Updated You Want To Pay When? Extended Terms in the Aftermarket

Transcription

1 Updated You Want To Pay When? Extended Terms in the Aftermarket March 2013

2 AASA Thought Leadership: Anti-Trust Note Please Read By: Paul T. McCarthy, AASA Vice President Industry Analysis, Planning, and Member Services The topics addressed in this discussion include matters that are the subject of specific negotiations and agreements between suppliers and their customers. Every supplier must make an independent decision about the terms that it will use with particular customers. Nothing in this analysis should be construed as a suggestion that suppliers should utilize identical or similar terms of any sale in any supplier is due. No agreement among or between suppliers as to any term of sale will be tolerated. This Aftermarket Thought Leadership article builds on content from the AASA/KPMG Extended Terms Report; the AASA Special Report, You Want to Pay When?; and the AASA editorial by AASA President and COO Bill Long, The Long View on Extended Terms. Visit to obtain these reports and additional AASA Industry Analysis articles and Special Reports. In 2012, AASA focused on the trend of extended terms in the automotive aftermarket and the implications of its growing practice for aftermarket suppliers and channel partners. Major customers are asking for terms ranging from 180 days to 360/365 days. Some customers are targeting 100 percent coverage (or more) of their inventory. Many aftermarket companies view the spread of this unusual and risky practice as one of the most critical challenges facing the industry. AASA embarked on a study of extended terms with KPMG, one of the Big 4 global accounting and professional services firms, in early The study s objective was to provide a better understanding of this practice and its significance for the aftermarket supplier community and the overall aftermarket value chain. Its scope was to identify the potential benefits, costs and risks, of extended terms with the goal of promoting dialogue across the industry on this important topic. The AASA/KPMG Extended Terms Report found that, The conventional wisdom that extended terms (and reverse factoring) is win-win-win ignores substantive costs and potential future risks, both of which fall disproportionally to suppliers. The practice of extended terms results in quantifiable costs and substantial indirect costs, according to the report. Extended terms growth will require sizable increases in most suppliers net working capital funding and would substantially decrease margins in likely future interest rate environments; Extended terms exposes the historically stable aftermarket to the unpredictable risks of the credit cycle. 2

3 After the release of this landmark report, AASA urged members to takes steps to fully understand this issue and the potentially negative implications it could have on suppliers and the automotive aftermarket. There are real dangers with extended terms in the aftermarket. According to a credit analyst quoted in the report, The retailers can only push suppliers so far If terms continue to grow, at some point the costs associated with the practice will eventually devastate some small suppliers and in turn lead to disruption of the supply base. This indicates the very real consequences from extended terms. Extended Terms: The Good, the Bad and the Unusual Excerpt from the AASA/KPMG Extended Terms Report Aftermarket suppliers have terms of doing business that are unusual compared to other industries. There are many examples of consolidated channels winning at the expense of weakened manufacturers and less consolidated channels. However, according to KPMG, Payment terms in the automotive aftermarket far exceed those in any analogous industry. Extended terms have become more widespread. AASA supplier members report that virtually all customers are requesting longer terms and the length of the average term is increasing. According the AASA/KPMG Extended Terms Report, as of early 2012, 40 percent of aftermarket sales were made with extended terms of 180 days to 360/365 days. That number was dramatically higher at aftermarket retailer customers. Just in the last two years, the percent of aftermarket sales under extended terms and the average DSO in the industry were estimated to have increased by a third. The KPMG report projected that, in the future, the push from customers for extended terms is only going to get worse. The report noted that suppliers estimated that in three years DSO for 3

