Author Topic: Changes in operating assets and liabilities:  (Read 7215 times)

KJP

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Re: Changes in operating assets and liabilities:
« Reply #10 on: February 05, 2018, 07:02:50 AM »
Concerning Wayfair, I haven't looked into details but their model is interesting. They invest a lot in publicity and marketing and I wonder if the return on that will, in the end, be more profitable than the traditional brick and mortar furniture store model. I would say that these days, tight working capital management may not be top priority if growth-hungry cheap capital is ready to fund your venture. That may change. I still like to sit on the sofa or test the mattress before I buy it. Maybe Millenials will change that. :)

Wayfair is essentially an internet marketplace plus a logistics company.  They largely sell third-party manufacturers' goods on their website, getting the cash from consumers on day 1 and then remitting the manufacturers' cut sometime later.  So, they carry essentially no inventory and have low accounts receivable, but high accounts payable due the timing of when they are paid versus when they pay the sellers of goods on their websites.   It's those working capital dynamics that have allowed the company to grow so quickly.  A traditional bricks-and-mortar retailer could never get the funding to grow that quickly.

As you note, Wayfair spends a ton on marketing.  I don't know if that will ultimately pay off, but I think Wayfair's business model has already hurt is going to continue to hurt competing retailers with more traditional capital requirements.  See the discussion on the Williams Sonoma thread for more details.
« Last Edit: February 05, 2018, 07:06:37 AM by KJP »


writser

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Re: Changes in operating assets and liabilities:
« Reply #11 on: February 05, 2018, 07:33:46 AM »
Fwiw I think there's no easy 'formula' to determine how to treat changes in working capital - you actually have to think a bit about the company and what is happening. Inventory buildup can happen because the company is ramping up production or because nobody wants to buy their crap products. Sometimes changes in working capital are seasonal, sometimes they're just random, sometimes they are due to the company growing, shrinking, due to changes in accounting or even due to management manipulating earnings. Changes in working capital have different implications for different types of companies, etc.
When you are dead, you do not know you are dead. It's only painful and difficult for others. The same applies when you are stupid.

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #12 on: February 05, 2018, 04:10:18 PM »
I think the ratio of operating cash flow to capital expenditures will become increasingly important to pay attention to if inflation intensifies. The change in this ratio, let's call it, real return on investment, as far as I can piece together from my readings will be the key determinant of whether a bond or a stock will be a better value. Taken to the extreme, a business that makes increasing amounts of money without requiring much money (sort of like the negative working capital example) would be the ideal business in any environment but more so if you keep having to plough back your profits and capital just to tread water.

Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #13 on: February 06, 2018, 05:15:39 PM »
"Taken to the extreme, a business that makes increasing amounts of money without requiring much money (sort of like the negative working capital example) would be the ideal business in any environment but more so if you keep having to plough back your profits and capital just to tread water."

Agree. A good scenario is a great business with high (and durable) returns on capital and low capital requirement. The high returns result in excess cash. How the cash is deployed is another input to consider. Buybacks make sense at relatively high levels only if the moat is maintained over time.

Long term compounders that require capital to grow and that produce adequate returns are interesting in the sense that the capital allocation decision is retained with the earnings.

http://basehitinvesting.com/buffetts-three-categories-of-returns-on-capital/

I would add that, in inflation or deflation, relatively high returns on capital will do the trick over the long term.
In his 1977 Fortune article "How inflation swindles the equity investor", Mr .Buffett argues that, in an inflation scenario, there is no fundamental reason to think that return on capital should be higher. However stocks are less swindled than bonds.

The ideal is to find compounders that require a lot of capital to grow. Simple but not easy.

Interesting comparison of Costco and Alphabet.
http://www.scuttlebuttinvestor.com/blog/2016/12/10/return-on-capital-and-other-diversions



scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #14 on: February 07, 2018, 03:01:46 AM »
Do you mean to find compounders that don't require a lot of capital to grow? Or do you mean there is the ideal and the reality?

One big issue is scaling up. You might have a great business with little capital and pricing power but it just can't scale up so you can't put the cashflow to work and usually return it to the shareholders who now have the problem of finding something intelligent to do with it.

The other issue is I see several opportunities that are not permanent holdings but cyclical. I.e. a teleco like T-mobile or a composites manufacturer like Hexcel that have had  - or are having a large capital spending cycle. The purpose of this of course is to increase earning power in future periods. This cycle could last a few years. If inflation hits, then obviously you can produce your product , increase the price and you have the infrastructure done. But after some time, you have to do it again - at the higher costs to build later on. I'm not sure if these businesses are good for a period of time and then lousy for another.

Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #15 on: February 07, 2018, 11:56:04 AM »
Investing in cyclical capital intensive businesses is tough.
Other cycles are easier to ride: underwriting cycles, sentiment/fundamentals cycles, but profits may be lumpy and long coming.
The goal is to find the firms that will earn high rates of return on high required incremental capital. The challenge is to figure out how much of a premium is reasonable for the embedded growth option. Graham vs Buffett type of discussion.

The discussion has drifted to return on capital and that validates, like writser suggested earlier on, that going through specific working capital items (unless there is something specific to look for) may not be where most of the money is.
« Last Edit: February 07, 2018, 12:04:56 PM by Cigarbutt »

Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #16 on: March 15, 2018, 12:22:05 PM »
This thread was initiated on the idea of free cash flow analysis and changes in operating assets and liabilities.

Looking at an interesting example: Carlisle Companies (CSLN), a global US-based diversified manufacturer.
During the previous CEO tenure (DA Roberts), many good capital allocation decisions were made but a significant amount of free cash flow was generated, over a few years, from "working capital management" as the WC/sales ratio significantly came down. Some of this was linked to an evolving profile from acquisitions and divestitures but at least some of the improvement came from pro-active measures to better manage inventory levels (increased turnover) and receivables collection (decreased DSO).
I tend to give credit to management who relentlessly focus on free cash flow generation, whatever the source.

The company's profile has changed somewhat with recent acquisitions and a new CEO. Will start a separate thread on the company if I come up with reasonable insights and if I can identify a valuable proposition.

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #17 on: March 23, 2018, 03:01:49 AM »
I've seen this line in cash flows statements too - "Pension and postretirement benefit plan contributions"

Is this a real cost, like expensing for stock options? I do notice it is a bit lumpy year to year. It obviously can be a huge number for large companies.


Cigarbutt

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Re: Changes in operating assets and liabilities:
« Reply #18 on: March 23, 2018, 10:15:27 AM »
"I've seen this line in cash flows statements too - "Pension and postretirement benefit plan contributions"

Is this a real cost, like expensing for stock options? I do notice it is a bit lumpy year to year. It obviously can be a huge number for large companies."

Usually get involved with the pension numbers once I get really interested and feel I need to read from cover to cover.

It seems that even pension funding is cyclical as many firms, in another era, had significant overfunding (potential source of extra income and cashflows) but now underfunding seems to be the order of the day (Have you seen the numbers? See at the end of this post). The funding decision is influenced by legal and tax considerations but it is very much a managerial decision. Just a step away from "managing" earnings and cashflows. The funding part is clearly not an operating item and that part needs to be reclassified as a financing cash flow every year.

Otherwise, I will tend to use the pension expense number without adjusting for the expected (vs actual) and amortization components as the fluctuations will tend to cancel out over time and adjustments may introduce unnecessary mark-to-market volatilty (with the potential exception mentioned below) and I see this as an operating and very real expense.

I understand that some only use the service cost as an operating expense and reclassify the interest cost and the return on pension asset numbers to the non-operating sections but I haven't found this to be useful.

Outside of this reclassification exercise, I do take into account the potential effects of "optimistic" pension assumptions on the potential free cash flows going forward. Often, with conservative assumptions about how markets "behave" under normal circumstances, for certain companies with large pension liabilities and incompletely matching assets, it is not difficult to see scenarios where an entire year's worth of normalized free cash flow capacity may be negated by less than a terribly adverse scenario on the asset side. I recently reviewed CNR (Canadian National Railway) and that is certainly a potential scenario. Interesting because, in such a situation, the market reaction would probably be out of proportion to the underlying intrinsic value because removing even an entire year of free cash flows does not really change the value of the business (if you think in a discounted type of way).

https://www.mercer.com/newsroom/january-2018-pension-funded-status-increased-by-two-percent-in-2017.html
And that's during one of the greatest bull market (stocks and bonds) of all times since we put some distance between pension assets and the 100% funded status.
« Last Edit: March 23, 2018, 11:04:55 AM by Cigarbutt »

scorpioncapital

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Re: Changes in operating assets and liabilities:
« Reply #19 on: March 24, 2018, 02:27:49 AM »
Thanks for the link. Seems one has to check funding status and flow of funds. It seems more like a non-operating expensive but most certainly a liability over time if not funded.