Corporate Finance

The Longest Cash Cycle

Can the asset-backed security market cure wireless carriers' elongated cash cycle and ballooning working capital requirements?
Vincent RyanJune 17, 2016
The Longest Cash Cycle

In the last decade, Amazon.com’s cash cycle — the time between when it pays cash for inventory and when it receives cash from the customer — started appearing in corporate finance textbooks as an example of brevity. While in many industries and companies a cash cycle can be one, two, three months or even more, Amazon’s was noteworthy because it was negative — its customers’ credit card payments were hitting its bank accounts before it had to lay out cash to suppliers.

The four largest U.S. wireless carriers have the opposite problem: a cash cycle that not only is positive but has expanded to extraordinary lengths. That’s because they must pay device makers upfront for the phones that their customers either lease or purchase on increasingly popular installment plans.

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To make matters worse, wireless carriers are pushing mobile phone installment plans heavily. During the three months ending August 31, 2015, 47% of the smartphones sold in the United Sates were linked to installment plans, according to Kantar WorldPanel ComTech. In AT&T’s first-quarter earnings report, the company said its Mobility unit had migrated more than 70% of its smartphone user base off traditional subsidy plans. And AT&T said more than 90% of new smartphone sales were installments or leases.

Cash Cycle: Flow of cash that begins with payment for raw materials and ends with receipt of cash on goods sold. Shorter the number of days in this cycle, more the amount of available cash, and lesser the need to borrow. (BusinessDictionary.com)

Consumers like equipment installment plans (EIPs) because they can pay very little money upfront and get a new phone. They pay for the phone over time, perhaps, two years. In the contrasting subsidy model, of course, consumers had to fork out some cash upfront for new premium phones, and the rest of the phone’s cost was included as part of the service contract.

“The ‘no contract’ phenomenon in the United States primarily started with T-Mobile looking for ways to shake up the industry,” says Chetan Sharma, chief executive officer of Chetan Sharma Consulting, a mobile strategy firm. “The operators never really liked subsidizing the devices. It was considered a necessary evil to keep the churn low. But, once one operator did it, it was easier for others to follow.”

Cash Cycle Woes

But now that the majority of U.S. consumers buy devices using installment plans, working-capital requirements for wireless companies have ballooned. They purchase devices like iPhones upfront and then carry the consumer for two years or more as he or she pays $10 to $15 a month toward the phone. Although, obviously, mobile carriers are service providers first and phone providers second, phone costs are a significant use of cash for wireless carriers. The four largest U.S. wireless companies, Moody’s estimates, reported more than $14 billion of installment plan receivables and more than $4 billion of leased phones in 2015.

mobile_phone_cashThe carriers’ cash cycle problems are equivalent to Amazon having to pay a publisher $19.99 for a book upfront, then having to collect about $1 per month from the consumer over a two-year period.

Besides the heavy working capital requirements, the question arises: Are mobile phone carriers smart to be in the business of financing handset purchases? That’s essentially what they are doing by giving consumers installment plans. The issue is especially important given the trouble nonfinancial companies got into by extending credit to consumers in the boom times before the financial crisis.

Fran Shammo, CFO of Verizon, told a group of London investors in June, “I don’t want to be in the [handset] finance business.” But for a couple of years now, Verizon has been, using off-balance-sheet receivables securitization to finance handset purchases. It’s the only way the wireless companies have found thus far to solve their working capital problem.

But it’s not an ideal solution. As Sprint says about its receivables facility in its 2015 10-Q, “This program subjects us to increased risks relating to consumer credit issues, which could result in increased costs, including increases to our bad debt expense and write-offs of installment billing receivables. These arrangements may be particularly sensitive to changes in general economic conditions. …”

Securitization Returns

AT&T was the first to securitize device receivables, initiating a program in June 2014. AT&T and Verizon employ an almost identical structure for the transactions, according to Moody’s Investors Service. First, receivables are aggregated and sold to banks, with the carrier receiving about two-thirds of the amounts sold (the advance rate) as cash and retaining the balance as a deferred purchase price. The cash received is then recognized as an operating cash flow (i.e. source of cash).

