Business is business:

Save our supplier, the concerned retailer asked his bank. In a Spilled Milk that takes an O. Henry osque twist, a bank learns that it's best to be cautious when undertaking a mission that it believes will help strengthen an important relationship. Just when you think you "know your customer..."

It was ten o'clock in the morning when Dave Mills, president of First National Bank, called John Earl to ask him to come up to his office to handle a new prospect. John is a vice president and 10-year veteran on the lending platform at First. Upon arriving at the president's office, John was invited to sit down while Dave explained what he had in mind.

Earlier that morning, Dave had received a visit from Peter Moss, the treasurer of one of the bank's largest customers, a major national retailer. Peter was seeking help from the bank for one of his firm's key suppliers. This supplier sold 2 million tents per year to the retailer but was experiencing financial difficulties. Since this was not the retailer's line of business and represented a profitable line of sales, Peter had decided to turn to the bank for assistance.

Peter provided very limited information to the bank:

* The supplier is Outdoor Tents Corp.

* The president is Tim Toolbert.

* The company is local and operates out of one facility.

* No financial statements were available.

Dave told the treasurer that the bank would do everything it could to assist, but could not make any promises under the circumstances. Peter replied that he understood, but would consider it a great favor if things could be worked out.

Dave related all of this to John, his trusted lending officer, who made an appointment to visit Tim Toolbert at Outdoor Tents facility. John asked the supplier to either fax or e-mail him the most recent financial statements on the company.

Outdoor's financial statements arrived and painted a very bleak picture. The company had lost nearly $3 million during the past three years. The losses had drained Outdoor Tent's liquidity and had increased leverage to 10 times ($5 million in debt and only $500,000 in equity remaining). The only good news was that the trade report on the company was clean and that a lien search failed to disclose any liens or judgments.

Before visiting Outdoor Tent, John called his boss to fill him in on the bad news. Dave responded by asking John to keep his appointment and to look for any way possible to help the company. Success in helping Outdoor Tent stay in business would solidify First National's relationship with its primary customer, the major retailer.

Following instructions, John visited Tim Toolbert. After a brief discussion, Tim took John on a tour of his operations. John was a little surprised with the labor intensity. Much of the fabrication of the tents could be more automated, providing for better consistency and efficiency.

After the operational tour, John asked Tim to review the economics of Outdoor's business. Tim explained that the firm purchased the tent fabric and tubing based on estimated sales. All sales were to one customer, the retailer who does business with First National. As such, sales volume was both high and predictable.

With this disclosure, John asked the logical question: Why was Outdoor Tent losing money? Tim answered that the losses were caused by the escalation of raw materials costs. Further probing revealed that Outdoor purchased its fabric and tubing at a variable price based on marker conditions at the time of purchase. On the other hand, the retailer insisted on a fixed price for the finished goods. This price was set at the beginning of each year.

The problem was so obvious, it hurt. Outdoor's cost of goods sold for material had increased steadily during each of the last three years on a per-unit basis. At the same time, the revenue per unit rose less rapidly, leading to continued operating losses. In essence, Outdoor's sales price failed to take into account the raw material price escalation.

Recognizing this situation, John asked Tim if he could alter either his purchase of raw materials arrangement to lock in his costs for the year and thus protect his gross margin, or modify his sales agreement to permit price increases to offset rising raw material costs. Based on prior and current year budgets, it appeared that Outdoor could return to profitability if it could match raw material costs to sales prices--not much different from the match funding that many financial institutions engage in to protect their net interest margins.

Regretfully, Tim responded that they had already signed contracts for the coming year to purchase raw materials at the market prices and to sell the finished goods at a fixed price. John immediately told Tim that until Outdoor was able to match purchasing and sales, either both fixed or both variable pricing, it was unlikely that First National or any other lender was going to be able to help the company.

As a passing thought before leaving, John asked Tim who Outdoor's contracts were with. Much to his surprise, Tim responded that he purchased the raw materials as well as sold the end product to the major retailer!

After the shock wore off, John reemphasized that the treasurer of this retailer had made a visit to the bank requesting that the bank try to help Outdoor. This would suggest that the retailer would be willing to reconsider the aforementioned contracts. Tim was less optimistic about this possibility and more hopeful about price stability.

John returned to the bank and reported his findings to the president. After pondering the results, Dave contacted Peter and invited him to the bank for lunch to discuss Outdoor's prospects.

Dave asked John to join the lunch. As they were having dessert, Dave asked John to relate his observations. John focused on the vice that the company found itself in as a result of the mismatch of variable price purchases and fixed price sales. Peter listened intently before thanking Dave and John for their efforts. It turned out that Outdoor was dealing with two separate profit centers of a very large organization.

Dave asked the most logical question: What would be Peter's next step? Much to the bankers' surprise, Peter stated that the firm would immediately seek an alternate supplier for the tents. In the meantime, it would continue to take advantage of Outdoor for as long as possible. Peter believed that anyone dumb enough to enter into this kind of an arrangement deserves what he or she gets. His company was not going to bail out a badly managed business.

Several months later, Outdoor failed as losses mounted and liquidity drained. Not highlighted here was the bank of account for Outdoor Tent Corp. Although all the assets of the business secured its loans, the liquidation of fabric and tubing did not yield much and led to charge-offs.

There are multiple lessons here.

1. Concentrations are rarely good. In this case, the concentration was with one account as both a seller and buyer. It is often the case that large relationships, like big loans, carry small spreads. The larger the concentration, the lower the gross spread is likely to be. Note that contra relationships as both a buyer and seller with another company are surprisingly common.

2. Economics in business often outweighs goodwill. Initially, the retailer liked Outdoor's product and price, but would not make financial adjustments to help the supplier out of problems created by its bad management choices.

3. Business is not always fair. Companies must remember that their first responsibility is to their own needs for profit and liquidity and not trust that another party or circumstance will change for their betterment.

4. The sole supplier of a product to an investment-grade customer is not a guarantee of success.

5. Each loan is to be underwritten on its own merits. Imagine the reaction of this retailer if First National had decided to provide financing support and Outdoor Tent had lasted a little longer.

May may be contacted by e-mail at JECDM@aol.com

[C] 2002 by RMA. May is retired from his position as executive vice president of Whitney National Bank and lives in University Park, Florida. He served as president of RMA (a title now known as chairman) from 1993 to 1994 and continues to serve as a member of the Editorial Advisory Board of The RMA Journal.

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