GROWING PROBLEMS
Focused on growth and more reliant on overseas suppliers, US companies have let inventories swell.
By Randy Myers

Maybe it’s globalization. As US companies source more goods from Asia and other far corners of the world, it makes sense that they would stock more inventory as a guard against potential breakdowns in their supply chains. Or maybe it’s economic priorities. With corporate coffers bulging like overloaded transpacific freighters, finance executives could be taking their eye off second-tier metrics like inventory, payables, and receivables. Whatever the explanation, 2006 marked the first time in five years that the 1,000 largest publicly traded companies in the United States (excluding automakers) failed to decrease the amount of cash they had tied up in working capital relative to sales. In fact, by year-end 2006, working-capital days were actually up a smidgen: 38.8 days versus 38.7 at year-end 2005.

Blame inventories, says REL, the US research and consulting firm that compiles the data for this annual scorecard. According to its figures, the nation’s biggest firms allowed their days inventory outstanding (DIO) to rise to 31.2 last year, up 2.1% from 2005. That performance overshadowed slight improvements on the payables and receivables fronts, the other two key components of working capital. Days sales outstanding (DSO, a measure of how efficiently companies convert receivables to cash) shrank to 39.5 from 39.9, an improvement of 1.2%, while days payables outstanding (DPO, a measure of how long companies hold onto their own cash before paying vendors) rose to 31.9 from 31.8, an improvement of 0.3%.

The paltry gains in DSO and DPO suggest that many CFOs are worrying less about working capital these days and more about taking advantage of a strong economy to drive sales. “We’re in a very high growth stage right now,” concedes a senior finance executive at one specialty retailer, who asked to remain anonymous. “Squeezing that last dime out of the payables account isn’t the biggest focus of our attention at the moment.”

This has implications for companies in Asia, particularly exporters in China and Southeast Asia. Many US companies don’t expect good times to end any time soon, and that is good news for their suppliers. But the high levels of inventory also suggest that, if there is a downturn, Asian exporters might get hurt more seriously than in the past, because it will take a longer time for their US customers to restock. The answers for Asian companies may be to pare reliance on America and diversify sales to Europe, for example, where days inventory outstanding have fallen by 4.6% (see “United States vs. Europe,” below).

Inside the rise in inventories

The diminished focus on working capital in the US is understandable, perhaps, but also unfortunate. As cash-flow connoisseurs seldom tire of pointing out, money tied up in working capital is money that’s not available to invest in the business, fund an acquisition, pay a dividend, or finance a stock buyback program. To be fair, however, US finance executives and supply-chain managers were fighting at least three headwinds last year as they sought to keep inventory levels to an optimal minimum. First, sales were growing in 2006 but not at the same pace as they were in 2005; the gain was up 10.6% in 2006 versus 14% the year before. As the growth rate slowed, says REL president Stephen Payne, some companies may not have been able to pare their inventories fast enough to keep pace.

Meanwhile, with companies searching ever farther afield for cheap goods and labor, some probably found it prudent to carry more inventory as a guard against potential supply-chain disruptions. And even if they didn’t physically hold more inventory, notes REL analyst Karlo Bustos, they might have found themselves posting higher inventory values on their books anyway, particularly where their supplier contracts required them to take ownership of goods during the long transit from Asia, eastern Europe, or South America.

“We’re producing merchandise in places many people have never heard of, even places where there’s a pretty significant element of instability,” says the specialty retailing executive cited earlier. “Any time you start producing in places like that, you end up allowing for longer lead times and ordering and carrying more inventory. We carry a lot of items that remain popular year after year, but for a retailer that depends on having the most-updated trends in its stores at all times – that can be a challenge.”

Payne agrees. The increased lead times associated with shipping product from low-cost and faraway countries, he says, force companies to house more inventory and reduce the speed with which they can respond to changes in customer demand. Not only can that increase overall inventory levels, he warns, but, more ominously, it also can inflate the amount of “slow and obsolete”, or SLOB, inventory on corporate balance sheets. “Companies have to find the right balance between taking advantage of cheaper product and creating flexibility in their supply chains,” he says.

Pockets of improvement

Not all companies suffered setbacks in working-capital performance this year. Of the 1,000 tracked by REL, nearly half, or 472, were able to reduce their DWC (days working capital) by an average 11%. By industry group, the top performers were hotels, restaurants, and leisure companies; independent power producers and energy traders; construction and engineering companies; and multiline retailers. The worst performers were gas utilities; oil, gas, and consumable-fuels companies; diversified consumer services companies; and food producers.

In some cases, dramatic changes in the way a few key players were managing their balance sheets helped entire sectors to look good. Multiline retailers were a top-performing industry group, for example, in part because some big companies in that group decided to sell their credit-card operations and the receivables associated with them, dramatically paring their days sales outstanding. When US$27 bn Federated Department Stores sold its credit-card accounts and related receivables to Citibank between October 2005 and July 2006, for example, it drove its DSO figure to zero from 33. Similarly, US$15.5 bn Kohl’s sale of its private-label credit-card accounts and outstanding receivables to JPMorgan Chase in April 2006 helped the retailer pare its DSO figure to zero from 45.

Going forward, opportunities for such dramatic gains in that industry group will diminish. Already, of the 16 companies in the group, only seven show a DSO above zero, led by US$59.5 bn Target, which has a DSO of 38, and US$8.6 bn Nordstrom, with a DSO of 26; both still operate their own credit-card programs. While they do sell their associated receivables through a securitization program, REL’s methodology factors securitized receivables into the DSO calculation.

As it happens, few industries have been affected by global sourcing more than the retail industry. That this is not a new development in the retail sector may help to explain why the multiline retail industry was among the 13 industry groups, out of 56 total, that managed to improve DIO last year, with a median reduction of 7%. Among the top performers, Federated reduced its DIO by 18%, US$6.4 bn Family Dollar Stores reduced its DIO by 13%, and US$4 bn Dollar Tree Stores reduced its DIO by 10%.

Specialty retailers weren’t as successful on the inventory front; the median DIO in that group rose 3% last year. However, with a median DIO of 57 days, they are working from a lower base than their multiline counterparts, where the median was 63 days. And the specialty retailers aren’t content with their inventory performance either. Clothier Abercrombie & Fitch is spending money on IT systems intended, it says, to help it become more scalable, efficient, and accurate in the production and delivery of product to its stores. Last year, the US$3.3 bn company’s DIO declined a modest 1%, to 47 days, but that was after ballooning to 48 days in 2005 from 38 in 2004. Similarly, US$2.8 bn clothier American Eagle Outfitters has invested in systems designed to help it mark down prices on aging inventory more strategically, and thereby better manage inventory levels. With days inventory outstanding of 34, it’s already among the best in its industry group on that score. And US$5.3 bn video-game retailer GameStop has developed a proprietary inventory-management system that it pairs with point-of-sale technology to allow it to see its daily sales and in-store stock by title, by store. That lets each GameStop location carry merchandise tailored to its own sales mix and rate of sales. Last year, the company shaved its DIO figure to 46 from 71 en route to posting the best DWC figure in its industry group, minus two days.

While performances like that are encouraging, Payne expresses surprise that more companies haven’t been aggressive in searching out ways to liberate some of the cash they have tied up in working capital. “Running a successful business is all about cash flow,” concurs REL’s Bustos. “You can do well on the top line and well on the bottom line, but if you’re not generating true cash, you’re not running the business to its full potential.”

In an age when private-equity investors are all too eager to help underachievers extract cash from their businesses, that’s a mistake few firms will want to make.