Growth, but at what cost?

For the clothing and particularly furniture retailers, credit sales are essentially their lifeblood. Chances are that very few Zimbabweans can afford to buy furniture for cash and if any significant sales are to be made, the option of credit purchases has to be available.

Pelhams results are evidence of just that. Since dollarisation, revenue has been on an uptrend gaining more than 1 000% to date partly because they were coming off a low base and also due to the re-introduction of credit. Their recent results were no exception. Revenue went up 95% to US$16,7 million, supported by a 127% growth in credit sales.

The company has been gradually relaxing its credit terms and during the last half of their financial year, credit terms were increased to a maximum of 24 months. Management indicated that this would most likely be their maximum in this environment. The period in which the terms were increased was strategic as it coincided with the festive season, where disposable incomes are usually high, and there is a spending frenzy.

With the generally high appetite for credit in the economy, favourable credit terms would be welcomed by many. Buoyed by such a topline growth, the company increased profitability by more than 10 times to US$1,5 million. Net profit margins were significantly improved as well, at 9%, from just above 1% in 2011.

What Pelhams has been able to achieve since dollarisation is impressive. The environment has been favourable to retailers, as has been demonstrated by the phenomenal growth and visibility of the once underdogs of the industry such as TN Harlequin.

However, if what has been happening in the banking sector in terms of  loan defaults is anything to go by, then credit retailers have cause for concern. It is no secret, though unofficial, that many consumers are over-borrowed. Appetite for credit has been rife and so has been the availability of the facilities.

 

Hence, it is not an usual scenario for one to be a debtor with a bank, his employer, the furniture retailer, the clothing retailer and, in some cases, some loan shark! Employers are better placed as creditors because they have a direct influence over recovering their dues — a simple deduction from salaries.

However, as you go downstream, retailers are most at risk since, in most cases, there are no stop order payments and accounts are opened based on the purchaser’s payslip, which probably does not reflect the full obligation befalling the consumer. With the absence of a credit bureau, these retailers would never know the level of indebtedness of their customers.

With its level of credit sales, Pelhams is not spared these risks. Credit sales comprise 77% of revenue while trade receivables take up 75% of current assets. Debtors have significantly increased, depicting the growth in credit sales as well as the increase in credit terms. Despite its positive impact on revenue, Pelhams runs the risk of a significant loss should this credit bubble burst.

Securitising a debtors’ book is not very difficult if the quality of the book is not in doubt. Pelhams has been doing so and as such has managed to get some cash for working capital purposes although this comes at a cost.  However, in the event that consumers start defaulting, it might prove difficult to be able to liquidate debtors under such an arrangement.

Most banks, which usually take up the securitising role, may not be willing to take on such a risk. If such events unfold, then Pelhams might start facing serious liquidity issues. Essentially, the company will be approaching technical insolvency, as it virtually banks on the performance of its debtors for survival.

The biggest dilemma then is how does the company balances profitability and credit exposure. Most retailers have tightened provision of credit to consumers. Truworths is a good example of a retailer that has resorted to focusing on debtors as opposed to aggressive growing of accounts.

In the absence of a credit bureau, the investigative work has to be done by the retailer themselves. The frenzy over aggressive account opening in this current environment is a recipe for potential default should the economy start contracting. It would not hurt to slow down on revenue growth to a level just enough to remain profitable, and alleviate, to some extent, the risk of default.

An additional risk also seems to be over-borrowing by Pelhams. Over the period, the company more than doubled its short-term bank loans to US$2,5million. In addition, the company acquired a two-year facility of US$1,2 million from a local bank which came at an interest rate of 20%. Average cost of borrowing for the company was 22,34%. Finance charges shot up to US$2,2 million, which is 222% higher than what it was last year.

Management stated that they have no other option but to borrow. Accessing cheaper credit is an almost impossible task for them just like it is for many Zimbabwean companies. To ensure the business continues uninterrupted, borrowing is necessary to fund the purchase of merchandise.

Such an arrangement, though it is said to be necessary, is very worrying.  Is such a model sustainable? Most companies have failed to return value to shareholders because of an overhang of debt which wipes out all profits.

Usually, such cases kick off in such a manner as Pelhams. Since they have become reliant on borrowing for stocking purposes, it will be difficult to get out of that cycle. If anything, their debt position might continue to increase. Already, finance costs for the year took away half of their operating profit. What will happen if their debt position increases? There is no indication of interest rates easing off anytime soon, considering the end to the liquidity crisis  seems to be  nowhere in sight. Therefore, if they continue borrowing locally, finance charges will most likely become a threat to the company’s overall profitability.

Clearly, the model of short-term borrowing as a source of  working capital is not sustainable in all circumstances. Considering they are not a cash-rich business, funding has to come from somewhere. Management has been talking about a capital raise for a long time now and it might be advisable for shareholders to seriously start considering this.

Of course, the alleged shake-up in the shareholding structure is yet to be resolved and this will stall such an exercise, should it be under consideration. However upon resolution of their outstanding issues, the owners of the business should really consider injecting funds into their business. Any funds raised can be channelled towards retiring short-term debt and as a buffer to cover the funding gap that results in the need for borrowing.

That credit has done wonders for the business is without debate. The success of furniture business is dependant upon the availability of credit. However, in a high interest environment like ours, more thought should be channelled to managing default risk rather than just focusing on growing the topline. It might be necessary for Pelhams to slow down on its credit sales.

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