The Luddite Trajectory

Lud•dite (lŭd'īt) n.

1. Any of a group of British workers who between 1811 and 1816 rioted and destroyed laborsaving textile machinery in the belief that such machinery would diminish employment.

2. One who opposes technical or technological change.
[After Ned Ludd, an English laborer who was supposed to have destroyed weaving machinery around 1779.]

I have to confess these things:

• I remember when the first ATM’s became available and I was unwilling to use them to make a deposit.

• I remember when electronic deposit of paychecks became available and I was unwilling to trust it; preferring to have a paper check in-hand on Friday afternoon.

• My first job was with a large financial institution in an investment department that routinely took weeks to process transactions because so much analysis was done via calculator. We had access to a leased-time mainframe computer which my boss never failed to term “the confuser”.

The Luddites could not change the course of the industrial revolution. My resistance to changes in banking technology was fear-driven and counterproductive. My first boss rendered himself obsolete (or “redundant” in the land of Ludd) in a few short years.

So, where is this going? Three data points:

The first:

I read a report from a British business newspaper this morning about the difficulty that smaller businesses are having collecting money owed them. The reporter made the point that a large percentage of the affected businesses had done nothing yet to change their processes to cope with the cash flow problems.

But, he reported, “9% have turned to invoice discounting and 8% have used factoring”! That was presented in a way that implied that the numbers seem small!

In the US market, achieving a 9% penetration in the invoice discounting business would translate to (at least) tens of billions of dollars of additional employed capital in the industry.

The second:

In this week’s edition of The Economist, also a British publication, an article on small business finance appeared, entitled “Markets for Minnows”. Among the points it makes are:

• Large businesses in developed economies can once again raise capital with ease, principally via the bond market.

• Spreads on loans to smaller businesses (however) are at their highest level in a decade.

• US banks holdings in commercial loans fell in the first quarter at an astonishing annual rate of 21% (this as we are supposed to be in recovery mode).

• Syndicated lending to medium-sized business is at less than half of peak levels.

• “Demand for factoring has fallen over the past year because businesses had fewer invoices to pledge, but is likely to rise sharply as small businesses struggle to finance an upturn in orders….”

• The head of Wells Fargo’s trade capital division sees the factoring market growing by 6-8% per year.

• “Another new form of invoice-based financing is The Receivables Exchange…..which helps users to overcome…the decline of traditional small-business finance and the stretching out of payment by their customers…”

The third:

• An article in last week’s Wall Street Journal (4/15 p B6) analyzed the extent to which small businesses, prior to the housing bust, depended on tapping real estate equity for working capital.

• In 2007 one survey showed that “30% of respondents tapped home loans for funding” their business working capital needs.

• In 2009 that figure had fallen to 7%.

• Based on that comparison, alone, 23% of small businesses have, in a very short time, lost access to one of their principal funding sources.

There is no question that small business MUST find alternate sources of working capital if they are to survive and prosper!

Last month we saw Morgan Stanley identifying TRE as a new and potentially important player on the invoice discounting landscape.

This month The Economist gives it prominent mention as an alternative.

Just last week I was shown promotional material of a company that appeared to be marketing a “copycat” program, which on further investigation actually offered nothing but some additional potential visibility for the Exchange, itself.

Here’s my take-away:

The British and the Europeans, in general, are far in front of the US in the adoption of invoice discounting in the SME community. We can and should learn from them (just this once).

Wells Fargo, now the largest player in the domestic factoring market, sees a 6-8% growth rate in the traditional-factoring sector of the business. That’s hardly a steep growth curve from present levels and hardly an answer for the smaller end of the market.

The SME market for invoice discounting in the US, while relatively immature and small, is one of the only avenues that will be available to meet the financing needs of the SME market going forward.

TRE, for all that it is neither perfect nor mature, offers a true alternative; efficient and scalable.

If it could provide the mechanism to take the US market just halfway from its current invoice-discounting penetration to the 9% level found in the British study quoted above, it would represent a significant avenue for employment of capital, a meaningful stimulus of economic growth and an important engine for job creation.

It took me a couple of years to trust ATM machines and electronic deposits. But thankfully both the world and I change faster now.

New questions are asked. New challenges posed. And in the great American tradition, new answers become available.

The job is to introduce the question to the answer.

Sizing It Up

In my March 21 post, “The Diet of 900 lb Gorillas”, I referred to the recently-published Morgan Stanley report on B2B Finance. That report raises a number of issues, only one of which was really addressed in that prior post, so I want to return to it again.

This time I want to point out a couple of statistics that are key to assessing the long-term potential of The Receivables Exchange.

The first of those statistics is the gross size of the SME (small to mid-sized enterprises) market. Morgan Stanley reports that the SME market accounts for about 45% of all business revenues in the US. Morgan defines the SME category as all businesses with annual revenues of less than $500 million.

Now for the purposes of discussing TRE’s near-to-intermediate term potential it’s unrealistic to assume that its addressable market includes businesses with $500 million in sales. So we have to adjust Morgan's 45% figure.

The smallest category Morgan uses comprises businesses with revenues of less than $25 million. That category accounts for 25% of total corporate revenues.

TRE requires Sellers to have annual revenues of about $1.5 million and, at present, a $25 million Seller would be at the upper end of the TRE size spectrum. So this is really the near-term target market-segment for TRE marketing efforts.

To eliminate those businesses that are too small to qualify for TRE Seller membership we have to reduce the 25% total. This is completely guesswork on my part but I suspect we wouldn’t be far off if we reduced the 25% figure to maybe 15-20% to eliminate the smallest businesses.

