Supply chain financing is legal, but harmful to small businesses

Supply chain financing (SCF) is a popular deferred payment program that has been in place for almost two decades between the industry’s largest retailers and their suppliers.

Together in 2015, Advance Auto Parts, AutoZone, Genuine Parts, Pep Boys, and O’Reilly Auto Parts acquired roughly $11 billion in inventory, which in part is a direct result from many of their suppliers agreeing to contractual terms that smaller warehouse distributors (WDs) and retailers cannot secure.

In fact, too many of the smaller retailers and WDs are unaware that this legal practice exists, even though it is used by some of their suppliers. A candid discussion about the implications of SCF is important because some of those suppliers that are selling to the industry’s retail giants are indirectly harming smaller businesses that are blocked from SCF.

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Offered by the nation’s leading banks, SCF serves as a bridge so that retailers and their suppliers can achieve their mutual goals of optimizing capital and trimming supply chain costs. With SCF, the retailer is able to defer payments owed to the supplier.

When the supplier enrolls in SCF, the buyer negotiates for payment terms, stretching as far out as 364 days, which materializes into interest-free accounts payable financing. Upon approval of the invoice by the retail buyer, the bank purchases it, which immediately transfers the receivable’s risk from the supplier’s current liabilities. On or before the invoice due date, the retailer must remit payment to the bank.

Conversely, the supplier may collect payment from the participating bank at any point during the life of the invoice at a prearranged regressive discount rate at partial payment, or be paid in full at maturity. The discount rate on day one is at its peak, but over time the rate gradually drops closer to 0 percent as the due date nears.

Let’s make a working example out of SCF.

Say that Seismic Shock Absorbers sells $1,000 of product to its customer, Al’s Auto Parts, at 360 days payment terms. Next, Al, signs off on the invoice, and remits it to the bank at an agreed-upon 3 percent annualized discount charge calculated off the days remaining. Suppose with 120 days left, Seismic Shocks demands payment from the bank. Based off the original invoice amount ($1,000 x 3 percent x 0.666)*, Seismic gets $980.02 and the bank pockets $19.98.

Retailers adore SCF because they can put product on their shelves without having to leverage their balance sheet. By delaying payment, they may build up a surplus cash flow instead of burning cash reserves under the traditional thirty-or sixty-day terms.

For example, O’Reilly Auto Parts declared 2015 a momentous year. Management reported that net inventory investment continued to decrease as a result of the enhanced supplier program, which enabled a reduction of all supply chain costs and negotiated extended payment terms with their suppliers. SCF contributed to more than $867 million in free cash flow, which they cite as “the best use of the cash we generate…” to buy competitors like Bond Auto Parts, improve preexisting stores, and enhance distribution.

From the supplier’s vantage point, it makes a big difference when a bank buys each invoice from their customer and accepts the short-term payment risk. With the worry of getting paid on time removed, suppliers may aggressively attract customers and accelerate receivables. Moreover, lower borrowing costs through SCF are more attractive than working with a bank that is charging higher interest rates benchmarked off the prime rate.

Motorcar Parts of America (MPA), a manufacturer that netted $367 million last year, cited SCF as a major enhancement to its liquidity position. Average day receivables totaled 341 days. Eighty-seven percent of its revenue depended on the top three national retailers, of which 48 percent came from AutoZone. Bundled together, MPA’s products made a presence at more than 24,000 locations from those three accounts. In March of 2016, management reported a positive cash flow to pay off their debts and build inventory.

However, other suppliers are wary about SCF. For instance, Dorman Products asserts that vendor negotiations tilt in favor of the retailer. Their annual report notes that “… many of our customers have grown larger and therefore have more leverage in the arms-length negotiations of agreements with us for the sale of our products. Customers may require us to provide extended payment terms and returns of slow moving product in order to obtain new, or retain existing, business.”

Dorman is faced with a dilemma since an aggregate 60 percent of their annual sales depend on the five retailers, and in detail, each account represents 10 percent or $80 million. Given the volume purchases through SCF, is Dorman at the mercy of its largest accounts to do whatever it takes to keep their business even if it means indirectly putting a non-SCF account at a disadvantage? Aside from the rapidly expanding retail segment, noted in the annual report, Dorman does not address what it would do to support its non-SCF customers’ growth prospects. Is Dorman giving up on them or, does it lack a solution to balance the needs of the smaller accounts with the retailers? Other suppliers in the motor oil, hard parts and accessories business are finding themselves in the same position as Dorman.

Banks perceive SCF as a perfectly sound way to grow themselves a profitable business in exchange for managing risk and for offering working capital expertise. But what about the smaller players that cannot compete with their rivals? A managing director of supply finance, who requested anonymity, said that lending institutions like SunTrust, BB&T, Wells Fargo, and the rest cannot justify doing business with a company earning less than $750 million in annual sales. Banks prefer highly leveraged retailers over their suppliers that want to engage in SCF. Suppliers like Dorman and MPA reap the benefit to ride the coattails of a credit-worthy retailer. By comparison, a WD making $75 million a year whose credit rating is weaker than a billion-dollar retailer will not bring a supplier that same level of cost savings.

By working capital standards, these top five retailers and their participating suppliers smartly worked SCF to their advantage by investing their surplus cash to build market share, which is what shareholders love. But there is another side to this. Concentration of corporate power is a bad deal for the auto care industry. With these chain stores expanding, and more WDs and smaller retailers shrinking, consumers will end up with fewer product choices, and they will end up paying higher prices. Since 1990, two thirds of America’s industries have consolidated, raising a red flag that receding competition is resulting in higher barriers for new job-creating firms. In separate annual reports, Federal-Mogul and Tenneco raised similar concerns about the future of the auto care industry. There is no telling what a consolidated industry controlled by Advance, AutoZone, or O’Reilly would bode for the commercial repair shop or the walk-in customer whose choices of a part store are shrinking.

It’s time that the auto care industry starts talking about the long-term implications about SCF and explore ways to reverse a contracting marketplace. Albeit an uncomfortable dialogue, suppliers should explain why their revenue income is dependent on SCF, and what they are prepared to do for their loyal customers who cannot qualify for these bank programs.

On the banks’ part, it’s understandable that they prosper off lending, but why not encourage the boutique banks to produce a comparable SCF package to the industry’s smaller businesses so that they may flourish rather than wilt on the vine? As the David and Goliath companies battle it out, the commercial repair shop and DIYer customers should never end up as collateral damage.

Editor’s note: SCF Formula: Requested Invoice Amount x Annualized Discount Charge x Days Remaining divided by Payment Terms ($1,000 x 0.03 x .6666).

Article Resources

Bank of America- Trade and supply chain finance - Bank of America Merrill Lynch: www.bofaml.com/en-us/content/trade-supply-chain.html

Bankers Branch &Trust- Supply Chain Finance | Lending | BB&T Bank: https://www.bbt.com/business/lending/commercial.../supply-chain-finance

Deutsche Bank- Financial supply chain management – Deutsche Bank: cib.db.com/_shared/financial-supply-chain-management.htm

SunTrust Bank- Supply Chain Financing | SunTrust Corporate Banking - SunTrust Bank: https://www.suntrust.com/commercial-corporate...solutions/supply-chain-finance