Magazine for Senior Financial Executives: Cash masters – 1998 survey on management of working capital by CFOs

Cash masters – 1998 survey on management of working capital by CFOs – Cover Story

Linda Corman

For all but a few, unlocking working capital is a challenge.

As companies grapple for competitive advantages amid increasingly fierce global competition, the crucial importance of working capital cannot be overstated. Every dollar locked up in working capital weighs down performance. Once unlocked, however, every dollar supports investment and value creation in the current and succeeding years.

On one level, boosting working capital sounds easy. “It’s basic stuff,” says Karl von der Heyden, a veteran of CFO posts at RJR Nabisco and, until stepping down in April, PepsiCo Inc. “[You] focus on collecting cash faster and parting with it more slowly,” he says. Pepsi, to von der Heyden’s credit, does this brilliantly. It hopped over five competitors this year to garner the top spot in the food and beverage industry. Why? “We decided to run the business as we would run a private business,” he explains. “When you run a private company, you run it for cash.”

For many of von der Heyden’s counterparts, however, unlocking working capital remains a challenge. The 1998 CFO Working Capital Survey, a joint project with REL Consultancy Group, a management consulting firm in San Francisco, underscores the broad range of working capital performance by roughly 1,000 companies in 35 industries, each with more than $480 million in sales.

As in our first working capital survey, published last year, we ranked companies overall and identified the top 10 within each industry group. (See accompanying charts, starting on page 37.) The survey results were derived by combining cash conversion efficiency (CCE) – the efficiency with which companies convert revenue to cash flow – with days of working capital (DWC), which is a summary of unweighted days sales outstanding (DSO), payables, and inventory. Each of these components is ranked separately so that readers can compare the underlying information. All data, from OneSource, are for the 12 quarters through calendar 1997.

As in all surveys of this kind, a word of caution is in order: the analysis is perforce based on publicly reported financial results. Nonetheless, anyone complacent about the general direction of cash-flow management might fret over the results of the 1998 Working Capital Survey. It’s not a welcome sign. Control over inventory and payables shows no improvement over last year; DSO worsened slightly for all businesses. Although companies have wrung more cash from operations, evidenced by a boost in CCE, the gains do not stem from tighter management of working capital. While cash flow from operations leaped, on average, to 10 percent of sales, from 6 percent, DWC actually slid to 64 days, on average, from 62 days. For most firms surveyed, in other words, more working capital sits idle this year than was revealed in the 1997 survey.

Not everybody suffered, of course. Industries turned in mixed results. All told, 16 industries improved their cash conversion efficiency, 8 recorded no change, and 9 deteriorated. Meanwhile, 14 industry groups reduced their average DWC, 3 stayed the same, and 16 lost ground.

In terms of optimal CCE, the petroleum industry blew away the competition by converting 48.1 percent of revenues to cash flow. The secret to this superior performance lies in oil rigs and other off-balance-sheet assets that generate rivers of cash flow. As a consequence, petroleum companies swept the topmost tier of overall rankings.

For most firms with fewer off-balance-sheet assets, process efficiencies such as consolidating operations drove cash-flow improvements, says Eric Wright, an REL senior vice president. That might sound disappointing to advocates of better working-capital management, but Wright sees it as hopeful. When these processes are efficient, he observes, cash rescued from working capital sprints to the bottom line.

A half decade of rigorous reengineering still leaves a treasure trove for companies that fine-tune their levels of receivables, payables, and inventory.

The four companies profiled supply evidence that corporate strategy ultimately governs these levels. The ability to predict demands on inventory gives grocery chain Hannaford Bros. Co. an edge in the 1998 Working Capital Survey, while success at Amgen Inc., in the pharmaceuticals business, rests on its distribution strategy. Divestitures helped PepsiCo shoot past famous rivals in the food and beverage category, while being the low-cost textile producer lifted Unifi Inc. to outperform its competition.


Mind the Details

Hannaford Bros., in Scarborough, Maine, jumped ahead of much larger rivals The Southland Corp. and Publix Super Markets Inc. and three other competitors this year to take first place in the food and drug store category.

