Excerpts from “Beanie Babies Vs Vendor Financing: Can the ‘Product’ (and Asia) Stand On Its Own?, July 2012 edition in On the Ground in Asia publication by KB Kee
Is this happening in America or Asia? All day long, people are charging in and screaming, “Which Beanie Baby do you have today?” Tempers flared as long lines forms for the stuffed toys, sold along with a Happy Meal, which were the cause of many fights. Theft of toys was prevalent at the height of their popularity and there was an active secondary second-hand market for them after the promotion.
The Beanie Babies craze from 1996-2000 caused Warren Buffett to be cautious in McDonald’s, one of the most recognizable brand names in the world. Yet, McDonald’s is not one of the core buy-and-hold stocks in Berkshire’s holdings, as explained by Buffett in a talk to MBA students in 1998:
“People don’t want to be eating – exception to the kids when they are giving away Beanie Babies or something – at McDonald’s every day. If people drink five Cokes a day, they probably will drink five of them tomorrow… I like the products that stand alone absent price promotions or appeals although you can build a very good business based on that.”
- Warren Buffett, October 1998
As China slows down, the classic quote of Buffett becomes increasingly relevant: “It’s only when the tide goes out that you learn who’s been swimming naked.” When everyone is enjoying good times, you don’t know who has taken on excessive risks. And multibagger opportunities present themselves to the diligent value investors who have been monitoring closely the few swimmers with unique, scalable business models run by farsighted outstanding entrepreneurs as they distinguish themselves from the weaker companies reliant on “Beanie Baby” incentives to push sales of products that might not be able to “stand alone” and at the expense of their balance sheet. This “Beanie Baby” incentive practice is increasingly being questioned in varied industries, from shipyards, construction and telecom equipment to property, autos and retail.
Emboldened by attractive Beanie-Baby-like vendor financing and generous credit terms with zero downpayment provided by construction equipment companies, buyers of these machines have been very aggressive in their purchases, resulting in China to account for 60% of worldwide concrete consumption, bubbling far above the so-called “concrete scowl”.
There are concerns that these buyers, which include debt-laden and cash-strapped property developers, are using the machines as collateral for further loans. Analysts at Jefferies in HK, who were reported by the media this month to have travelled to Jiangsu province to study the concrete market, said that more than half of the concrete machines sold by a prominent Chinese construction equipment company had not even been switched on and were lying idle in storage. In our “On the Ground in Asia” March 2011 edition, we mentioned that one Asian top manager shared with us how his MNC counterpart in China told him that they might not be able to sell any new equipment in China this year. He thought his MNC friend was joking to him until he was told the reason for the pessimism was because two-thirds of the machines sold were not turned on as indicated by the GPS tracking signal. Industry executives are reported to be talking of a “collapse” and are looking to export their way out of trouble via acquiring overseas companies and setting up overseas factories, often used as fronts for more loans.
In the case of the construction machinery industry, the accounting bent in us also noted how the sellers of these machines have not recorded these vendor financing activities on the balance sheet and do not have proper bad debt provisions on the corresponding ballooning off-balance-sheet receivables despite the fact that banks require them to guarantee loan/lease payments in the event of customer defaults. These off-balance sheet receivables, estimated to be connected to around 30% of total sales in the industry, should be treated as debt on the liability side since it is the same as the machinery companies incurring a debt and then selling the machines to customers on credit. The cashflow from operations that come from this vendor financing activity should be re-categorised as cashflow from financing, which would turn most of these companies to be running negative cashflow positions in the last four years.
Since the loss amount on a loan default is the difference between the outstanding loan and the residual value of the machine that can be salvaged, and most of the financing consider the equipment as collateral, the second-hand market is important in understanding the scope of loss. In North America, the fair market value (FMV), orderly value (OLV) and forced liquidation value (FLV) of used equipment were around 75%, 64% and 54% of the equipment costs, respectively, generally in line with the write-off ratio of 40% on average.
The second-hand machine market in China, however, is much less mature than that in the developed countries. Domestic machinery manufacturers‟ single-minded focus on new machine sales and lack of refurbishing capabilities also hurt the value of second-hand machines. Most machines can only be sold at around 30-40% of the original price when they are three year-old. Yet, the loss rate of these receivables reported at the machinery companies are less than 1%, much lower than the 40% write-off ratio on average at say Caterpillar’s financing receivables.
It is likely that many repossessed machines were sold internally within the company and became part of its operating lease fleet, consequently hiding the net impact on P&L. It is now very prevalent for dealers to give their customer cash advance to avoid towing back of equipment and reflected in the default rate for the machinery companies. We are cautious whenever we hear from bullish analysts and promoters about how machinery and cyclical companies are “cheap” on a price-to-book historical valuation basis.