Investment Matters

Costs are rising. Who benefits (and who doesn’t)?

UBS hosted their annual conference this week which we attended (virtually).

Invariably, there are one or two questions that are consistently repeated at every conference.

Obligatory, and often banal, they rear their heads during Q&A time.

However, a question repeated this year was one we, too, have often contemplated:

“Are you seeing your costs rising, and if so, how are you dealing with these pressures?”

Why?

Inflation is here. We have seen costs rise and continue to do so across a broad range of inputs that companies rely on, be it shipping, energy prices, labour (in the US) or base metals.

Are companies experiencing a rise in costs? And have they been able to pass them on i.e. recoup them through raising prices?

In reality, most companies have experienced cost pressures and have passed them on to some degree.

However, the impact of rising costs is far from uniform across companies.

We look at rising costs, their impact more broadly and specific examples as they relate to client portfolios.

Some (highly relevant) examples

It will not be news to readers by now that clients’ Australian Equities portfolios are positioned with the prospect of higher inflation and interest rates in mind.

With every stock in the portfolio, we have run over the scenario of what companies look like in an inflationary environment.

To illustrate, we can point to two companies that presented at the UBS conference that provided examples of this.

RWC logo small

We own Reliance Worldwide for its strong brands and the exposure it provides to housing activity globally (ageing homes that need repair, homeowners looking to remodel).

Its products are sticky – plumbers want to make sure the products they use get the job done right, the first time. Its fittings have a proven track record that is hard to replicate - which has served as a barrier to competitors and product clones.

It generally sells products of a low dollar value but in high volumes. Furthermore, it helps drive profits for its customers. It has strong relationships with wholesale/retail distributors, providing support that helps them grow their sales, profitability and in turn demand for its products.

In addition to a fantastic business with high returns on capital, the outworking of this is pricing power.

It means the company has been able to consistently push price rises through as it has seen the cost of copper rise - and is confident it will continue to be able to do so as it sees pressure in steel, cardboard, resin and shipping costs.

Incitec Pivot logo small

Incitec Pivot’s returns on capital are less impressive than those of Reliance.

However, it has dramatically benefited from inflation, seeing it return 38% this financial year.

Incitec has invested a lot of capital (plant and equipment) over the years including into plants (fertiliser and explosive), warehouse facilities and mining infrastructure.

One of the biggest costs is maintaining this capital (approx. 25% of its operating expenses). A large proportion of the investment is required to maintain its plants. However, the bulk of this investment has been completed over the past few years (plants require a “turnaround” approximately every 4 years).

As inflation has taken hold (impacting energy costs and food prices – which have compounded favourable planting conditions and supply disruptions), we have seen fertiliser prices rise.

Fertiliser Prices have risen significantly over the year

  DAP Vs SoybeansAmmonia Vs Soybeans

Source: Macquarie research

Meanwhile, Incitec Pivot’s operating expenses have stayed relatively flat, as shown below.

This has resulted in a dramatic lift in the company’s profitability:

  FY-20 FY-21
Revenue $3,942m $4,348m
Cost of goods sold  $1,828m $2,054m
Gross profit  $2,113m $2,294m
Gross Margin  54% 53%
Operating Expenses $1,526m $1,498m
Depreciation, repairs
and maintenance (sustaining investment)
$497m $508m
Operating profit  $91m $289m
Invested Capital $6,526m $6,498m

 

 
  

 
 
  
  
 
 

 

 

 

 

Above: Incitec Pivot’s statutory profit for FY-20 and FY-21. Figures include Individually Material Items (IMI) but exclude asset impairment write-downs and site exit costs.

Why is pricing power in an inflationary environment important?

At the risk of losing some of our readers, we can illustrate through the following simple company model (ignoring re-investment and taxes).

Revenue – Costs / Invested Capital = Return on capital

Using this framework let compare two identical companies that make $100m in revenue and $80m in costs. Both have $100m of capital invested i.e. required an investment of $100m to set up.

Both also earn a 20% margin

$100m - $80m (20% margin) / $100m = 20%

Revenue - Cost = Profit/ Invested capital = Return on capital

However, one company has pricing power while the other doesn’t.

Now, let's assume inflation hits and costs rise across the board by 20%.

How does this impact these companies?

Pricing power

$120m - $96m (20% margin) = $24m /$100m = 24%

Revenue - Cost = Profit /Invested capital = Return on capital

No pricing power

$100m – $96m (4% margin) = $4m / $100m = 4%

Revenue - Cost = Profit/ Invested capital = Return on capital

Granted this is an exaggerated example and fairly intuitive.

Reality is often much more complex than this (for instance, companies have varying cost structures – i.e. fixed vs variable costs, experience different relative price changes, have different leads and lags to their revenues and costs).

However, it is important as it shows that companies that can maintain their margins can benefit and generate higher profits.

Furthermore, if we assume the capital a company has to invest does not change much, we also see a dramatic improvement in a company’s return on invested capital.

This is exactly what we saw with Incitec Pivot above.

Conclusion

Who benefits in a rising cost environment? It’s clear that in general, those with pricing power are better positioned. However, inflation protection isn’t binary and there is often much more nuance needed in determining the degree to which companies may or may not benefit.

We have spent a lot of time thinking about what companies in client portfolios may look like in an inflationary environment and have positioned portfolios accordingly – with the benefits of this beginning to flow through.