operational turnaround –focus on working capital and supply chain-lecture by igor zax at lbs

Operational Turnaround –Focus on Working

Capital and Supply Chain

Igor Zax, CFA, Sloan Fellow (LBS)

Managing Director- Tenzor Ltd

© Tenzor Ltd 2009-2012

www.tenzor.co.uk 1

Strategic Value Drivers Buying “Cheap”

– Typically driven by distressed seller

– Timing is critical

– Limited due diligence

Navigating Insolvency process

– Loan to earn

– Pre-Packs

– Winning capital structure battles

– Heavy reliance on legal process


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Strategic Value Drivers

Efficient Liquidation

– Sum of parts is more than the whole

– Individual assets are valuable but buyers are not

interested in the whole

– “Bodies in the cupboard”

Operational Improvements

– Management Change

– Integration/Synergy

– Specialist Turnaround Strategies


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Why Turnaround?

Insolvency may be an efficient solution if there are

substantial assets in the business (based on actual

liquidation value) and they can be easily secured.

Otherwise, one needs to keep the company as going

concern as the best way to recover- and this is not only

lender’s decision.

To do so, one needs to answer why the company exists and

how is it linked to its environment.

Bank lender makes a one-off decision to lend-supply chain

partners making their decisions (including granting credit)

every time


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Five “C” of Turnaround Control

– Creditors seek to control assets and decision making

Capability

– The team (existent, new or interim) need to be capable for the task

Credibility

– Turnaround plan and the team need to have credibility with all

stakeholders

Clarity

– What is the company’s core business, how it fits with the industry

structure and does the business model match it

Co-operation

– Lending group are not the only stakeholders. Ongoing support

from suppliers, customers, distributors and others are vital for

survival


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Steps for Distressed

Turnaround

Diagnostic – “post deal” due diligence

Fixing the team

– Loyalty

– Competence

– Communication

Re-defining the business

Process optimisation


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Operational Due Diligence-key

part of M&A deal


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Accounting

Legal

Target

ODD-Multi Dimensional Picture Just one side?

We need not only answer “what” but “why” and

“what does this mean?”

Operational Due Diligence-

core questions to answer Re-construct the link between the numbers and physical

process

– Get the access outside of “professional seller”!

– Do not limit your conversation to finance people- they talk about

numbers, not the business

– Speak to sales, procurement, manufacturing- and reconcile what

you hear to what you see in the numbers

– Understand external environment- suppliers, customers,

distributors- they may tell you a lot of things you would not hear

from the company

– Visit the warehouse and manufacturing and ask few simple

questions


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Practical Example- What Can

you find in a warehouse


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What Do you see in Warehouse?

– Two similar boards (one of which is PCB and one is assembled) are on the

warehouse shelf

What do you see in Accounts?

– Working Capital problems

What do you see in Manufacturing:

– Delays, quality issues

What do you see in Customer Service

– Quality Issues

PCB PCBA

Question to ask – Why? And

Is there a link? The company is buying printed circuit board from a small

supplier with advance payment

They have no way to properly do QC before assembly

They send the board for assembly to another far away

provider

When they finally got the board back, they find not all of

them pass testing. Complex process to find out whose fault

(from the two suppliers) it is.

What we discovered – WRONG SUPPLY CHAIN causing

the problem


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Industry structure and Supply

Chain Global industry structures changed massively

Platform companies "Produces nowhere but sells

everywhere... know where the clients are and what they

want and where the producers are. Platform companies

then simply organise the ordering by the clients and the

delivery by the producers (and the placing of their logo on

the product just before delivery).“- GaveKal

Integrated and collaborative supply chains.

Contract manufacturing, outsourcing, muli-tier distribution

Changed structures are often ignored by analysts


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Supply Chain- Distribution of

Risk and Reward


www.tenzor.co.uk

Component

Manufacturers

Contract

Manufacturers

Component

Distributors OEM Distributors VARs

Customers!

• Understanding the supply chain is core to determining the future

of the company.

• How is wealth and risk distributed?

• What is outsourced to whom? Who does financing- is the

company a bank? Should it be?

• Is the issue overall health of the chain, distribution of rewards and

risks at particular layer or just company specific issues?

• Who can “shortcut” the chain and what would be consequences?

• Who is going to loose the most if company disappear and what

can they contribute to rescue?

12

Working Capital- Good

Starting Point Most of the problems of companies manifest themselves in

working capital (A/R, Inventories, A/P)

Aged debtor list and its analyses vs. sales

– Are receivables real?

– Is ageing real ?

