Submitted by Martin Sibileau of A View From The Trenches blog [21],
A week later and everyone is a bit more nervous, with the speculation that US sovereign debt purchases by the Federal Reserve will wind down and with the Bank of Japan completely cornered.
In anticipation to the debate on the Fed’s bond purchase tapering, on April 28th (see here [22]) I wrote why the Federal Reserve cannot exit Quantitative Easing: Any tightening must be preceded by a change in policy that addresses fiscal deficits. It has absolutely nothing to do with unemployment or activity levels. Furthermore, it will require international coordination. This is also not possible. The Bank of Japan is helplessly facing the collapse of the country’s sovereign debt, the European Monetary Union is anything but what its name indicates, with one of its members under capital controls, and China is improvising as its credit bubble bursts.
In light of this, we are now beginning to see research that incorporates the problem of future higher inflation to the valuation of different asset classes. One example of this, in the corporate credit space was Morgan Stanley’s “Credit Continuum: Debt Cost and the Real Deal” published on May 17th, 2013. Upon reading it, I was uncomfortable with the notion that inflation is the simple reflection of the change in a price index, which implies the thesis of the neutrality of money. For instance, the said research note discusses how standard financial metrics compare vis-à-vis a rate of inflation.
Why is this relevant? The gap between current valuations in the capital markets (both debt and credit) and the weak activity data releases could mistakenly be interpreted as a reflection of the collective expectation of an imminent recovery. The question therefore is: Can inflation bring a recovery? Can inflation positively affect valuations?
I am not going to comment on others’ views or recommendations, but on the underlying method. A price index is a mental tool that has no relation to reality. In the real world, we trade driven by relative prices. To infer economic behaviour off changes in a price index is a mistake. The impact of inflation is more complex. For this reason and in anticipation of future debates on this topic, I offer you today a microeconomic analysis of such impact, on value.
Framework
I suggest that a good way (but certainly not the only one) to assess the impact of inflation on the valuation of a firm is to think of the same within the typical free-cash flow approach. After all, what matters is not how inflation can affect a certain component of its capital structure, but how the entire value of a firm is impacted, before the same can be shared among the different contributors to the said capital structure (i.e. equity, debt holders, etc.)
Simplifying, as far as I can recall from the times when I worked in the area of Private Equity, the way to calculate the free cash flow of a firm for a determined period is to obtain its operating margin, add to it depreciation & amortization costs and subtract capital expenditures, changes in net working capital and taxes. I show the formula below:
Revenues
– Operating Costs
Operating margin
+ Depreciation & Amortization
- Capital Expenditures
- Change in net working capital
- Operating tax
Free Cash flow
Analysis
What follows is a discussion on the impact of inflation on each of the components of the valuation formula above:
Revenues (= unit price x volume sold)
Under inflation, only those firms that have pricing power can defend the value of their production. At the same time and because inflation brings unemployment and the destruction of purchasing power, in general (not for all firms, of course), sales volume drops too. This backdrop encourages consolidation, where big players get bigger and small ones disappear. With it, the bigger firms obtain oligopolistic to monopolistic pricing power which assures two things: The currency zone where this development takes place loses in innovation and prices become less flexible. This inflexibility, when fully unfolded, directly leads to indexation, which is the stepping stone for any hyperinflationary process. If the consolidating firms are public, it is likely that during the consolidation process they become private via leveraged deals, as long as credit is still available.
Operating costs (=unit cost x volume bought + factors)
With regards to direct inputs, the same pricing problem described above arises. There are those firms that have leverage with their suppliers and can force these to delay price increases (i.e. margin contraction) and those that can’t. Consolidation therefore pays off on this front too, carrying the same consequences mentioned above. From an accounting perspective, when inflation is high, firms can’t even measure the cost of their inputs and are forced to take a Schrodinger [23] approach, with either Last in-First Out (LIFO) or First in – First Out (FIFO) accounting.
With regards to indirect inputs, these can be segmented into labour and capital. Labour intensive firms will struggle with a unionizing work force and inflation always nourishes the growth of unions, to renegotiate labour contracts. All things equal, this context simultaneously encourages higher unemployment and illegal immigration, because while credit is available at negative real rates (i.e. the nominal interest rate is lower than the inflation rate), firms will find more convenient to replace labour with capital. This takes place during the lower stages of an inflationary process. In later stages, credit disappears and the higher interest rates make refinancing debts unfeasible, bankrupting those firms that dared to invest in capital expenditures.
Where the required labour is low skilled but expensive due to social security legislation, firms will also replace it with illegal immigration, whenever possible.
Conclusion
The impact of inflation on operating margins (i.e. revenues – operating costs) is to drive consolidation, the replacement of labour by capital, indexation, price rigidity and the loss of competitiveness. The loss of competitiveness is the natural result of an environment that favours oligopolistic/monopolistic structures and short-term investment opportunities. It is very common to blame entrepreneurs or management for this outcome. However, the conditions that drive firms to adopt these survival strategies are the exclusive responsibility of politicians.
