By Bob Kramer, May 1, 2013 at 7:50 pm
“Criticism may not be agreeable, but it is necessary. It fulfills the same function as pain in the human body. It calls attention to an unhealthy state of things” – Winston Churchill
Drew Hofler from Ariba got into the act of commenting on the P&G article in the WSJ by correctly noting that P&G’s payment term extension, when combined with Supply Chain Finance, would actually help suppliers. Unfortunately he took it a bit too far with his comments on Dynamic Discounting.
Dynamic Discounting is like P-Card, a high cost / low touch form of supplier finance that appeals to a very small percentage of spend at a Global 2000 company. No doubt there’s a niche role for it with smaller indirect suppliers and one time spend suppliers. Very few suppliers though (as a percentage of spend) will find typical Dynamic Discounting interest rates of 8% – 36% APR attractive. Drew cites an example of $3 Million in savings per $1 Billion in spend using Dynamic Discounting which implies an annual APR financing rate of about 9% to 14%. I doubt any company this side of Wal-Mart could find a billion dollars in spend with suppliers who would find such high rates attractive.
Drew goes on to say that Dynamic Discounting offers an “overall increase in days payable outstanding when offered in conjunction with terms extension program”. With Dynamic Discounting, the buyer pays the supplier early which decreases Days Payable Outstanding (DPO). To say Dynamic Discounting increases DPO in conjunction with a terms extension is simply not true. If a buyer extends their payment terms from 45 days to 75 days, and then pays the supplier on day 3 through Dynamic Discounting, they will have reduced their DPO from 45 days to 3 days. That’s a cash flow killer for the buyer. A buyer might be fine with that if they’re earning 14% APR on the cash their using to pay early, but if I had a direct material supplier that found 14% APR money attractive, they would rise to the top of my supplier risk watch list. Compare that to SCF which, in the P&G example, is offered at 1.3% APR and there really is no comparison.
Drew mentions that SCF programs are “typically narrowly focused on the top tier of suppliers, where there is sufficient spend for banks to reap a profit on such a low margin product”. It depends on the specific buyer and the bank, but at PrimeRevenue our SCF programs cover suppliers down to about $30,000 per year in spend. That’s going to cover nearly all of a Global 2000 buyer’s direct spend and most of their indirect spend as well. Yes, there is a role for Dynamic Discounting, it’s pretty much the same role as P-Card, and it covers a small percentage of a Global 2000 buyer’s spend.
By Bob Kramer, April 25, 2013 at 7:47 pm
“Every man takes the limits of his own field of vision for the limits of the world ” – Arthur Schopenhauer
The responses to the WSJ article on P&G’s effort to optimize working capital and payment terms has generated a lot of responses. Nearly all of them missed the key point, that P&G is collaborating with suppliers in their efforts to move to industry standard payment terms. By offering Supply Chain Finance, P&G can reach industry standards while at the same time improve supplier cash flow and reduce supplier costs.
Typical of the responses is Bill Connerly’s article in Forbes. Bill describes P&G’s efforts as hurting both P&G and suppliers. “Procter & Gamble is about to lose money thanks to CFO hubris”. Even after receiving a comment from P&G about their SCF program, he still feels it is detrimental for both P&G (in the long run) and their suppliers. Let’s go through the math and look at the example Bill used, a supplier with $100,000 of sales to P&G and a supplier borrowing cost of 4% APR.
- With SCF in place, the supplier can access funds based on P&G’s credit rating, not the suppliers. According to the original WSJ article the SCF rate to the supplier is 1.3% APR.
- According to the article, suppliers can use SCF to get paid on day 15 so let’s do the math from day 15. Prior to P&G’s term extension and SCF offer, the supplier with a 45 day term pays $333 to finance their receivable to day 15 ($100,000 / 360 * 30 days *4%). After P&G’s term extension the supplier pays only $217 ($100,000 / 360 * 60 days * 1.3%). So the supplier actually saves $116. Said another way, it’s cheaper for the supplier to finance 60 days of their receivable at the SCF rate of 1.3% than 30 days at the supplier’s own rate of 4%.
Bill also undervalues P&G’s benefit. In the example above, by extending payment terms 30 days, P&G will generate $8,219 in incremental operating cash flow, not debt. How do they value that cash flow? They can use that cash flow to invest in their business, buy back shares, pay dividends, etc. Let’s say they value that cash flow at a WACC of 6%. The value to P&G is then $493, far greater than the $8 Bill calculates by using P&G’s commercial paper rate of 0.10%. This isn’t short term cash or debt for P&G so it shouldn’t be valued at a short term debt rate such as their commercial paper rate.
So, since P&G is making SCF available to suppliers, the reality of the example above is the supplier saves $116 and P&G makes several hundred dollars depending on how they value capital. With SCF in place this is an example of collaboration, not hubris.