– Why payments are late – disputes vs. credit?

– Are sales real?

– What happened prior to sale?

Sale is converting inventory to A/R showing a profit. Did it

– Push the problem next level?

– Chanel overstocking?

– Produce uncollectable A/R

– Is there actual end user demand?


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Working Capital Analyses –

cont.

Analysing late payments allows to uncover issues with quality,

logistics, systems, etc. –credit management is the best source of

information about the company issues

A/P

– Short terms – why terms are not offered?

May be wrong supplier, no insurance cover, bad history?

– Long terms –are these sustainable?

– Overdues- would these be tolerated?

– Key question – are suppliers still supplying or they already

or about to stop?

– May be significant cash outflow post acquisition.


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Working Capital Analyses-

cont Inventory

– Clear distinction between finished goods, components and work in

progress

– Obsolescence

– Components for wrong models? They may be perfectly good but perfectly

useless

– Is there a process for managing inventories?

Overreliance on ratios- these are just averages

– “Good” DSO may be a mixture of prepayments and massive overdue

– “Good” DIO may be a large pile of useless stuff and a massive shortage

of needed inventories

– “Good” DPO may be a mixture of pre-paid suppliers and the ones who

already stop supply and looking for legal action


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CAPEX/ Development Costs

EBITDA focus creates a strong incentive to under invest

Company can run on close to zero CAPEX and even

maintenance for a while – but this would mean massive cost in

the future

Cutting R&D improves short term profitability but negatively

affects future cash flows.

Cutting people improves profitability but in many business this

is the main asset.

Particularly relevant for industry buyers- often overestimating

own ability to develop/support


www.tenzor.co.uk 16

Processes

Assets are not enough –there should be a process for business to

run

If one thinks of outsourcing (either manufacturing or service)

one needs to have a n efficient process in the first place

Efficient and well documented process can be “portable”- i.e.

Moved to different location etc. If the “process” is based on a

“fire fighting” skills it is not only inefficient, but not “portable”

One needs to understand what they are buying – “whole

business” or its part (for example sales team or R&D capability)

If part of the business is not needed, what would it cost to

liquidate and would this adversely affect the “desired” part.


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Working Capital Management Loosing supplier credit is the major risk-do not provoke by late

payment (but try to negotiate longer terms) and keep good

communication. No supplier’s support-no deal.

Receivables are major asset- they need to be managed properly

and financed were appropriate. Both quality and financibility of

receivable book may be key in pre-deal due-diligence.

Manage inventories-but understand that many optimisation

models assume risk free counterparties.

Analyse the product mix not only from profitability standpoint,

but also working capital effect –and go out of products you can

not afford

If the company is not right place for financing and risk, find one

in the supply chain who can take it


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Redesigning the Model -

Distribution example

Supplier Distributor purchase

Sell

Payment

Provides:

Marketing/Sales

Logistics

Service

Working Capital

Finance?

Risk mitigation???

Risks:

Distributor credit risk

This risk may be highly

concentrated

Customer credit risk (if

distributor has little capital)

Product liability (any case)

Credit Insurance?

Factoring?

Securitisation?

What credit limit?

Diversified risk?

Low concentrations?

Single vs. multi tier?

How do you finance

receivables in EM? © Tenzor Ltd 2009-2012

www.tenzor.co.uk 19

Distribution example

Supplier

Distributor-

now agent?

Sell

Provides:

Marketing/Sales

Logistics

Service

Collections?

Performance risk

mitigation?

Credit Insurance-

easier to obtain?

Invoice discounting?

Factoring?

We are in Europe!

Diversified risk?

Low concentrations?

Single vs. multi tier?

No need to finance in

EM?

Low working

capital needs! © Tenzor Ltd 2009-2010

www.tenzor.co.uk 20

Why Do You Need Working

Capital-Business Model? Working Capital needs are related to structure, not

necessarily value added

Supplier’s upmost concern now is risk

Learn the core lesson from banking crisis- the fact that you

transferred risk on paper DOES NOT mean you transferred

it if counterparty is or becomes week

Variety of legal structures to mitigate risk, while reduce

working capital needs

Similar models can be applied to contract manufacturing,

printing, material processing, etc.


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Example-Printing


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Component

Supplier Assembler OEM

• What business the assembler is in?

•What worries the component supplier?

•What worries the OEM?

•What worries banks/factoring company/credit insurer?

•Would acquisition resolve any of these?

• Is there alternative model?

•Whom do you need to speak about what?

•When would the “original” structure work best?

