Negative Working Capital Strategy
Let's compare AutoZone and Walmart.
I suppose, first and foremost, I should say that I hate when news agencies are wrong about something and don’t loudly correct themselves. Recently, it was rather aggressively asserted that I was wrong about AutoZone, and there were two counterpoints that I think had enough merit to deserve a thoughtful second look. If you make a habit of analyzing stocks, one thing is certain: if you ever say that you don’t like a stock, it will send some of that company's shareholders into a rage. So, you definitely have to have thick skin and still be able to consider a counterpoint, no matter how rudely it is conveyed. That being said, many people are capable of being polite. Recently, when I shared my post on AutoZone, the two main counterpoints I had coming back at me were:
That many companies operate with negative working capital and therefore nothing is concerning about AutoZone.
Inventory should never be excluded from current ratio calculations.
The response to the 2nd point is simple and fairly easy to address. Let’s use JCPenney as an example. JCPenney declared bankruptcy on May 15th, 2020. I have a link to the last 10-Q report they filed with the SEC before declaring bankruptcy.
When JCPenney declared bankruptcy, they had about $2.2 billion in inventory on their balance sheet. This accounted for about two-thirds of their current assets, and JCPenney had a current ratio of 0.5. This did nothing to prevent JCPenney from declaring bankruptcy. AutoZone, in my opinion, is in a worse position, with 83% of its current assets consisting of inventory, although its current ratio is 0.8. Having billions in inventory did nothing to prevent JCPenney from going bankrupt and the same risk it is present for AutoZone.
This is why I prefer the formula of Cash and Short-Term Investments + Total Receivables > Payables and Accrued Expenses instead of the current ratio. If a business runs into trouble, inventory doesn’t always count for much unless it can be sold off at full value very quickly. This isn’t the case often, but an exception could be made if a business had that ability or if something else unique was occurring. Does Walmart merit such an exception? I think the answer will become clear as we continue. But first, let’s look at the difference in how the two companies are managed, since the person making the counterpoint specifically pointed to Walmart as an example:
AutoZone:
Walmart:
AutoZone has been using cash in excess of its cash from operations to buy back shares. While Walmart has not, Walmart did issue about $6 billion in dividends, but as you can see, even when you add Walmart's dividends to its share buybacks, it doesn’t come anywhere near its cash from operations. The picture looks even worse when you consider free cash flow. AutoZone only had about $1.9 billion in free cash flow for the fiscal year 2024, while Walmart had $17 billion in free cash flow. Running a negative working capital strategy can already be perilous for a business, but at least in the case of Walmart, they are otherwise behaving in a responsible manner. Meanwhile, AutoZone is taking on new debt to buy back shares. In the last three years, AutoZone has taken on $3.5 billion in debt, while Walmart has paid off $2.29 billion in debt over the same period. It is also important to note the difference in the size of the businesses as well. Walmart has a market cap of $835 billion, while AutoZone has a market cap of $58 billion. When you take into account the size of each enterprise, Walmart’s change in debt is fairly meaningless, while AutoZone’s new debt accounts for 6% of its market cap.
The differences continue. Walmart also has $88 billion in shareholder equity, while AutoZone has shareholder equity of -$4.67 billion. That’s right—it’s a negative number, which is bad. To use an everyday example, if you buy a house and gradually make payments, you build equity. If you sold your house, that would be the money you get back. A very basic example, and my intent isn’t to be patronizing. But the equivalent behavior for AutoZone would be if you bought a house, only ever made payments on the interest, and then actively took out loans using your house as collateral. Another difference in the behavior between the two businesses.
Thus far, I’ve talked about the merit of excluding inventory from calculations of the current ratio when determining the financial strength of a corporation. Then I discussed the differences in the behavior of the two corporations as a distinction in quality, with Walmart behaving in a much more intelligent manner for a company running with negative working capital. But this doesn’t answer perhaps the most important question.
How are Walmart and AutoZone able to kick the can down the road? After all, a current liability means that it has to be paid within a year. What enables these two businesses to postpone that due date?
Well, AutoZone tells us on page 32 of the 2024 10-K:
Historically, we have negotiated extended payment terms from suppliers, reducing the working capital required and resulting in a high accounts payable to inventory ratio. We plan to continue leveraging our inventory purchases; however, our ability to do so may be limited by our suppliers’ ability to factor their receivables from us. The Company has arrangements with third-party financial institutions to confirm invoice balances owed by the Company to certain suppliers and pay the financial institutions the confirmed amounts on the invoice due dates. These arrangements allow the Company’s inventory suppliers, at their sole discretion, to enter into agreements with these financial institutions to finance the Company’s obligations to the suppliers at terms negotiated between the suppliers and the financial institutions. Supplier participation is optional and our obligations to our suppliers, including the amount and dates due, are not impacted by our suppliers’ decision to enter into an agreement with a third-party financial institution. A downgrade in our credit ratings or changes in the financial markets could limit the financial institutions’ and our suppliers’ willingness to participate in these arrangements. We plan to continue negotiating extended terms with our suppliers, benefiting our working capital and resulting in a high accounts payable to inventory ratio.