Blythe McGarvie, Hannaford’s executive vice president and CFO, attributes her company’s new stature to a multimillion-dollar information system that tracks inventory “as it goes out the front door.” Most food and drug chains track inventory as it moves from the warehouse to their retail stores, and they calculate gross margins based on what they estimate is being sold, says McGarvie. But, with Hannaford’s new system, the company always knows exactly what is on its shelves and how fast inventory is moving off the shelves, she says. While other stores have people laboriously perusing the aisles to get estimates of what is on the shelves, Hannaford’s new proprietary system produces much more precise data. “We keep perpetual inventory,” says McGarvie.

Since the system enables Hannaford to calculate more accurately than a back-door tracking system would when it needs to replenish inventory, the company has been able to reduce days working capital from 8 days last year to 6.9 this year, maintaining its significant superiority to the industry norm (21.6 DWC). The reduction arises primarily from an increase in inventory turns, from 12 to 12.6. The information system, producing better forecasting and thus fewer instances when products are out of stock, has also cut the company’s labor costs in warehouses and stores.

“Hannaford is a company that is focused on being efficient in all its operations and on using technology and systems to do that,” says Sally Wallick, a retail analyst with Legg Mason Wood Walker Inc., in Baltimore. Investing in the information system “is very consistent with the kinds of things this company does.”

Hannaford has also risen in the working capital rankings because the investment it made in a new $40 million distribution center in Butner, North Carolina, has begun to pay off. With the late-1996 opening of the distribution center, which serves 44 stores, the company no longer has the drag on its cash conversion efficiency that the capital expenditure produced. Hannaford is also now enjoying far greater efficiency from no longer having to rely on outsourcing its distribution function.

“We have control over our own supply again,” says McGarvie. “With outside vendors, you have to rely on them for when they can deliver. We can now have good scheduling and forecasting, and reliable deliveries.”


Consolidate Distribution

Amgen’s vice president of finance and CFO, Kathryn Falberg, is not surprised that her company has topped the pharmaceuticals category for the second year in a row, while improving its overall ranking from 37th place to 12th place.

One of Amgen’s main advantages, Falberg explains, is that a relatively small percentage of its sales – $281 million of $2.2 billion in 1997 (12 percent) – are international. That figure, in comparison, is closer to 50 percent for many of its competitors. This alone gives Amgen, in Thousand Oaks, California, a major boost in its DWC – 48 versus an industry average of 90.7 – because terms for receivables overseas are often considerably longer than the standard 30-day terms domestically.

Another advantage Amgen enjoys is that the majority of its sales are to wholesalers, whereas its competitors sell more directly to end-customers. Payment terms for retailers tend to be 60 to 90 days versus the standard 30 days for domestic wholesalers, says Falberg.

Further, Neupogen and Epogen, which accounted for more than $2 billion of Amgen’s $2.4 billion in 1997 revenues, are far less costly to produce than many of its competitors’ products. That’s because pharmaceutical companies are often in multiple businesses, such as animal health and consumer products. “The cost of genetic engineering versus mixing chemicals is much lower,” says Jeff Swarz, a director at Credit Suisse First Boston.

Not only does the company do without the more expensive infrastructure required for manufacturing other products, but it also lacks the extensive sales forces many of its competitors have. Because of the nature of its products, used exclusively in hospitals and dialysis clinics, Amgen’s market is very focused and the company fields only 400 salespeople and medical support specialists. By comparison, many of its competitors employ thousands of salespeople to call on general practitioners nationwide. Largely because of these advantages, the company has gross margins of around 86 percent versus an average of closer to 75 percent for its peers.

“They’re generating cash like crazy,” says Swarz.


Shed Sluggish Assets

PepsiCo leapfrogged ahead of arch-rivals Coca-Cola, Coca-Cola Enterprises, and Coca-Cola Bottling in the past year, rising from 6th place to the top of the pack in the beverage category. At the same time, it jumped from 128th place to 39th overall.

Propelling its ascent was a near doubling, from 12.8 percent to 23.6 percent, of its cash conversion efficiency, and a drop in its days working capital from 13 last year to 9.8. These numbers place PepsiCo, in Purchase, New York, well ahead of its peers, whose average CCE is 13 percent and average DWC is 15.9 percent.

