CNH Industrial
CNH Industrial
CNH released disappointing results last week, as Q3 sales missed expectations and management warned of weaker industry demand into 2024. Meanwhile our software picked up a number of flags associated with the balance sheet, in particular an increase in the level of finished goods inventory.
A casual look at the Q3 balance sheet (below) shows how much assets have expanded over the past 9 months (during a period of relatively flat sales). There are two line-items that are broadly responsible for this: Inventories and Financing Receivables, both of which we discuss further below
Inventories are up by over 30% and now represents close to 5 months worth of sales (based on COGS in Q3). This is in addition to downstream dealer inventory which management described as having “pockets of excess”. Looking at the breakdown of inventory we see a skew towards inventory of finished goods (57% of total inventory versus 50% at year end). This can be a sign that slowing demand has taken management by surprise (particularly if it occurs right at the end of the quarter). The build up of finished goods often requires a period of adjustment requiring production activity to slow, potentially having a knock-on effect to margins.
The other account on the balance sheet that has grown rapidly is the “Financing Receivables” which forms part of the financial services business. This is up by 15% since the year end (representing a massive $3bn in 9 months). This comes on top of a 25% increase through the course of 2022. The additional growth has necessitated further debt being raised to fund it (again reported in the financial services business), and resulted in a company that increasingly resembles a bank. The risk from an investment perspective is that the company has an incentive to relax credit standards in order to drive incremental orders on the industrial side.
As well as putting its balance sheet to work, it appears that the company has been increasingly aggressive with the use of “sales incentives” for dealers. These represent rebates paid to dealers to support sales to retail customers. However there is a degree of estimation involved in measuring their impact, as described in the revenue recognition policy (taken from the 10-K):
“CNH Industrial grants certain sales incentives to support sales of its products to retail customers. At the later of the time of sale or the time an incentive is announced to dealers, CNH Industrial records the estimated impact of sales allowances in the form of dealer and customer incentives as a reduction of revenue. Subsequent adjustments to sales incentive programs related to products previously sold are recognized as an adjustment to revenues in the period the adjustment is determinable. The determination of sales allowances requires management to make estimates based upon historical data, estimated future market demand for products, field inventory levels, announced incentive programs, competitive pricing and interest rates, among other things.”
As the CEO noted on the call, they are likely to increase further the use of these incentives in order to clear excess inventory:
“Q4 net pricing will be about flat year-over-year as we will need to increase some incentive programs to address the pockets of excess dealer inventory”.
We can get a sense for the extent of these incentives from the liability account “Marketing and sales incentive programs”, which represents the estimated rebate payable to the dealers based on management’s estimates. We can see from the disclosure below (extracted from 10-Q) that there has been an increase of nearly 40% in this balance over the past 9 months. At $2.2bn, this seems fairly significant in the context of quarterly revenues of $6bn. Because of the degree of estimation involved, this use of these programs increases the risk that the company could overstate revenue.
This brings us to the final point from the Q3, which is the disclosure of a “material weakness” in internal controls over financial reporting (see extract from 10-Q below). Taken all together, we think the shortcomings in internal controls, combined with the increasing complexity of revenue recognition mentioned above, warrants a high level of caution from investors.