4 sales under extended terms could reach an average of 256 days. Subsequently, many suppliers have indicated this may be an underestimate given the recent acceleration of the trend. There have also been discussions between customers and banks to extend terms beyond 360 day terms, despite the resulting considerable accounting complications. These longer terms are driving substantial decreases in net working capital requirements at customers and better return on capital. But is the shareholder value generated by aftermarket resellers coming at suppliers expense? KPMG estimates that without extended terms, public channel partners would have required an additional $1.8 billion in working capital investment in According to the report, this created a virtuous circle for retailers. Extended terms reduced working capital, which improved cash flow, allowed share buybacks and funded new store openings. This increased size improved leverage with suppliers, helping to further extend payment terms and start the circle all over again. Viewed in this light, extended terms raise serious questions regarding the current aftermarket business model. Does it make sense for suppliers to fund more profitable and financially strong customers in this way? There are valid business reasons that many suppliers accept these longer terms. In the current environment, extended terms supported by reverse factoring can be a financially attractive way to retain or grow sales. Interest expense currently is modest, and in many cases, suppliers are able to provide lower cost financing versus other facilities. Many suppliers have noted that accepting longer terms has increasingly become the cost of entry to win business with a new customer. Some suppliers receive incentives from customers to accept longer terms/reverse factoring. This allows suppliers to receive positive terms in exchange, including a possible price increase on a one-time basis. It is important to note the distinction between extended terms and reverse factoring. Reverse factoring also known as supply chain financing, confirmed receivable financing or buyercentric factoring is provided by a financial institution that unites the buyer s credit rating and its supplier s need for receivables financing. Usually initiated by buyers, it offers them significant benefits. For many aftermarket suppliers, reverse factoring is often an inexpensive option to access capital to fund extended terms. If a supplier agrees to extended terms, reverse factoring certainly has appeal in the current environment of low interest rates. It also can serve as a form of receivables insurance. In sum, reverse factoring is simply a response to the underlying trend: extended terms. That said, suppliers need to understand that reverse factoring is uncommitted lending and can preclude access to other funding. In reverse factoring, customers own the bank relationship, unlike in normal factoring. Reverse factoring has no funding commitment to the supplier, and can disappear at any time at a bank s discretion. Suppliers have noted several historical incidents when access to reverse factoring programs has been disrupted. Furthermore, most investors and financial institutions regard factored receivables as debt, which can affect borrowing capacity and valuation. As one supplier noted in the KPMG study, (After factoring) we talked to over 20 banks for asset backed lending and asked for a line; not a single bank would take our account. 4

5 Cost of Extended Terms In the AASA/KPMG Extended Terms Report, it was noted that accounts receivable have increased by almost $7 billion across the industry on an annualized basis due to extended terms. Funding this results in considerable costs for suppliers, and that cost will increase over time. According to an aftermarket supplier cited in the KPMG report, Increased payment terms would put strain on our business due to a significant increase in required working capital. Excerpt from the AASA/KPMG Extended Terms Report In a conservative three year scenario estimated by KPMG, it is predicted that the aftermarket would see a $12 billion increase in total receivables for suppliers and a 77 percent increase in the amount of factored receivables. Please note that this is just one scenario, which most members believe is based on assumptions that are more conservative than they now expect to happen given the accelerated expansion of extended terms. In the full AASA/KPMG Extended Terms Report there are multiple scenarios including worse outcomes and sensitivity tables to allow suppliers to estimate the potential future impact of extended terms on their business. Additionally, there are hidden and indirect costs beyond the direct funding costs of extended terms. Common indirect costs that suppliers face include receivables holdbacks, stock adjustments, warranty adjustments and demands for incremental price concessions. As members noted to KPMG in the study, Terms included a 20 percent holdback this significantly increased our costs. There are tons of inventory write offs resolving issues adds about 40 days. We often refuse a draft two or three times before an accurate amount is paid. This can add a month. 5

6 Too Much Inventory in the Channel? Extended terms can also have unintended consequences. One of the most common concerns we hear from industry executives is that extended terms is worsening the long-standing issue of too much inventory in the channel. In the estimation of some AASA supplier executives, the result of longer terms may be more inventory in the aftermarket than ever before. Excess inventory has long been viewed as a systemic risk to the aftermarket. By funding inventories with extended terms, some members believe that the inventory overhang in aftermarket supply chain has increased. That creates unnecessary waste and risk for all players. Let s take the retail sector as an example. To attract increased professional do-it-for-me or commercial business, retailers need to have larger inventories to compete with the traditional channel. Yet, their working capital and inventory costs are down. These declines are at a time when retailers segment expansion would normally be increasing working capital and inventory. Through the trade credit of extended terms, aftermarket suppliers essentially are helping fund retailers move into the professional market, increasing competition in that segment. Extended terms also may be increasing total system costs. Many retailers have noted publicly that they are attempting to place more parts at their retail locations. This increases total inventory costs, as inventory at a retail store is always more expensive than inventory at a warehouse. It can lead to more parts than would be needed if demand was fulfilled by the warehouse, as warehouses enjoy the benefits of demand and risk pooling across multiple retail locations. This trend in turn is likely increasing competition on individual parts sales, as demand for a single part from a service professional can now be met by redundant parts at multiple nearby jobbers and retailers, decreasing channel partners pricing power on a sale. It also contributes to the ever-slower inventory turns experience over time in the aftermarket. In total, this just-in-case inventory model is creating significant redundancy in meeting market demand, increasing system-wide costs. As an executive at a major channel partner noted at a recent AASA event, We have been buying more than we have been selling for several years, and we expect that to continue for the foreseeable future. Other channel partners could undoubtedly say the same thing. Over the long term, that does not sound like a sustainable business model for the aftermarket. Impacting the Entire Value Chain In fall 2012, Advance Auto Parts made headlines with the rumor that it was considering a potential leverage buy-out (LBO) with private equity. However, the use of extended terms in the industry complicated this option, as seen in comments from equity analysts at the time: BB&T: Given that recent trends for the aftermarket retailers have been to extract cash from working capital by extending days payable terms with vendors, such a strategy generally involves vendors having access to reverse factoring programs at the retailer s borrowing rate. Morgan Stanley: heavier levels of debt might make it more difficult for AAP to offer vendor or commercial customer financing programs, which might add working capital and limit flexibility on inventories. 6

