Working Capital – Hidden Timebomb or Hidden Goldmine? [Part 2 of 3]
- Rupam Deb
- Dec 17, 2020
- 7 min read
In our previous article (Part 1 of 3 here), we looked at what is net working capital (NWC), how to think about it, and a fictional example of a business with accounts receivables greater than accounts payables, to see how that positive NWC dynamics make running and expanding the business difficult.
Businesses with Positive NWC
Today, we will look at one such actual business with positive NWC dynamics, using real numbers – Pax Global.
Pax Global is a leading global player in the development and sales of electronic funds transfer point of sale (EFT POS) products, and the associated solutions and services.
It was founded in China in 2000, and has expanded worldwide to selling 11 million of POS terminals in more than 100 countries in all regions of the world in 2019, becoming the world no. 3 player (with 10% global market share in 2018). Over the years, it has continued to spend lots of money in research and development, producing innovative solutions including the latest smart Android terminals, allowing it to grab more and more global market share.
If we look at its revenue and profits (recorded in its income statements), it has grown really well, at a compounded annual growth rate (CAGR) of 22%-26% for the revenues and profits during the period 2009 to 2019.
Does that mean it’s a good business to own, given the high growth in profits? Most investors who just focus on accounting profits and income statements might say yes. But wait – if you are a seasoned investor, you would know that what matters to shareholders is not accounting profit (which can be easily manipulated), but the amount of free cash flows (FCF) available to equity shareholders, which could be very similar to or very different from the accounting profits. And you would go dig up the cash flow statement (to figure out the FCF), instead of just the income statement (and maybe balance sheet). (Read our article on what drives a company’s intrinsic value growth here)
For Pax Global, its free cash flows are very different from the accounting profits. When this happens, it is usually due to two broad factors:
A company being asset intensive, having to spend lots on capital expenditure (more so than its depreciation and amortisation (D&A) expenses) to maintain or grow its business – This is not the case for Pax Global, as it adopts an asset light fabless model to manufacture the terminals; and/ or
A company having strong and growing needs for working capital requirements, where lots of capital are stuck in the business as working capital when it grows (and even more so when it’s growing faster) – This is the case for Pax Global, which we will elaborate now.
As shown in the chart below, from 2014-2018 (2014 was the year when Pax Global started going international (outside of China) much more):
the blue bar is the (adjusted) profits;
the red bar is the (adjusted) profits adjusted for some non-cash items (like share based compensation, D&A expenses, and impairment losses), which is greater than the blue bar;
the green bar which is the red bar adjusted for NWC changes, is significantly lower than the red bar. This means that there are a lot of cash outflow every year due to changes in NWC; and
therefore, the overall operating cash flows (OCF) are much lower than the adjusted profits, at around 36%-50% of adjusted profits. What does this mean? This means that an investor who looks at just profits might think that he/she is entitled to profits of say HKD 500m a year. However, he/she is actually entitled to OCF of less than half of HKD 500m a year. In fact, it’s even lower, because he/she is entitled to only the FCF which would be lower than that OCF, as other expenses/cash flows like capital expenditure and some proxy for share based compensation expenses need to be deducted. See the difference, and how different the profits and OCF/FCF could be?
To understand why is this happening, we need to delve (slightly) into Pax Global’s business model and working capital needs.
1. Inventory – Pax Global partners with manufacturers that provide assembly and processing services to it in accordance with its product designs and specifications. It is responsible for procuring all raw materials. From the time an order is made to the end product being delivered to the customers, Pax Global needs to hold a lot of inventory, be it in the form of raw materials, intermediate goods, or final products (including during the time when the products are shipped from China to all regions in the world).
Pax Global’s inventory days (the blue line in the chart above) was 114 days in 2014, i.e. it had to hold inventory for around 4 months. However, as it increasingly sells more to countries outside of China (where its manufacturing base is located) from 2014 onwards, its inventory days gradually crept up to 164 days (i.e. around 5.5 months) in 2019, i.e. an increase of 1.5 months. This is also compounded by the fact that it is increasingly producing more complex products like the recent Android products which entail more raw components.
This increase in inventory days leads to increased NWC requirements, resulting in lots of capital stuck in the business (as inventory), instead of being free and available to shareholders.