Mike White, CFO of PepsiCo since March, says the company’s performance may largely be explained by the divestiture of its restaurant businesses – Taco Bell, Kentucky Fried Chicken, and Pizza Hut. Its working capital numbers benefit because CCE in the restaurant business is lower than that in the beverage industry – 10 versus 13. Some indication of the relief PepsiCo has enjoyed from the divestiture of the restaurant businesses can be seen in the CCE of Tricon Global Restaurants, if extrapolated for all of 1997 – 7.8 percent. Tricon comprises the three former PepsiCo restaurant properties. On top of that, PepsiCo certainly got a boost from the $5.5 billion in cash accruing from the $12 billion sale that was dividended to the parent company.

But its new working capital stature can by no means be entirely accounted for by the divestitures. (REL attributes 70 percent of PepsiCo’s improvement in CCE to the divestitures.) The company has also been pushing its CCE very hard with several initiatives, says White.

In the past year, it has altered its compensation scheme so that managers are rewarded with a “cash-flow kicker” in their annual bonuses, says White, who deflects credit for the improvement to his interim predecessor, Karl von der Heyden. Prior to 1997, bonuses were based on after-tax earnings. Recently, the compensation arrangement has again been changed so that one-third of managers’ long-term compensation packages are tied to three-year cash flows in their divisions.

“Consumer products are usually solely focused on earnings,” says White. “We’re trying to get closer to shareholder value.”

George Thompson, an analyst at Prudential Securities, in New York, says the change in the bonus scheme is “very, very important,” and emulates a shift Coca-Cola had already made and that is a trend throughout the industry. “That has tremendous implications for this business. It makes working-capital management significantly more rational,” he says. Rather than increase revenues by jacking up prices, the bonus system encourages managers to increase sales volume.

PepsiCo is also striving to improve its cash conversion efficiency by learning from its various businesses. Whatever practices seem to work best – whether within Frito-Lay or the drinks division – are being adopted by other divisions.

Despite success, the motive remains powerful. “We’re in a war like I’ve never seen before,” says White.


Top-Down Approach

Billy Moore, senior vice president and CFO of Unifi, in Greensboro, North Carolina, says his company led the field of textile manufacturers this year, as it did last year, because it remains keenly focused on being the low-cost producer and on driving down its days sales outstanding. “We take a top-down approach,” says Moore.

Key to its recent performance is its investment in an automated accounts payable system that scans invoices. It replaces employees who manually recorded and tracked invoices until the invoices were finally paid and filed in cabinets. The system has allowed the company to reduce its accounts payable staff from 14 to 9 over the past two years. Besides reducing staff, the system has lowered costs by cutting the number of checks written, trimming supervisory time, and freeing employees to analyze problems in the system rather than perform clerical tasks, says Moore.

Unifi has also squeezed out costs by consolidating its receivables and payables operations in one location, Greensboro. The centralization of the operations two years ago – there had been two processing locations – has reduced processing time and produced more accuracy and less duplication in record keeping.

Yet another explanation for Unifi having maintained its DWC well below the industry norm (this year at 54.8 versus a norm of 104.5) is its rigorous system of “exception” reporting. Instead of, for example, getting inventory reports that he must rifle through to find out if there are problems of aging inventory, Moore receives exception reports that specifically alert him to problems. The same system operates for payables and receivables.

Unifi has also made substantial investments in capital equipment, and therefore has very efficient manufacturing operations, says Dennis Rosenberg, an analyst at Credit Suisse First Boston.

Although Unifi’s inventory turns declined slightly from 11 to 10.6 from last year to this, the company maintains a level more than twice the industry norm of 4.0 last year and 4.6 this year. This partly stems from the fact that Unifi’s sole product, yarn, requires a short lead time, and much of what the company produces is made to order, says Rosenberg.

While systems are indispensable to Unifi’s performance, the most important ingredient in its working capital management is the attention that employees throughout the organization devote to it, says Moore. That in turn is driven by the close attention Bill Kretzer, Unifi’s president and CEO, gives it, he says. Divisional presidents report receivable and inventory levels monthly to Kretzer, and the president meets frequently with the division chiefs if performance slips.

Linda Corman is a freelance writer in New York.

COPYRIGHT 1998 CFO Publishing Corp.

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