By Paula Rosenblum, Managing Partner
10/28/2008
Asset-based lines of credit fund at least some portion of most retailers’ merchandise purchases. Those lines of credit include different types of covenants depending on the retailer’s line of business. The asset these lines of credit are based on is inventory, and typical covenants focus on those things that might devalue those assets to a point where a bank might not be able to recover its investment. Break those covenants, and the bank can call your line and force you into bankruptcy. After all, banks are supposed to make money on interest and fees, not lose money because an asset isn’t worth what they thought it was (uh-oh, that sounds very familiar doesn’t it?).
Not surprisingly, each retailing segment has different types of covenants, depending on the nature of its assets and its business. For example, retailers selling direct to consumers consider a return rate of 20% to be “good.” Brick and mortar retailers would be horrified by that kind of number, but it’s just what happens when a customer buys something without touching and feeling it.
The problem with returned merchandise is that it’s often not in pristine condition. Hence, you’ll find the loans for retailers primarily selling direct to consumers contain covenants associated with the ratio of sales to returns. The same is true of furniture retailers. While the ratio of returns may not be as high as 20%, anyone who has ever packed up and moved knows that furniture doesn’t travel well. It’s hard enough to get it delivered in good condition, but if the customer returns it, the item is not a pretty sight after its return trip to the warehouse on an otherwise empty delivery truck.
For other segments, the average age of inventory is a key metric and often baked into covenants. Only wine ages well. Everything else gets tired in one way or another. Hence sales shortfalls can lead to a retailer falling out of covenants as well. You might have a lot of merchandise, but the bank might not consider it A-1 saleable.
Given the volatile state of the credit market, we can expect lenders to keep a sharp eye on retailers’ adherence to covenants. Obviously, if you can, the best solution is to stay far away from your line of credit ceiling. I’ve done some research in this area and it appears that the largest retailers tend to be very conservative in their usage of these seasonal lines. Mid-sized and smaller retailers, however, often really rely on them, and can get themselves into serious trouble. In the spirit of full disclosure, I worked as a CIO for one retailer who put itself into Chapter 11 by letting its inventory levels go too low without replenishing it with fresh product. All of a sudden we bumped up against the ceiling and the bank called the line. Suffice to say, it wasn’t pretty.
So, what’s our best advice? How does a retailer avoid the “arc of the covenant,” preserve working capital and keep control of its own destiny? The name of the game is working capital conservation.
Are “Fixed Costs” REALLY Fixed?
Retailers’ knee-jerk reaction is always to tweak their payroll to sales ratio. Payroll is viewed as a controllable expense. But there’s a well of “fixed costs” that are actually controllable. They do require some investment, but the payback should be quick.
· Store HVAC expense: In our benchmark survey on “What Can Green Do for You,” retailers reported that their best opportunity for carbon footprint reduction and cost savings lie in their stores. Of course, retailers have been locking their in-store thermostats for years, but times are changing. I’ve been working on some webinars with a company named Site Controls, and it has taken store energy consumption control to new levels. According to Site Controls, increasing the temperature in 300 small-footprint stores with six cooling months by ONE degree can result in annual savings of over a million dollars. Participating in ‘demand response’ programs, which effectively allow the electric company to “brown out” a location during peak demand periods can not only result in savings, but announcing the brown-out in one store, actually drew applause from customers. What’s most interesting about Site Controls is it is hooked up to the web, so it can provide real-time exception alerts to the home office. That’s a lot better than waiting for the bill to come in to find out a store is out of compliance.
· Real Estate costs: I’ve written about this topic before, but it’s worthy to call out again today. Miscommunication during re-models and new store construction can drag phenomenal amounts of capital OUT of the retail enterprise, while missed opening dates can create unexpected lag times for revenue. Companies like Accruent and others provide ways to insure that construction is on-target and coordinated. Their lease management applications also help insure that retailers are getting all they are due from landlords, and not overpaying in down sales times.
These are two examples of ways retailers can tweak their fixed costs. In the case of HVAC costs, exposing the customer to these initiatives can even build retailers’ brands. In times of plenty, these steps may not seem quite so important. But when you’re butting up against the arc of the covenant, working capital conservation can mean the difference between squeaking through a difficult time and becoming just another retail failure. In today’s economy, cash and the customer are joint rulers of the retail enterprise – both are king.
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