Managing Director
Tiger Valuation Services
Could today’s global supply chain disruption contain some good news for asset-based lenders? That may seem like a counterintuitive question given that the current inventory crunch — supplies have dropped to levels not seen since just after the Great Recession — has led many borrowers to massively downsize their ABL lines. In addition, many of these companies have shifted strategies in ways that further reduce their need for working capital. For example, they may have postponed major capital expenditures or backpedaled on expansion/product-development plans.
Against this backdrop, asset-based lenders could be forgiven for worrying that deal flow will continue to be slow and that borrowers might face stiff headwinds for performance; however, there are solid reasons for optimism, now and into the future.
The Resilience Factor
The so-called “retail apocalypse” was well underway prior to the COVID-19 pandemic. Given that the pandemic was expected to further decimate retail when it first began, many observers predicted an onrush of additional bankruptcies. Consumers, though, were surprisingly resilient with their spending, and bankruptcy filings and failures have been relatively few and far-between.
The counterintuitive truth is that asset-based lenders are generally in a surprisingly strong position right now. Borrowers are continuing to increase prices and capture higher-than-normal margins. Many have also slashed spending and defensively hoarded cash. As a result, their balance sheets are often healthier today than they were prior to the pandemic. With limited exceptions, such as wear-to-work apparel, asset values have largely remained the same — or even appreciated — since the start of the pandemic.
In my view, asset-based lenders have reason to be optimistic moving forward: Inventories may be suppressed today, but they are likely to bounce back in a major way in 2022, translating into robust activity for the ABL sector as the restoration of supply drives up borrowers’ capital needs.
All of that said, context counts. Now and in the near-term future, the fortunes of individual borrowers are bound to vary dramatically. In addition to closely scrutinizing borrower health, asset-based lenders need to pay attention to certain headwinds that could pose further challenges.
Haves and Have-Nots
Supply chain disruption has worsened the gap between the haves and have-nots across the U.S. economy. With the onset of the COVID-19 crisis, U.S. retail chains with the greatest scope and scale were able to stock up on inventory in anticipation of supply chain bottlenecks. As a result, this dominant subset has been able to offer otherwise unavailable inventory and further push up prices.
Suppliers have always prioritized their biggest and best retail customers. Over the past year or so, they have doubled down on playing favorites. That means behemoths like Walmart, Target and Costco are even more likely to get first dibs on the best inventory. For their part, smaller retailers are like the glasses on the lowest level of a wedding champagne tower: As the bubbly runs out, they get nothing, so it is important to evaluate where borrowers sit in this hierarchy.
Holiday Risks
As North American retailers enter the critical fourth quarter, they face greater risk from further supply chain disruption. Many brick-and-mortar stores are already suffering from inventory holes — partially empty shelves and clothing racks — that are reminiscent of the day after Christmas, not the run-up to the holidays. Lack of inventory will, unfortunately, force some of these borrowers to miss their Q4 (and, possibly, Q3) projections.
Online shipping is a related concern and it is likely to be a major headache over the holiday season for all but the largest operators. Indeed, UPS and FedEx now limit the holiday shipping capacity of many smaller e-tailers (FedEx Freight recently cut off about 1,400 smaller customers without warning, and we could see similar announcements as the holidays approach). Obstacles associated with online shipping could cause smaller, thinner-margin borrowers to struggle to satisfy their customers during the worst possible time for such failures.
Meanwhile, international shipping rates continue to increase. The lack of shipping capacity, according to McKinsey, is due in part to COVID-19 safety measures, including lockdowns and temporarily mothballed container ships. In response, North American companies have sought to book air freight and container ship space at a frenetic pace. This rising demand is yet another factor driving up shipping costs.
Inventory Flip
As supply constraints ease in the quarters ahead, these shifts could lead to a reversal of the present situation. Simply put, the stakes are just too high for the current supply chain crisis to last indefinitely. Consider the extraordinary efforts to right the ship by the likes of Walmart, Ikea and The Home Depot, which, according to NBC News, are “chartering private cargo vessels and buying their own shipping containers to keep goods produced overseas flowing ahead of the busy holiday season.”
Nonetheless, it will take time before a broad-based restoration of equilibrium can be achieved, and so expectations for Q3, Q4 and even the first half of 2022 should be tempered. In my view, however, inventory supply should be dramatically longer this time next year. That means borrowers will be turning to asset-based lenders to support their growth in inventory and rebooted growth plans. In the meantime, gauging borrowers’ ability to adapt should be a priority. For example, retail or wholesale borrowers that are heavily dependent upon Q4 performance need to be able to secure enough supply to meet customer demand during this period.
Asset Lifecycles
As today’s borrowers race to stock up on inventory, the advisability of this strategy depends in large part on whether the assets they aim to acquire are short- or long-lived.
At Tiger, we support the strategy of “going long” on long-lived assets (examples could include non-fashion basics like t-shirts, top-selling models of air conditioners or popular SKUs of car tires, all of which can be sold for years without any modifications). As lenders scrutinize borrower health, they should look to see whether those with long-lived collateral are being proactive, based on the premise that it’s better to stock up and work through this inventory over time than to be caught flat-footed.
By contrast, making similar investments in short-lived assets, such as fashion apparel or highly seasonal merchandise, is a gamble. Consider some of the dynamics prevailing among these borrowers. Already, many sellers of short-lived assets have slashed SKU counts (for example, an apparel retailer, having previously stocked both regular and fitted cuts, may offer just regular cuts for now). Others have switched to air freight — causing increases in inbound costs of 500% or higher — and have raised prices as a result.
Typically, companies that sell short-lived assets are less able to pass along such costs. Today, they are largely able to do so thanks to the short supply; however, this situation will not last forever.
The bottom line for lenders: In many cases, today’s borrowers are doing far better than many predicted. Barring any major new curveballs in the global economy, a strong upswing in ABL activity is just around the corner.
Ryan Davis, managing director of Tiger Valuations Services, leads Tiger Group’s appraisal division and is responsible for the valuation of more than $30 billion of retail, wholesale and industrial assets annually. Davis can be reached at rdavis@tigergroup.com.