7 ISI: We are updating our LBO model to reflect a potential $600 million working capital impact assuming AAP loses its investment grade credit rating in an LBO scenario. These market responses further highlight the key findings in the AASA/KPMG Extended Terms Report, namely that extended terms have an impact and cost not just for aftermarket suppliers, but for the entire value chain. Effectively, extended terms limited the strategic options and financial flexibility available to Advance, as it could and may do for other channel partners. It also shows the topsy-turvy world of extremely extended terms. Essentially, our customers have become like insurance companies they need to have an investment grade to make their business model work. That s a strange requirement for an automotive aftermarket company. Risks of Practice As stated in the AASA/KPMG Extended Terms Report, the long term impact of extended terms on the aftermarket as a whole is cause for concern. Risks to the aftermarket value chain include: Interest rates: A significant rise in interest rates would require the industry to reverse extended terms or come up with billions of dollars of capital to fund this unusual business model. Exposure to the credit cycle: The preponderance of extended terms means the aftermarket industry is now more sensitive to credit availability and cost. Credit cycles, like economic cycles, are inevitable and hard to predict. This may be a greater near-term risk than interest rates. This risk exposure is a sea change for the historically stable aftermarket. The aftermarket traditionally has been one of the most resilient industry sectors, highly resistant to fluctuations in external business conditions. However, this evolving business model makes that less true for all players in the aftermarket. Inventory: Extended terms has exacerbated the long-standing industry risk of excess inventory in the aftermarket and minimized the focus and need to improve inventory turns. A customer credit downgrade or continued lengthening of terms are further areas of future risk. These scenarios aren t predictions there is no certainty of what will or will not happen. However, the aftermarket value chain retailers, distributors, suppliers and financial institutions need to work together to ensure all participants are pursuing business practices that promote the long-term sustainability and resiliency of the industry. Moving Forward From Extended Terms The following represent potential areas of collaboration across the aftermarket to promote mutual long-term success: Alignment of goals through the entire value chain to reduce costs and improve customer satisfaction and profitability for the entire aftermarket value chain. A common goal to increase inventory turns for channel partners and suppliers. Inventory turns have been dropping in the industry for a generation and that can t continue. Too much inventory in the system exposing all channel partners to systemic industry risk which has fostered the request for longer terms. Contracts that recognize and mitigate risk that automatically adjust terms when credit or interest rate conditions change. AASA recommends all suppliers work with their customers to institute precautions such as these. 7

8 A new approach to slow-moving part numbers. Is just-in-case inventory the right approach? Key to achieving the above is improved information, information flow and true partnering. Working together, the industry has a very positive future but it will take cooperation, collaboration, mutual respect and commitment to what is in the best long-term interest of all channel partners to make that future a reality. Learn More: AASA/KPMG Extended Terms Report As a follow up to the AASA/KPMG Extended Terms Conference in August 2012, AASA members can access the full report prepared by KPMG, as well as other documents to assist in joining in this important industry dialogue. All are available exclusively to you as an AASA member. To access the full AASA/KPMG report you can go to Analysis/Extended-Terms or scan the QR code below to request a copy and accept the Terms of Use. Once accepted, an electronic version of the report will be ed to you, along with AASA s slides from the August 2012 Members Meeting. Bill Long, Bailey Watson, Margaret Beck and KPMG contributed to this report. 8