It’s not a great look. AutoZone has to have "third-party financial institutions to confirm invoice balances owed by the Company" and "These arrangements allow the Company’s inventory suppliers, at their sole discretion, to enter into agreements with these financial institutions to finance the Company’s obligations…" AutoZone is entirely dependent on outside financing in order to continue functioning, and if their credit rating is ever downgraded, things will get ugly fast.
What about Walmart?
Page 44 from the 2024 10-K:
Cash Equivalents and Working Capital Deficit
Cash and cash equivalents were $9.9 billion and $8.6 billion as of January 31, 2024 and 2023, respectively. Our working capital deficit, defined as total current assets less total current liabilities, was $15.5 billion and $16.5 billion as of January 31, 2024 and 2023, respectively. The decrease in our working capital deficit is primarily driven by a decrease in accrued liabilities primarily due to the payment of the remaining accrued opioid legal charges and an increase in cash, partially offset by an increase in accounts payable and a decrease in inventories as part of working capital initiatives. We generally operate with a working capital deficit due to our efficient use of cash in funding operations, consistent access to the capital markets and returns provided to our shareholders in the form of payments of cash dividends and share repurchases.
We use intercompany financing arrangements in an effort to ensure cash can be made available in the country in which it is needed with the minimum cost possible. Additionally, from time-to-time, we repatriate earnings and related cash from jurisdictions outside of the U.S. Under current law, repatriations of foreign earnings will generally be free of U.S. federal tax, but may incur other taxes such as withholding or state taxes. We do not expect current local laws, or other existing limitations on anticipated future repatriations of cash amounts held outside the U.S. to have a material effect on our overall liquidity, financial position or results of operations.
As of January 31, 2024 and 2023, cash and cash equivalents of $3.5 billion and $2.9 billion, respectively, may not be freely transferable to the U.S. due to local laws or other restrictions or are subject to the approval of the noncontrolling interest shareholders.
Certainly, bonus points to AutoZone for being direct about what’s going on. I don’t feel like reading that gave me any clarity about Walmart. Are they entirely dependent on third-party financial support like AutoZone? Maybe, but what other information is out there? Since I don’t like citing random blogs, I went back to the university where I got my master’s degree since I still have access to their research databases. Walmart, of course, has been a widely studied company.
Walmart's Impact on Supplier Profits
Wal-Mart: Supplier performance and market power
Retailer power and supplier welfare: The case of Wal-Mart
This paints a very different picture than what is going on with AutoZone. AutoZone comes to suppliers hat in hand. It does offer access to a large distribution network to its suppliers, but at the end of the day, it is dependent on financing from its suppliers. AutoZone isn’t operating from a position of power; their suppliers enter into a financial agreement with a third party.
Walmart, now this is a very different picture. Walmart doesn’t ask suppliers if they would mind entering into a financing agreement with a third party. Walmart is a bully. Walmart is the number one retailer in the United States. It’s been well documented that Walmart’s suppliers accept a lower profit margin to sell items in Walmart’s stores. Walmart leverages its vast size to put the squeeze on its suppliers in order to deliver its customers the lowest possible price. In the long run, this ends up being mutually beneficial since, although Walmart’s suppliers have their margins squeezed, they do so much more volume that it more than makes up for the shortfall.
This gets back to how Walmart can operate with negative working capital, and it is a sign of strength, not weakness. In some cases, Walmart’s suppliers agree to accept payment only after the item sells. AutoZone doesn’t have this leverage, and their suppliers typically get paid before the item sells. This is how negative working capital is a sign of strength with one business and a weakness with another. A large part of Walmart’s payables and accrued expenses represents what is essentially an interest-free loan from their suppliers.
Being self-taught in the field, I’m always hypervigilant for something I might not know that would be common knowledge for someone who was formally educated in the area. When I got the instant clap back from an AutoZone shareholder that negative working capital is a good thing, for a moment I was definitely thinking, “Oh no, what did I miss?” I hadn’t considered that this structure could be a good thing because, at the time, I wasn’t analyzing Walmart. I was looking at AutoZone. After digging into the specifics it’s pretty clear that the claim that negative working capital is good because Walmart does it is a false statement.
Specifics matter, details matter, and there is no shortcut around putting in the effort to verify if what one is saying is accurate. That is what I always strive to do, and I figured I would write up the rabbit hole I went down to see if either of these two counterpoints had merit. In the end, I can comfortably say that I gave the two counterpoints fair consideration, and they do not have merit.
Ok, bye bye now.
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