QUESTION: How is Inflation impacting consumer goods companies?

ANSWER: To the average person, inflation is most noticeable in the consumer goods sectors. In reality, inflation, which is at multi decade highs, is broad in scope and impacting all sectors. One reason that inflation is so noticeable in the consumer goods sectors is that prices in these sectors reflect the increased costs in other sectors. In fact, consumer companies are impacted by rising costs across the income statement — input costs, labor, transportation and even utilities. This was exacerbated in the wake of the invasion of Ukraine. In particular, high oil and gas prices have a widespread and cascading effect, impacting everything from logistics/transportation, to fertilizers and food, to derivative products such as plastics and consumer packaging.

Labor is also a key inflationary item and it can increase costs in a few different ways. First, the obvious, is higher wages. Second, shortages can cause production inefficiencies and delays, which can lead to higher expedited logistics costs. Third, overtime pay may be required to get more labor hours out of a company’s existing workforce. Labor shortages have not been as acute outside of the U.S. as they have been within.

Companies are doing their best to pass on input cost inflation by raising prices, even in places like Japan where price increases have been infrequent and notoriously hard to achieve. For example, a Japanese beer manufacturer we hold is raising prices on beer for the first time in 14 years and they’re doing that despite a difficult competitive environment.

However, even if a company can pass on higher costs on a dollar-for-dollar basis, it is still a headwind to margins (same gross profit dollars divided by a higher revenue number). In addition, costs have generally risen faster than cost actions can be put in place or pricing has been passed through. As a result, we’re seeing pressures on sector gross margins.

Pricing power is paramount. Key drivers of pricing power include: strong brands, critical or highly desirable products, lack of substitution/alternatives, high switching costs, products that make up an inconsequential percentage of the consumer wallet, and products that offer a value proposition even at a higher price. This period of high inflation is acting as a test of pricing power across the sector.

QUESTION: How are supply chain issues impacting consumer goods companies?

ANSWER: As with inflation, the supply chain challenges are numerous but ultimately distill down to securing sufficient raw material availability and ensuring finished product gets to market in a timely fashion. Companies have engaged in a number of strategies to ensure continuing operations, such as securing secondary supply of critical raw materials or ingredient substitutions to lower costs while not sacrificing quality. But substitution is often limited. In some cases, production is held up due to the lack of a single critical input. Sometimes companies are faced with a decision to pay for expensive expedited logistics costs or run the risk of missing out on sales and donating market share.

Other ways companies have tried to mitigate supply chain issues are commissioning new third-party manufacturing nearer to end-consumer use to reduce the need for ocean freight, and using more expensive modes of transportation (e.g., air freight) to expedite product to market and avoid congested ports. This may not make sense for every product, however. For example, it may make sense for video game systems, which are relatively small in size and have a high price point to ship via air freight as the incremental cost isn’t that substantial in the context of the product’s value. On the other hand, it may not make sense for bulkier, less-premium items, thereby making the higher cost less palatable.

As a result of these challenges, we are seeing working capital increase on company balance sheets. Inventory levels are going up as companies face a Catch-22: either hold a “safety stock” or face a surge of unfinished products awaiting final components. In either case, the higher working capital is stretching out the cash conversion cycle at a time where interest rates are going up. The notion of “just-in-time” inventory simply does not work in this type of supply chain environment, pushing companies towards the concept of – “just incase”.

QUESTION: What is the outlook for consumer goods companies?

ANSWER: Margins will continue to face pressure until we start to see either the inflation and logistics headwinds subside or pricing no longer lags cost increases, at which point this dynamic will play out in reverse. Additionally, with real consumer incomes under pressure, the prospect of demand elasticity will rise. This will vary tremendously by product, category and geography. The good news is that, at least in the U.S., there have been some signals that suggest inflationary pressures may be peaking. The path to normalization, however, is highly uncertain. Supply chain issues continue to mimic the arcade game “whack-a-mole.”

The companies that are best positioned to successfully navigate this environment are the ones that have pricing power, for all the reasons discussed above, and strong balance sheets. Those companies will be able to pass on the input cost inflation and invest in working capital to meet customer demand, which may even result in market share gains. In addition, companies with higher gross margins should be better placed to navigate the inflationary environment by virtue of requiring less pricing, in percentage terms, to counter rising input costs. Companies with readily substitutable alternatives or that skew toward lower-income consumers have the potential to be most impacted.

Epoch’s strategies have a disciplined and repeatable investment process that focuses on fundamental quality factors. And one of those factors is pricing power. We try to find companies with strong brands, critical or highly desirable products and products that may have limited substitutions or alternatives. We also look for companies with products that have high switching costs; products that might make up a small percentage of a consumer wallet; or products that offer a strong value proposition, even at a higher price. A good example of the type of company we are looking for would be a restaurant equipment manufacturer that sells a product that increases labor productivity. This would be valuable despite a higher cost, as it would help combat the previously mentioned labor shortage. Another example would be a large luxury goods manufacturer whose target consumer has an above-average income and is willing and able to pay for a product’s scarcity value.


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