Depreciation & Amortization
“…Both depreciation and amortization (as well as depletion) are methods used to prorate the cost of a specific type of asset to the asset’s life…these methods are calculated by subtracting the asset’s salvage value from its original cost…” (Investopedia [24])
It is clear that any attempt to accurately portray the value and life cycle of fixed or intangible assets under inflation becomes irrelevant. What if due to high inflation the salvage value of an asset is higher than its original cost?
Under inflation there is uncertainty on the true cost of maintaining the fixed resources involved in the operation of a business. This uncertainty forces firms to cut back on capital expenditures. Investment demand and economic growth therefore collapse
Capital expenditures
Because nothing can be reasonably forecasted under inflation and growth and efficiencies are better served via consolidation and without innovation, capital expenditures can only be of a very short nature, if any.
Change in net working capital
This item is perhaps the most neglected and yet, most relevant, in my view. For valuation purposes, an increase in net working capital means that a higher amount of capital is tied to the operations of a firm. Therefore, a lower amount of cash is available to the contributors of capital to the firm (i.e. debt and equity holders). For this reason, the change in net working capital is subtracted in the valuation formula above.
What is net working capital? In simple terms:
Accounts receivable
+ Inventory
- Accounts payable
Net working capital
If from one period to another the time necessary to collect on accounts receivable increase and/or the inventory turnover [25] necessary to run an operation decreases, the value of the firm falls, as less cash is available to the contributors of capital. Alternatively, if the firm manages to increase the time necessary to honor accounts payable –all things equal- more cash is available.
What is the impact of inflation on net working capital? Complete! Under inflation, firms seek to delay any cash outflow. The higher their accounts payable, the more debt they dilute. At the same time, bank lending quickly shrinks. At high inflation levels, even working capital lending disappears. At this stage, vendor financing is key and only those companies that demonstrate a steady commitment to their suppliers can obtain credit from them. Suppliers, on the other side, often go bankrupt precisely because they cannot collect on their receivables. One of the painful ironies of inflation is that under it, liquidity evaporates!
With regards to inventory, this is counter intuitive, but firms will try to maximize its amount, as long as they can get vendor financing. The accumulation of inventory allows firms to lock in a cost of production that would otherwise be uncertain. This is very inefficient. Just-in-time production models become totally unfeasible. The accumulation of
inventory is more understandable when one realizes that inflation is the destruction of the medium of indirect exchange, which forces us to barter. Under barter, inventory is not a burden.
Just as much as firms seek to delay cash outflows, they will want to collect as quickly as possible. Those firms that operate at the end of the distribution chain and can sell to a granular, cash-paying public will be at an advantage over those that operate at earlier links of the chain (and have a concentrated customer base which demands vendor financing). Inflation therefore leads to consolidation on this basis too, towards the end of a distribution chain.
An example of a firm that would fit this profile, benefitting from an inflationary context would be Costco Wholesale Corp. (and no, this is not an investment recommendation, but a hypothetical example). As Costco sells in bulk, its customer base would grow, since the public that seeks to escape from a devaluing currency and lock the price of necessary staples would see an advantage in purchasing the same in quantities, at a discount. Simultaneously, the company would be in a privileged position to exert pricing power over its suppliers and grow via acquisitions. As an extreme (but illustrative) example, I recall that during the ‘80s in Argentina, when employees were paid their salaries, many took the day off (and parents left their kids with nannies) to go shopping. They were simply ensuring that not one day would pass with them holding depreciating currency, which had to be exchanged as fast as possible for all the goods that were going to be consumed until the next wage payment. They set off in a hurry and bought, when possible, in bulk!
Operating tax
Tax payments are simply one more cash outflow. Even without inflation, one tries to minimize and delay this outflow. Under high inflation, delaying its payment is a matter of survival and represents and additional source of financing. Because all hyperinflations took place before the internet era, we don’t know how easy it will be to delay tax payments when the next hyperinflation arrives. I imagine it will be much harder in the digital era.
Conclusions
The inflationary policies carried out globally today, if successful will have a considerably negative impact on economic growth. The microeconomic impact described above brings the following unintended and unnecessary macroeconomic consequences:
-Oligopolistic/ Monopolistic structures
-Loss of innovation, competitiveness
-Indexation, price rigidities
-Unionization of labour force and higher unemployment
-Illegal migratory flows
-Destruction of public capital markets
-Higher fiscal deficits
If this analysis is correct, the record asset values we see today cannot be interpreted as the omen of an imminent recovery. I am not saying that these nominal values are not justified. What I am saying is that they should not be interpreted as an indication that economic growth is on the way