2. Receivables – Pax Global sells its products to customers, mainly (i) acquirers who then sell/provide the POS terminals to end customers like small and medium business merchants), or (ii) distributors (who then sell to acquirers). (An acquirer is a bank or financial institution that processes credit or debit card payments on behalf of a merchant – Examples of good publicly-listed acquirer businesses are StoneCo in Brazil (watch our analysis here, where Berkshire Hathaway is also an investor), and Adyen which is based in Netherlands (watch our analysis here).)
It adopts two different sales/ distribution channels to reach those customers – (i) a direct sales model where it sets up local subsidiaries in the countries, or (ii) an indirect distributorship model where it works with distributor partners in various countries to sell to the customers there. Each model has its own pros and cons (which we cover in our detailed analysis of the company).As Pax Global internationalised more from 2014 onwards, it started having more sales to its distributors in overseas markets, and one large market it was selling to was Brazil. In Brazil, it partnered with a distributor called Transire, who sell to major acquirer customers in Brazil like StoneCo, PagSeguro or Cielo.
Now let’s imagine the goods and payments flows. When a customer like StoneCo wants POS terminals, it orders from Transire, which then orders from Pax Global. Pax Global ships the terminals to Transire, which then passes on to StoneCo. Transire then sends an invoice to StoneCo, which StoneCo takes a few months to pay Transire. After receiving that money, Transire then takes a few months to pay Pax Global. So it actually takes many months for Pax Global to collect that revenue in cash, after the actual delivery of the products.
Pax Global’s receivables days (the red line in the chart above) was 118 days in 2014, i.e. around 4 months to collect the revenue money. As it sells more to overseas markets, with many markets using distributorship model, that figure ballooned to 164 days (i.e. 5.5 months) within 2 years in 2016. Fortunately, Pax Global was conscious about it, and started controlling the receivables collections and implementing payments terms more strictly, helping it to bring that figure down to 134 days (i.e. still a high 4.5 months) in 2019.
As with inventories, the long receivables collection cycle, inherent to the business and sales models adopted by Pax Global, reduces the amount of FCF that shareholders actually get access to, affecting its intrinsic value.
3. Payables – The payable days for Pax Global (the green line in the chart above) was 105 days in 2014, i.e. around 3.5 months to pay its suppliers. Since then, it had managed to increase its payable days to 158 days (i.e. around 5 months) in 2019. This means that it is increasingly paying its suppliers slower, and thereby having more cash on hand for use.
Overall, the cash conversion days (i.e. inventory days + receivables days – payables days) has increased from 127 days in 2014 to 161 days, mainly due to the increasing inventory and receivables needs. Therefore, during that period, when revenue and profit growths were high, the increase in FCF (which is the factor that matters most to shareholders) was actually not that high.
Does this mean that Pax Global is a bad business to own? Not necessarily. Despite the not favourable working capital dynamics, Pax Global has several attributes that we like. In addition, although having a positive NWC dynamics is not ideal, as long as that dynamics is not worsening (i.e. increasing cash conversion days), i.e. either remaining stable or improving, then the FCF can actually grow in line with, if not faster than, the growth in profits.
However, what’s important for us as investors to consider in such circumstances is to:
understand the drivers of the working capital of the company, to aid in estimating whether the NWC dynamics could deteriorate, remain stable, or improve materially in the future;
be careful with our thinking on the valuation of the company, to be basing it on the FCF and not the profits (e.g. if the FCF is only 60% of profits, applying a simple P/E multiple on the profit level could potentially overvalue the company by ~52% (= 100% / 60% – 1)); and
understand the sensitivity of the valuation to changes in NWC dynamics, e.g. what happens to the valuation if CCC increases from 140 days to 150 days, or goes the other way round.
These are the things that we ourselves have done (and spending weeks on) for this company (given the materiality of the NWC dynamics for this company), and discussed in our in-depth analysis of this company in our Multibagger Research Series program.
If you are keen to understand this company (Pax Global) more, including its business model, competitive landscape and why we still like it, do watch the video below.
In our next and last article of this series (Part 3 of 3), we will look at the complete opposite – companies with very favourable negative NWC dynamics, which flood them with lots of free (interest-free) cash and capital to deploy into whatever best opportunities they have, to the extent where one company actually used those cash to buy back its shares so much that it went into negative book value equity position! Read on here!
P.S. If you have enjoyed, or learned something from, this article, do subscribe to our newsletter to be informed of our future articles, and share this with your friends so that they get to benefit too!
Comments