Pay Me Now or Pay Me Later

I hate slow pay. I hate it with a passion.

The world of business runs on a concept called trade credit. Trade credit basically means that you ship product to your customers before they actually pay for what they have bought. Similarly, if your suppliers extend trade credit, they let you have what you have ordered before money actually changes hands.

This is different then buying things with a credit card. When you use a credit card, the bank that issues the card transfers the money directly to the merchant, treating the balance due as an unsecured loan. The merchant gets paid right away, just as if you use cash, and therefore never takes on the risk of nonpayment. With trade credit, your vendors are supplying you with product solely based on your promise to pay up.

When I started in business, the standard terms for trade credit were Net 30 Days. That meant that one month after receiving product, you agreed to pay the net balance shown on the invoice. To manage your cash flow, you would hound your customers who went over the 30 day limit, knowing that you needed the money both to meet payroll and to keep your promises to your suppliers.

About ten years ago I started to see a change in these terms. Big companies started to demand extended terms. First sixty days, then 75 days, then even more then that. General Electric now has 120 day terms written into all of their contracts. Four months.

I think the move to extended terms was originally pushed by Wal Mart and the other big retailers, Lowe’s, Home Depot, Target and the like. Remember, the consumer pays for product before they take it out of the store. So if you turned your stock over fast enough, all of the cash required for your inventory was actually provided by the suppliers. For the big boys, it is a great idea. If you can get your vendors to pony up most of the working capital you need, that makes your return on equity look just a little bit better.

On the other hand, for a smaller company like the one I work for, this kind of trade credit policy puts you in a real bind. Our suppliers won’t extend 120 credit to us, either because they are so much bigger then us that we don’t have the leverage to force it, or because they are so much smaller that they couldn’t survive for that long.

For that matter, we don’t have enough cash to tie up four months worth of operating expenses in Accounts Receivable. So we are forced by our customers to borrow money for working capital.

I bring this up because our salesmen have heard rumors that next year GE is going to go to 150 days on their terms. They are a big enough customer that they will probably make it stick. After all, might makes right in situations like this.

But might does not necessarily make smart. By compelling their suppliers to focus on locating financing, and spending time keeping the bank placated, attention is necessarily shifted away from improving quality and delivery, and working on process improvements and product innovation. Not to mention, of course, that the interest charges you have to pay the bank reduce your profit margins.

But the real reason excessive slow pay is a bad idea is that it puts your supply chain in the hands of the bank. When you force your vendors to borrow money to meet payroll, the bank can shut your vendor down just by shutting off the line of credit.

Your vendor wants to keep you, the customer, happy. But your vendor’s bank does not care about you, the customer, at all. The bank cares about limiting its risk.

The more vendors you force to borrow money, and the more money you force them to borrow, the greater the odds that one of them will run into problems and be shut down. When your vendors shut down, you shut down.

Increasing leverage makes returns on equity look better, but it also increases systemic risk.

Isn’t that how the financial industry dug themselves into the hole?

We Bring Good Things to Light?

GE stock has fallen precipitously in value over the last year. It was trading at a little over $6 per share last week, having come down from a high of $40+ in 2007. This is the same GE that builds both jet engines and refrigerators, light bulbs and MRI scanners. GE even owns NBC and Universal Studios. They are a leader in globalization, noted for having a deep management bench and the ability to develop talent. GE is one of the few American companies with AAA bond rating. The bluest of the blue chips.

And yet, panic selling drove the price down 45% in one month. This, despite the fact that the company was profitable last year. What gives?

The problem is that GE has xx in assets, but has yy in liabilities. If GE has problems paying back those liabilities, that spells real trouble for the stockholders. In corporate finance, the owners of the liabilities (bondholders) always get paid before the owners of the equity (stockholders). The reason the stock price has fallen so far is that the judgement of the market is that GE’s liabilities won’t be paid back.

You may think “What’s the problem? They’ve got a lot more assets than liabilities.” Well, maybe yes, and maybe no.