The carrier is the servicer of the receivable, and billings that are collected and remitted to the purchasers never flow through the reported financials. For its troubles, the carrier is paid a servicer fee and retains amounts collected above the outstanding balance on the securitized facility (i.e., above the advance rate).

Receivables securitization has not been a bad deal for the wireless carriers — or any company. Indeed, the accounting treatment for receivables securitization boosts operating cash flow, as Moody’s points out. “Cash proceeds from these facilities are reported as operating cash flow and can favorably sway credit metrics, most notably [the] free cash flow to debt ratio,” the rating agency said in a report. (Even for a large carrier, handset financing can represent 20% of operating cash flow in a given quarter.)

In addition, although little cash may be collected at origination under EIP compared to what can be collected under the subsidy model, “GAAP allows the carrier to book most of the device revenue up front, minus an estimate of the early-trade-in value, imputed interest, and bad debt,” explains Moody’s. “Combining the favorable effect of securitizations with revenue accounting for [equipment installment plans] which boosts EBITDA, the investment required to finance devices is masked within reported financials,” Moody’s said.

“Accounting rules allow [the wireless carriers] to essentially smooth out the reported results, and GAAP doesn’t capture the credit implications,” says Mark Stodden, a Moody’s vice president and senior credit officer. (Moody’s views the sale of a receivable as a secured debt obligation, similar to drawing on a line of credit.)

Planning an Exit

So why would carriers want to jettison receivables securitizations of this kind, and do it soon? Many reasons, it turns out.

The first two reasons were pointed out by Verizon’s CFO Shammo in London. He said the cash from securitization that flows through [Verizon’s] operations, about $2 billion a quarter, “is generally at a little bit higher cost and it also kind of degrades our [credit] rating because the rating agencies take that securitization and add it back to our unsecured debt.”

Verizon has been having discussions with the rating agencies for the past year about financing handsets via the public asset-backed security market. Such financings already exist in Japan, where Moody’s has rated more than 60 securitizations of consumer loans used for purchasing mobile phones since 2007. Verizon could start doing so as early as the third quarter.

Shammo told investors that both S&P and Fitch have said they will treat the use of the ABS market like captive financing (Moody’s chose not to, says Stodden). That is similar to the way the credit raters treat financing of automobile purchases. It means the debt would not be added back to the carrier’s unsecured debt. “It will be treated as a separate pool of financing, short-term asset-backed security debt,” Shammo said. A lot of the debt will be rated triple-A, said Shammo, “so there’s a benefit to my borrowing cost.” That would be a third reason for dumping the current form of receivables securitization.

In a February 5 report, Moody’s said the credit quality of mobile phone ABS would hinge on many of the same factors as other consumer loan ABS, such as borrower creditworthiness, deal structures, and the strength of the economy.

Still, says Sanjay Wahi, a vice president in Moody’s structured finance group: “Although borrowers’ performance likely will be boosted by mobile phones being essential to Americans’ lives, that performance has yet to be tested in a stressful economic environment.”

The final reason carriers need to get out of off-balance-sheet securitization? “Receivables securitization accelerates future-period cash flows into the current period, creating a future headwind, because the receivables sold are no longer recognized in reported results,” says Stodden.

The benefits to receivables securitization are temporary, explains Stodden, because “the EIP programs reach saturation, the net cash proceeds (i.e. cash received from sales less billings collected and remitted to the banks) will decline and could even turn negative. This will represent a drag on reported operating cash flow.” Financing via a public ABS market would end the problem — the receivables would not flow through cash.

Tapping the ABS market will be beneficial to Verzion (and the other carriers if they choose to do it) because it is a deep pool of capital that is larger than the bank market, says Moody’s Stodden. And it will certainly provide the cash needed to finance handset purchases. In addition, because it is also secured debt, and wireless carriers are large issuers of unsecured debt, it could take some pressure off their unsecured borrowing costs.

But the move will also cause some problems for Verizon and any other carriers that move to the ABS market. Most importantly, they will have to explain to investors why operating cash flow is deteriorating on a reported basis (since it is no longer inflated by the receivables securitizations — the cash from ABS sales will be a financing inflow). “It will make their financials look worse,” says Stodden. In other words, an ABS market will solve some of the problems of bank-financed securitization, but it will also create new ones.

Image: Thinkstock

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