Why Excellent Working Capital Management is So Underrated
Value creation on steroids: yes please!
Introduction
It was about time to share a new post on what we call “Fundamental Concepts”. Working capital management is one of the most important responsibilities of finance managers. It’s quite easy to understand why running with too much working capital isn’t ideal: cash is simply being tied up.
It could highlight some financial distress (aging receivables), unfavorable supplier payment terms (not playing from a position of strength), carrying too much inventory in product categories where you don’t want to see it (i.e. retailers in more discretionary merchandise after the post-COVID tailwinds had started to fade).
If your business experiences sizable swings in working capital, it could lead to a permanent lock-up of cash which some would view as “excess” liquidity.
What Einstein said about compound interest (he who understands it, earns it… he who doesn’t, pays it) is applicable to very working capital efficient companies. And our portfolio holdings are very good at it (to say the least). It drives proactive capital allocation, as outlined in our yesterday’s H1 2024 Letter to our Partners.
Most importantly, we’ve found that companies with positive working capital are more difficult to model, and that the analyst DCF models tend to be overly optimistic. The opposite is true: negative working capital businesses are oftentimes being underestimated by the investment community.
As one of our favorite CFOs, Linde’s Matt White, said during the Q3 2023 conference call (this quote is on our office’s walls):
We've been following the same capital allocation policy for decades. It starts with generating true operating cash flow because contrary to what some might think, working capital does matter.
Working capital dynamics have to be sustainable in order for us to model them and gauge a company’s true free cash and long-term value creation potential. We don’t want to jump to the wrong conclusions.
For industrial serial acquirers in 2022, organic ROIC got somewhat hampered by supply chain constraints and prudent inventory buildup should new macroeconomic disruptions emerge. Interestingly and when talking about optionality, a normalizing working capital situation is a clear plus to enhancing organic growth and thus future shareholder returns. That’s because organic growth will require less NOPAT to be absorbed by working capital requirements. This cash flow saver could be put to work in M&A or returned back to shareholders.
So time to dive into two of our sector buckets and their working capital dynamics!