GE is really two companies. There is General Electric, which is the collection of industrial businesses that makes all the stuff. They have twice as many assets as liabilities. Then there is GE Capital. GE Capital provided half of GE’s profits for 2007. The problems are in GE Capital portfolio. In the 2007 annual report, GE Capital had $646 billion in assets, and $587 billion in liabilities. If the assets are worth only 10% less than what GE said they were worth a year ago, that would be enough of a fall in value to wipe out GE Capital’s equity, forcing the company to put more cash into the business.

GE Capital uses the AAA rating to borrow money cheaply. They then use that money to make loans. A lot of the loans are equipment leases. You want to lease a jet engine or MRI scanner, GE Capital will help you do that. But they make a lot of other types of loans as well. For a financing company, the money borrowed is a liability, and the loans made are the assets.

The market is concerned about writedowns hidden in the loan portfolio. Another way of saying that is that the assets are worth a lot less than what GE has been saying, and GE will have to ‘fess up soon.

I decided to go looking through the annual report to see if I could spot any potential problems. In corporate annual reports, the pesky details that can cause trouble are usually buried in the notes that follow the financial statements at the back of the report. Opening up the report almost at random, I found Note 12: GECS Financing Receivables.

Inside Note 12 was a line item for a division called GE Money, listing Non-US Residential Mortgages: $73.759 billion. So GE owns a mortgage company that is holding almost $74 billion in mortgages. I’m guessing that most of the mortgages are in the UK.

Attached to the line items was a reference to subnote (A). In little, tiny print, subnote (A) included the following statement: “approximately 26% of this portfolio comprised loans with introductory, below market rates that are scheduled to adjust at future dates; with high loan-to-value ratios at inception; whose terms permitted interest-only payments; or whose terms resulted in negative amortization.”

Yikes. Let me translate that for you: “GE holds over $19 billion dollars of toxic subprime mortgages in a collapsing real estate market.” After those UK homeowners stop paying, GE will foreclose, and then sell the houses for half. My back of the envelope calculation is that GE will have to write down that sliver of their portfolio by about $10 billion dollars. The total reserve for losses in their Financing Receivables is only $4.3 billion.

GE recently eliminated 70% of their dividend. This contributed mightily to the free fall in the stock price, but it will free up $9 billion a year in cash to apply to other uses, like writing off foreclosed mortgages. I have a feeling that they are going to need the cash.

The 2008 annual report is due any day now. I can’t wait to read it.

Feet of Clay

The ongoing turmoil in the US credit markets appears to have snared another victim. General Electric announced 1st quarter earnings that were sharply lower than what they had led investors to expect as little as a month ago. The gunslingers, oops, sorry, the professional investors who work on Wall Street don’t like surprises, and they hammered the stock. The price for a share of GE dropped 12% on Friday, which was the largest one-day decline for GE in over twenty years. The last time GE stock dropped so much was in the stock market crash of October 1987, when the Dow Jones Industrial average dropped 25% in a single day.

The damage to earnings was apparently not caused by the industrial and high tech businesses, which are doing well. Companies all over the world are still buying jet engines, power plants, and MRI scanners. The financial services businesses in the GE portfolio did not provide the profits that had been estimated.

The guys who run GE know that Wall Street punishes surprises on the downside. So there are only two possible explanations for missing their earnings targets by so much:
1. Senior management does not know what is going on inside the company. That is, losses in GE Capital were piling up, but no one wanted to take the write off, or tell the higher ups about the losses.
2. Things turned around so much in the last two weeks of March that they overwhelmed the progress of the previous ten weeks.

Jeffrey Immelt, the CEO of GE, choose what was behind Door #2, saying: “the extraordinary disruption in the capital markets in March affected our ability to complete asset sales and resulted in higher mark-to-market losses and impairments."

These results are important because GE, due to the size and breadth of their operations, is considered a bellwether for the US, and indeed, the global economy.

Also, GE is considered an unusually well managed company, with excellent risk control. In the annual report for last year, much was made of the fact that GE had no debt that was secured by sub-prime mortgages as collateral.

If GE is having problems in the financial markets, than other banks and investment companies will be having problems as well. Even with all the announced write downs and loans made by the Federal Reserve, we’re not out of the woods yet.