A Perfect Storm

The shipping industry is in rough waters lately. In many categories, global capacity exceeds demand, and shipping rates and ship values have sunk to near-abyssal lows. Take the VLCC (“very large capacity carrier”) tanker business, for example. Back in 2005 and 2006, shipping companies had every reason to be optimistic about potential demand. Asian economies were booming, and their need for oil was surging. So they ordered scores of large, new vessels. Between 2007 and 2011, the world’s VLCC fleet grew by 10%, but demand for oil grew by only 3%. With capacity that far ahead of demand, shipping rates plunged to near-record depths. Reduced income from ships meant reduced values for ships, and vessel prices fell by 55% over the same period. The industry got caught in a perfect storm of business cycle and industry cycle risk. The business cycle drove down demand for shipping when the United States and Europe went into recession in 2008 and 2009 and emerging economies slowed down. But even after the global economy recovered in 2010 and 2011, shipping remained trapped in a classic industry cycle. Industry cycles occur when capacity exceeds normal, recovery-stage levels of demand. Prices plummet, and revenues fall with them. Industry cycles are different from business cycles. In business cycles revenues are demand-driven; in industry cycles they are price-driven. There is more at work in industry cycles than the simple microeconomics of supply and demand. They have a complex set of drivers. They are most common in industries with these characteristics: commodity products or services; large economies of scale; high fixed costs; intense competition. Commodity industries are especially...

Inventories Explode

Over the past 15 year, many businesses have adopted sophisticated inventory tracking systems and just-in-time inventory policies.  As a result, they have gotten much more efficient in their use of inventory, as shown in this chart: Source: Wachovia Economics   This long downward trend in the inventory-to-sales ratio has recently and dramatically reversed.  What happened?   As we noted in an earlier post, companies are often slow to respond to lower sales, waiting to cut production and/or reduce purchases.  As managements “catch up” to the current sales reality (or as sales improve), we would expect the inventory-to-sales ratio to return to normal, lower, levels (with the associated benefits for corporate cash...

Lower Sales Means Higher Cash Flow (Eventually)

As we move further into recession, we often see a pattern in corporate free cash flow (defined here as cash from operating activities minus capital expenditures and dividends). A company’s ability to manage cash flow as sales decline is a key determinant of credit quality and an important way to judge management effectiveness.   Here is a typical pattern:   Phase 1: Denial. Sales begin to decline, but management is unclear if it is temporary or the sign of a longer term trend. Optimistic management teams (and those without real-time sales data) do not cut production or purchasing, so inventory balloons in the face of declining sales. Receivable days may also increase as customers struggle with their own cash flow problems. These increases in working capital push free cash flow negative, even as operating income and net income remain positive.   Phase 2: Manage Working Capital. A good management team (with good financial reporting systems) will quickly recognize the cash flow drain and act to bring down working capital. Actions may include cutting production and/or purchases to reduce inventory, aggressively collecting receivables, and perhaps slowing payment on accounts payable. These actions can quickly generate significant amounts of cash, but can also hurt relationships with customers and suppliers.   This chart shows the quarterly financial performance of a capital goods manufacturer in the 2001 recession (shaded). As expected, sales and operating income began to decline as the recession began. However, there was an immediate large drop in free cash flow (caused by a large increase in working capital) followed by an equally large increase in free cash flow (as management...