P&G has the opportunity to generate $2 Billion in operating cash flow simply by raising payment terms to industry standards. If I were a P&G shareholder, I’d be pretty upset with the management team if they didn’t capitalize on this opportunity, especially when SCF is available to actually improve supplier cash flow. Why should P&G, in effect, subsidize competitor’s longer payment terms and cash flow by paying sooner than industry standards?
By Bob Kramer, April 22, 2013 at 8:51 pm
“What’s in a name? That which we call a rose, by any other name, would smell as sweet” – William Shakespeare
The Wall Street Journal recently published an article titled “P&G, Big Companies Pinch Suppliers on Payments,” which discusses Procter and Gamble’s effort to optimize supplier payment terms. The article highlights a useful strategy which companies can employ to generate shareholder value while at the same time strengthening the financial health of their supply chains. Unfortunately the article is inappropriately titled and, more importantly, buries the lede.
This is a great move by P&G. According to the WSJ article, P&G lags industry standards on payment terms. Catching up will generate $2 billion in Free Cash Flow (FCF). That’s clearly a big number. To put that in perspective, given P&G’s FCF margin, P&G would have to sell an additional $18 Billion in product to generate $2 billion in Free Cash Flow. P&G’s management team would be derelict in their duty to shareholders if they did not execute against this opportunity to get in line with industry standard payment terms.
They key here though is that P&G is doing this in a collaborative way based on industry benchmarks, individual supplier characteristics and the use of Supply Chain Finance (SCF) technology and services. You can see the letter to suppliers from CPO Rick Hughes here. SCF gives suppliers the ability to take early payment at a low discount rate based on P&G’s credit rating, not the supplier’s. This offsets some or all of the negative economics to the supplier. By offering its suppliers a multi-bank SCF technology platform, P&G can improve its Free Cash Flow and reduce total cost in the supply chain rather than just shifting costs.
By Bob Kramer, April 18, 2013 at 8:39 pm
“What is a cynic? A man who knows the price of everything and the value of nothing” – Oscar Wilde
Many people think suppliers value capital obtained through Supply Chain Finance based on their cost of debt. According to this logic, a supplier will participate in SCF only if the SCF rate is less than the supplier’s short term borrowing costs. On the surface this looks like it makes sense, since it seems that short term borrowing is the alternative to SCF funding. However looks can be deceiving. Digging a little deeper, SCF provides Free Cash Flow (operating cash flow minus capital expenditures), while borrowing provides financing cash flow. The two are not the same. Free Cash Flow (FCF) is clearly more valuable – it is the basis on which companies are valued. Most manufacturing and consumer goods companies use Free Cash Flow as a key objective. I don’t see many with increasing debt as a key objective.
So how much more valuable is Free Cash Flow than financing cash flow? In other words, how much more valuable is SCF cash flow than borrowing? The value of Free Cash Flow is somewhere between the cost of debt on the low end and the cost of equity on the high end. I think we can narrow it down further than that to somewhere between the cost of debt and the weighted average cost of capital (WACC). Based on observed supplier behavior, the more material the spend is with the supplier, the closer they will value Free cash flow from SCF to their WACC. Another key factor in how suppliers value FCF is their corporate objectives. Suppliers with objectives around asset efficiency (eg. ROIC, Working Capital /Sales, FCF/Sales, etc.) will also value SCF cash flow closer to their WACC. Other supplier business drivers which impact how they value SCF include growth opportunities, capital intensity and ownership structure.
One of the most important things we can do when educating suppliers about SCF is to make sure they understand that cash flow from SCF is Free Cash Flow, not financing cash flow, and that the two should not be valued the same.
By Bob Kramer, April 11, 2013 at 9:25 pm
“However beautiful the strategy, you should occasionally look at the results” – Winston Churchill
People often ask why supplier’s take early payment through Supply Chain Finance in order to determine which suppliers will find SCF most valuable. Usually people think suppliers take early payment or “trade” because the SCF program rate is lower than their cost of short term debt. This is simply not true. At PrimeRevenue, half of the top 10 trading suppliers by trading volume are large investment grade suppliers who actually have a lower cost of short term debt than the SCF rate. So, why do supplier’s trade? Empirical evidence from our SCF programs over the last 10 years, which includes tens of thousands of suppliers and hundreds of billions of dollars of transactions, shows the reasons why suppliers trade are, in order of importance:
- Materiality of spend. Is the buyer’s spend with the supplier material to their business? This is based both on the percent of revenue that comes from the buyer and the absolute level of spend. The more material the spend, the more likely the supplier is to trade.
- Payment term. The longer the payment term the more likely the supplier is to trade.
- Value of capital. The higher the supplier values capital, the more likely they are to trade.
100% of trading activity is captured by these 3 variables. A supplier with a small percentage of revenue from a given buyer, short payment terms and a very low value of capital won’t be taking early payment through SCF. A supplier with any one of the three characteristics listed above may find SCF attractive and trade invoices for early payment.
Materiality of spend and payment term are of course easy to calculate. How a supplier values capital is a far more slippery affair however. I’ll take a look at that in more detail next week.