84% of its accounts payable), just cut its quarterly dividend by over 80% and saw its outlook revised to negative by Moody’s and S&P. Ball Corp., a packaging company that had $608 million of SCF outstanding (17% of its accounts payable) as of the end of Q1, has a non-investment-grade (high-yield) credit rating from Moody’s and S&P, and its net debt/adjusted earnings before interest, taxes, depreciation and amortization ratio was 4.7x at the end of Q1.
On the topic of Advance Auto Parts’ substantial dividend cut, that was far from the only sign of retailer stress in Q1. Dollar General substantially reduced its full-year earnings-per-share guidance and canceled its share repurchase plans this year. It plans no repurchases, compared to its previous expectation of $500 million of repurchases.
Left unaddressed thus far is why large, stable companies with more than sufficient cash on hand would effectively be borrowing from their suppliers on a short-term basis via SCF. We’ll use the CPG industry as an example. In an environment in which several CPG companies are using SCF to boost their operating and free cash flow, others that aren’t doing so look comparatively worse, such that they have an incentive to “keep up with the Joneses” and do what their peers are doing. Investors in CPG companies pay close attention to free cash flow yields and tend to pay less attention to the composition of that cash flow (for example, the extent to which SCF is contributing to it).
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