Rise of ABL

Cash flow lending was the main trend in the past. Today,

EBITDA is much more volatile- not only reducing

multiples, but also making cash flow lending unavailable

in many areas.

Lending against assets becoming more used, especially

where the value can be clearly determined.

Illiquid and long term assets are difficult to lend against-

shorter term is easier.

“New Financial Engineering”- how to reduce the risk in

transactions

Unlike cash flow lending, ABL often needs understanding

of operations © Tenzor Ltd 2009-2012

www.tenzor.co.uk 23

Credit Insurance and Receivables Financing

In Europe, credit insurance is extremely important (domestic and export)

The supplier may not be the one making decisions

If cover is withdrawn, company can try to negotiate with insurer (to restore cover)

and/or supplier (to continue sell uninsured) IF debt is current

If the payments are overdue, supplier may not supply or risk the claim not being

paid...

Receivable financing is underutilised by suppliers-they paid for taking off the risk

but did not use the financing available!

Trade Receivables % Insured % Financed

Europe 35 5

UK 30 6

US 5 4


www.tenzor.co.uk 24

Supply Chain and Turnaround

Financing

The supplier (even a highly distressed) is a lender,

providing next step in the chain (distributor, manufacturer,

end user etc.) with credit through payment terms

(sometimes they are the only or main source of credit).

Buyer of the goods can effectively provide money to the

seller through reduced payment terms without taking risk

(providing supplier fulfilled the contract).

This may provide a workable alternative to DIP (Debtor in

Possession) financing, allowing in some cases to provide

funds to distressed company without being affected by

possible bankruptcy procedures


www.tenzor.co.uk 25

Practical Implications for Companies

in Emerging Markets Setting up oversees distribution entities is currently

seen mainly from tax planning perspective

Setting an oversees distribution/operation entity

(with transparent operations and reasonable

capitalisation) may create significant financing

opportunity as:

– The company will have access to efficient receivable

financing

– The company will effectively lend to the EM one

through short payment terms without joining queue of

creditors © Tenzor Ltd 2009-2012

www.tenzor.co.uk 26

Examples of possible deal

structures EM Company (high margin/low liquidity) buying

a low margin/high volume distributor

– Lower price-higher margin at distributor level

– Distributor has access to WC finance-some times even

for sales back to EM

– Short payment terms- resolving liquidity issue

Buying distressed EM exporting Company

– Very difficult to refinance locally

– Invest at distributor level-refinance through payment

terms © Tenzor Ltd 2009-2012

www.tenzor.co.uk 27

Why Vertical Integration? Recent years show a global trend to “platformisation”

This was driven by lower transaction costs, supply chain coordination

and general low risk environment

This is changing now, as risk is again high on the agenda, and

transaction costs are up

Deals start coming small and very large

Cost of acquiring supply chain partner may be lower than switching cost

Resolving of concentration problem- getting away from excessive

dependencies.

A lot of supply chain optimisation techniques designed for a “risk free”

world

In a risky world it is cheaper to have a solution within a firm- the very

reason firms exist (Richard Coase, Nobel price in economics 1991)


www.tenzor.co.uk 28

Supply Chain-its importance to

creditors and turnaround investors Company’s working capital needs depends from business model-

and this can be changed (meaning less money needed to support

the turnaround)

Instead of distressed financing of troubled company, one can often

finance healthy one (such as its distributor) with the same net effect

but different cost and risk

One needs to be aware of cross border differences- for example

there are more solutions for financing sales to Emerging Markets

from the West than for domestic financing within Emerging

Markets.

Sick companies in healthy chains have much higher chances of

survival than in sick chains.


www.tenzor.co.uk 29

Vertical Integration- Working

Capital Implications Buying a week player up the chain- moving from concentrated

non- financeable receivables book to diversified

Merged company can finance receivables- target on its own find it

difficult because of operational risks.

Inventories – can be managed down on elimination of bullwhip

effect and reduction of safety stock to cover supply risks

Payables. If target facing withdraw of lines from suppliers or credit

insurance, restoring of these can provide immediate working

capital boost.

Conclusion: Working Capital may change tremendously in a

successful acquisition, providing cash boost instead to cash drain to

acquirer


www.tenzor.co.uk 30

Thank You and Good Luck!

Igor Zax, CFA, Sloan Fellow (London

Business School)

Managing Director, Tenzor Ltd. (London)

Tel: +447775708426

E-Mail: [email protected]

Web site: www.tenzor.co.uk


www.tenzor.co.uk 31

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operational turnaround –focus on working capital and supply chain-lecture by igor zax at lbs

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