If we apply the 15-20% range to the estimate (based on the Fed’s flow-of-funds report) of the overall volume of annual B2B accounts receivable generation (about $18 Trillion), that suggests a potentially-addressable, near-term market size in the range of $2.7 to $3.6 Trillion.

That ignores the fact that some of those businesses, especially the smaller ones, probably do not extend trade credit, but it’s also the case that some large businesses extend very little trade credit. It’s hard to know how to adjust those volume figures with any confidence, so I’ll just let them stand with the caveat that there are potentials for error from a number of sources.

If we use the mid-point of that indicated range, or $3.15 Trillion, and we assume an average AR duration (days-to-pay) of 45; that suggests that the average outstanding AR balance on the books of that segment of the business community would be about $390 Billion.

That’s a big number!

The Morgan Stanley estimate of the total US factoring market is given at $136 Billion, suggesting that our estimate of the near-term, potential TRE-addressable market is three times the size of the entire current industry. But that's not really the appropriate comparison.

It is clear that the smallest businesses will account for no more than their relative percentage of the total factoring market and probably quite a bit less. How much less is a guess, but let’s just say for conversation that it’s overstated by 100%, or that the actual factoring activity in this smallest segment of the economy is half its representation in the total economy.

That would suggest that $10-$13 Billion is employed by the factoring community in the smallest segment of US business.

If that’s anywhere close to the mark, it implies a current market penetration of only 3% or so of indicated near-term potential.

If a realistic maximum penetration were, for argument's sake, to be measured at 25% of the currently-addressable market, the implied potential would be $390 Billion x .25 = $97.5 Billion, less (about) $12.5 billion (already served), or something in the range of $85 Billion in potential for capital employment.

That’s clearly a market worthwhile pursuing.

And that is without considering the potential ultimately afforded by businesses with revenues above $25 million, some of which, over time, should be attracted to the flexibility of an auction environment.

On the other hand, it has to be recognized that many smaller businesses are in no condition to be brought to TRE at this point.

TRE’s marketing effort has to include a long-range education program to bring potential Sellers to the realization that “clean” and accurate financial records and disciplined management of their billing and other AR functions are critical to positioning themselves for access to a market like TRE.

It’s easy to make the case that the market potential for TRE is substantial in the near-term and extremely substantial in the longer-term.

It’s not a stretch to view the TRE growth curve as exponential for some time to come.

But that doesn’t mean achieving that potential is a certainty.

There are difficult problems to be solved, not least of which is maintaining the discipline required to adequately vet potential Sellers and to strictly implement the safeguards in place to protect against abuses.

But it seems clear that the size of the opportunity makes tackling the problems well worth the effort.

The Diet of 900 lb Gorillas

In my post of March 11, “The Perversity of the Possible”, I wrote about large companies unilaterally changing payment terms for their obligations to suppliers.

My thanks to Dave Schmidt for his response to the post and confirmation of the problem!

Coincidentally, a report by Morgan Stanley was released at about the same time. It offers Morgan’s help to large firms in devising programs to leverage their cost-of-capital advantage to essentially squeeze discounts out of their suppliers.

This is presented as a win-win proposition, but that’s clearly just a smoke-screen.

Morgan Stanley’s suggestion is really that large firms with excess cash or credit capacity propose to pay suppliers early at a 4% discount. For those who chose not to participate, the unacknowledged flip-side would be a lengthening of payment terms.

Morgan uses relatively large print and bold typeface to trumpet its conclusions that these transactions increase profitability of BOTH the large companies that would be Morgan’s clients and their suppliers.

In the small-typeface, cramped-format analysis, however, we find that the assumption on which these conclusions are based is a 100-day acceleration of the supplier’s payment!

What is Morgan Stanley saying here?

It is saying that the large company, the 900-lb Gorilla, will force the supplier to either take a 4% discount or wait 100 days to get paid. This is very close to the situation I described in my March 11 post.

Let’s be clear, here. This is in no way an attempt to find a win-win solution. This is Morgan offering to coach large companies in the fine art of squeezing small ones. As if that were necessary!

To put an even finer point on it—this is Morgan Stanley offering to provide 3rd party justification for such squeezing so that the leaders of the large companies have the cover of expert advice as a defense for their actions.

Now, the Morgan report does introduce The Receivables Exchange as a potential alternative to using the large companies own excess working capital capacity. Its presentation of TRE and its process and benefits is flattering (if not completely accurate). And that is a good thing for TRE.

But the point of their bringing TRE into the report is as a thinly-veiled option for squeezing the suppliers WITHOUT using the large company’s own working capital.

They’re saying, even if you don’t HAVE the excess capacity yourself, you can STILL force extended payment terms on your suppliers by simultaneously suggesting that the suppliers utilize TRE to compensate for the extended payment terms.

Make no mistake. Morgan is not in this to help the supplier.

The Morgan report explicitly states that it is not a product of their research unit. This is a marketing initiative to help Morgan generate fee revenue by coaching large companies in the creation of accounts-payable strategies that increase their own profits at the expense of their smaller, weaker and less-well-capitalized suppliers.

I’m sure that Morgan publishes a list of its annual charitable initiatives. This isn’t one of them!

In individual or isolated instances, squeezing the suppliers as recommended by Morgan can work. It cannot work as a wide-spread, systematic shift in large-company AP strategies. At least, not without compensating pricing adjustments.

There might be room in the forest for one or two 900-lb Gorillas. But if all gorillas were that big there wouldn’t be enough food to sustain them, and some would have to die off or change their diet in order to restore balance.