The "Two-Feet-Deep" Danger

We’ve all heard the one about a man (hopefully a statistician) drowning in a river that is, on average, only two feet deep.

It’s not that the information about average depth is either inaccurate or unimportant. It’s just that it’s not ENOUGH information if you happen to be crossing at the wrong point.

In my last post I said that I’d write next about the 2nd quarter figures in the “National Summary of Domestic Trade Receivables” published by the Credit Research Foundation. The CRF has published this survey quarterly for 50 years.

I’ll only make broad comments because the material is copyrighted. See www.crfonline.org for subscription information and other products and services offered.

The CRF has devised and publishes a “Collection Effectiveness Index”, which is a single-figure indicator of the general health of the domestic trade receivables market.

That measure showed a significant improvement in 2Q-2010 compared to 1Q and a small improvement over the year-ago period. Most other aggregate measures they report showed similar improvements:

a) decreasing days-sales-outstanding,

b) decreasing delinquencies,

c) increasing percentage of accounts current, and

d) decreasing percentage of accounts over 91 days past due.

These high-level, market-wide measures are useful indicators that nevertheless have to be understood in the context of potential lag-effect, bias from sample size and bias from self-reporting.

The breakdown provided by industry group can be more valuable since it reveals substantial variances from the reported medians.

For example, in the category of “% Current” the range among industries in 2Q-2010 was from 39.13% to 94.76%.

Of particular interest to me as I studied the results was the disconnect between the improving picture painted in the CRF report and the anecdotal information that I’ve been hearing recently from clients and others. The message I’m hearing is that there has been a continued deterioration in the ability to collect money owed to small and mid-sized businesses.

I’ve written in prior posts about an organized and concerted movement by Wall Street houses to educate large, credit-worthy businesses on the virtue of substantially lengthening payment terms to their suppliers and then offering to accelerate payments at a discount.

This “squeeze the little guy” campaign demonstrates a cynical disregard for the long-term damage to the SMB community, which is so important a source of job creation. Its openly-stated purpose is to leverage the large companies’ access to cheap capital as a tool to force suppliers to reduce effective prices.

Let me add a few, admittedly anecdotal, data points from conversations I’ve had in just the past week:

1. A colleague told me the other day that he had knowledge that a large, multi-national company had instituted a new, purposely-draconian, “reject the invoice” policy. The AP staff of this company will now reject any invoice for ANY deviance from its increasingly complex and difficult-to-understand invoicing policy; requiring a revision and re-submission. And, of course, stringing out the time to payment.

2. A client told me this week that one of their customers; an architectural firm that had done a substantial amount of work for a large public hospital; had had to fight for over 120 days to get a check, which then bounced.

3. A colleague reported that a large, national customer recently notified a certain class of supplier that it suspected that there had been fraud on the part of some of those suppliers and so had put a freeze on ALL payments to ALL suppliers in that category until an audit could be completed. Completion of the audit is not expected until YEAR-END!

4. A professional services firm that has been in business since 1914 has had to enter into a workout payment arrangement with a subcontractor on some UNDISPUTED bills to a large municipal school construction agency that have been unpaid for nearly a YEAR.

5. A painting contractor that has been doing a significant volume of work for one of the largest residential property management firms in the area for over 20 years now has about 75% of its receivables at over 90 days.

These are just a few items that have come up in the past week.

It’s certainly possible that my experience reflects a regional bias. It’s possible that the lag effect is a partial explanation. It’s also possible that it reflects a bias toward the kind of client I typically deal with in my spot-factoring business.

But the anecdotal reports that I’ve been getting certainly paint a picture that is at variance with that of the 2Q CRF report.

I do not question the CRF results. I think that the information they compile and analyze is valuable and important and I’d recommend it to anyone interested in top-line industry trends. It might well be that the next quarterly report will show the sort of softening that current anecdotal information hints at.

What I do suggest is that the need for liquidity in the SMB market and, specifically, for acceleration of receivable collections in that market, continues to be among the top two or three problems facing business owners.

And that’s good for prospecting by the TRE Seller-marketing group.

Misfiring Synapses

Some days the coherence of a rifle shot gives way to the less-organized pattern of a scatter-gun. This is such a day.

Rather than a single topic, I have a scatter-shot list of points to make and issues to address.

So, here goes…..

1. This week we’ve marked the close-out of our 150th TRE auction. (We’ve bought all or part of 189 auctions to-date.)

I can no longer say that we have encountered NO repayment problems but I CAN say that the issues that we have encountered have been handled professionally and successfully.

2. It has ALWAYS been unrealistic to suggest or to believe that everything would always work smoothly in the environment of SMB factoring. It doesn’t and it won’t. The challenge is to anticipate and avoid situations with a higher likelihood of problems, even if that means refraining from bidding on auctions that seem very tempting.

3. I was reminded this week that holding-period duration can be every bit as important as discount rate. I made an error and bid on an auction that could potentially have been repaid so soon that the TRE fee structure would generate a negative or negligible return to the Buyer. As I was berating myself for the bidding error and hoping that somehow I could be spared “success” on that auction, another Buyer placed a more aggressive bid that I’m convinced was also an error on his part. Give thanks for dodged bullets!

4. I continue to believe that the TRE fee structure should be re-considered. It provides a powerful disincentive for Buyers to bid on short-duration auctions and, therefore, acts to damage Sellers’ ability to maximize utilization of the platform.

5. In last Friday’s “Liquidity Weekly” email, Bill Siegel noted that July was another record month for exchange volume. The actual volume figures are TRE’s, not mine, to make public. But I think I can add a specific data point of interest without violating the Buyer confidentiality agreement.

