Why Companies Should Prepare for Inflation

Why Companies Should Prepare for Inflation

          
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Why Companies Should Prepare for Inflation

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    Inflation Losers—and Winners

    Inflation generates unusual risks. But like any situation of instability and crisis, it also offers opportunities for differentiation. It may change the rules of the game in an industry by establishing new sources of potential competitive advantage—for instance, advanced pricing and sourcing strategies, vertical integration, or superior asset productivity. Which industries and companies are likely to be most negatively affected by inflation? Which will be the losers—and which the winners?

    To answer these questions, it is important to keep in mind that in order to cope with inflation, a company must increase prices faster than the rate of inflation—or see its enterprise value plummet. As Bruce Henderson, founder of The Boston Consulting Group, noted in 1974, “It is not enough for prices to go up parallel to inflation. They must go up enough to provide financing for the increased valuation of assets too, as well as cover increased costs.” Why? Because cash flows—not earnings—drive the value of a company. A company must increase its earnings faster than the rate of inflation in order to meet the correspondingly higher cash requirements for net working capital and investments.

    A simple financial model shows what happens to enterprise value when a company manages to increase prices only in line with costs during an inflationary period. (See Exhibit 3.) Given certain financial assumptions about a hypothetical company, 2 percentage points of additional inflation will reduce enterprise value by a full 10 percent. Higher inflation rates produce increasingly more severe declines in enterprise value. For example, 6 percentage points of additional inflation will destroy a full quarter of total enterprise value.

    exhibit

    Therefore, the companies most vulnerable to inflation will be those that are unable to increase prices faster than the rate of inflation. This will be the case for companies whose pricing power is weak owing to generally high price sensitivity in the market (for instance, because substitutes are easily available), a weak position in an industry with strong competition, or a high proportion of long-term sales contracts that cannot easily be renegotiated. It will also be true for companies with little control over critical production inputs owing to a high share of variable costs, short-term supply contracts for key raw materials, or higher labor costs than rivals (for instance, because of a unionized workforce)—or to the fact that its competitors are less exposed to price hikes for raw materials because of backward integration. Whatever the precise cause, such companies will find it difficult to pass higher costs on to their customers.

    Typically, such companies will already have lower margins and returns on capital than their competitors—or, if not, they will discover that they are unable to preserve their margins and returns in the inflationary environment. They may try to raise their prices—indeed, they may have to raise them in order to survive financially—only to see their market share eroded by higher-margin competitors that are in a better position to delay their price increases for a period of time.

    A company’s ability to protect its gross margins from erosion by inflation was a key differentiator between inflation winners and losers during the U.S. Great Inflation. When we compared the development of gross margins for pairs of inflation winners and losers (defined by their TSR performance) from various industries, we found that the winners were able to maintain their gross margins in a way that the losers could not. (See Exhibit 4.)

    exhibit

    Another category of companies especially vulnerable to inflation are those with the highest capital requirements, whether because they operate with high asset intensity and high levels of net working capital or because they have old assets with short remaining lifetimes and therefore face a major reinvestment program. Such companies will have to anticipate sharply inflated cash requirements for their future investments. They may have to forgo critical or attractive investment opportunities if they cannot finance these investments either through price increases above the level of inflation, through significant cost reduction, or through higher debt from unused borrowing capacity.

    The vulnerability of companies with high capital-expenditure requirements in times of inflation can also be observed during the U.S. Great Inflation. (See Exhibit 5.) We sorted companies from the S&P 500 into ten groups on the basis of the size of their capital-expenditure requirements, measured by the average ratio of capital expenditures to depreciation and amortization at the beginning of the three inflationary cycles in 1965, 1973, and 1978. Next, we calculated the average annual TSR of each group for the years of rising inflation: 1965 through 1970, 1973 through 1974, and 1978 through 1981. We found a significant negative correlation between the relative level of capital expenditures and TSR during the inflationary periods. The decile of companies with the lowest capex requirements achieved an average annual TSR of 10 percent, while the decile with the highest capex needs delivered an average TSR of less than 3 percent.

    exhibit

    Finally, among companies with high capital-expenditure requirements, those with the highest degree of leverage will be especially vulnerable to inflation. During the U.S. Great Inflation, for example, the TSR performance over periods of inflation for companies with the highest capex requirements was negatively correlated with their leverage ratio at the start of the inflationary periods. One would think that inflation would benefit companies with a lot of debt by making it easier to pay down that debt with inflated cash. It may be, however, that highly leveraged companies suffer the most because they don’t have the capacity to borrow additional credit to finance investments at the levels necessary to meet the higher cost of capital expenditures in an inflationary environment.

    For a formal analysis of the impact of inflation on enterprise value, see Geofrey T. Mills, “The Impact of Inflation on Capital Budgeting and Working Capital,” Journal of Financial and Strategic Decisions, Vol. 9, No. 1 (Spring 1996), pp. 79–87.