By my reckoning, July 2010 represented the 12th consecutive month during which auctions were closed on EVERY trading day of the month. That’s pretty cool—a full year without a zero on the daily volume chart.

6. As I was considering the last twelve months activity, I looked back just out of curiosity, at the activity in the last week of July 2009 versus that of the last week of July 2010. What I found was interesting.

A high percentage of the Sellers active in the current period were also active in the year-ago period. Some of that seemed coincidental. Two Sellers, for instance, that were active in July 2009 have been largely absent from the exchange over the past several months but happened to pop up in the last week of July 2010. And their auctions were treated very well buy Buyers.

In a couple of cases, Sellers that were active in both year-apart periods found that their pricing in the 2010 week was much different than in the 2009 week.

My interpretation of that is that the Buyers are paying more attention to the updated financial statements, to the strength and payment records of the Account Debtors and to the likely duration of auctions; and they are adjusting their bids accordingly.

In other words, the analytic process is improving, at least among the Buyers that have been active for a while. That’s a good and healthy development.

7. While there was a surprising number of Sellers active in each of the two periods studied, there has also been an interesting pattern of rotation in the more-active Sellers over the intervening months. One Seller will be a major driver of volume for a few months and then go “quiet”, for instance. Some of these are seasonal issues. Some seem to reflect the Seller acquiring more traditional financing sources.

8. The positive aspect of the historical pattern is that when one major Seller goes quiet another tends to come along to replace it in fairly short order. The volume pattern of the last year should not be interpreted as continually building on a base of established and reliable Sellers (although there are certainly quite a few in that category).

Rather, the pattern is more like “rotation” in the equity markets. Leadership changes and Seller -participation changes for a variety of reasons, but the top-line trajectory remains strongly positive.

9. It is to the Exchange’s credit that, so far, there have been new leaders brought on to replace those who go quiet in a fairly seamless pattern.

10. The Credit Research Foundation has just published its newest quarterly “National Summary of Domestic Trade Receivables”, which is quite interesting. I’ll write about that in my next post.

In the meantime, pardon the misfiring synapses of an August Friday afternoon!

A Comment on Risk

I heard a marketing presentation not long ago in which it was asserted that that “only three-tenths of 1% of invoices ultimately go unpaid”. The unspoken but implied conclusion was that buying invoices involves only minimal risk.

I asked for the source of the statistic quoted and was told that it came from the Credit Research Foundation. I contacted the CRF and obtained a copy of the quoted report, which is entitled “National Summary of Domestic Trade Receivables: 2008 Annual Bad-Debt Report”.

The top-line analysis is provided in two statements:

1) “Net bad-debt write-offs during 2008 totaled $30.00 per $100,000 of sales. This is a net change of $0.00 over 2007, and

2) Allowance for uncollectables during 2008 was 1.00% of receivables. This is an increase of .50% over 2007.”

(Not to be picky, but $30 per $100,000 is actually three one-hundredths of one percent, not three-tenths.)

A few observations:

• The number of respondents to this survey was 555. It is not clear how large a part of the overall economy this sample represents.

• The figures quoted in the summary statements above represent the median responses.

• While the write-off figure did not increase in 2008 over 2007, the allowance taken in 2008 was double that of 2007.

• In the case of the write-off figures, the upper-quartile break-point of the sample was at .19%, or about 6 times the median level.

• In the case of the allowance for uncollectables, the upper quartile break-point was at 3% of sales---100 times the level of the median write-off reported!

So you can choose to highlight the finding that the median write-off remained the same from one year to the next. Or you can take note that the expectation of losses, captured in the allowance figure, increased by 100%.

Or you can acknowledge that the upper-quartile, forward-looking statistic is 100 times the median backward-looking statistic.

The waters might not be as placid and shallow as they appear!

There’s another source of data that is more relevant to the operation of The Receivables Exchange. It is collected by The International Factoring Association. For 2008 this data represented the experience of 120 companies in the factoring business.

• The median write-off experience of that group in 2008 was .3% of gross invoices purchased, 10 times the median of the CRF sample. The average write-off experience was 1.3% of gross invoices purchased, more than 4 times the median.

• The IFA presents results broken down by size of respondent. The largest companies providing data; those with $100 million or more in gross receivables purchased; had the lowest loss experience, at .6% of invoices purchased. The smallest companies, buying less than $5 million per year, had an average loss experience of 2.5% of gross purchases.

• These figures, from companies actually involved in the industry, are far higher than those reported by the CRF. But more importantly, I think, these figures represent the experience of companies that KNOW the risks of buying invoices and take all of the normal precautions against losses.

I’ve detailed in other posts the ways in which the Exchange’s practices in qualifying Sellers, in obtaining security and in verifying invoices fall short of those in common use among buyers of individual invoices. (I've also pointed out some unusual benefits of the TRE process as well, however.)

I’ve argued that the TRE Buyers are exposed to incremental loss levels because of those shortcomings in risk mitigation.

It’s too soon to say what level of incremental return should be required by TRE Buyers to adequately offset the added risk.

It is not too soon to say, though, that the increment should be added to the IFA experience, not to the much lower CRE numbers.

And I would argue that the baseline point of the analysis should not be the experience of the largest companies but rather of the smallest, recognizing that the majority of TRE Sellers would not qualify for funding by the largest factoring companies.

We've all heard the one about the guy who drowned in a river that was only 6 inches deep, on average! Some statistics can be correct and irrelevant. Some can be correct and dangerous.

It's only coincidental that the first three letters of Treasuries, are TRE. We're not buying Treasuries here!