Inflation hurts more than just the consumer

Good morning. We are doing due diligence on some companies we have heard of. These are the downtrodden stocks we often speak of.

I am reflecting on a few stocks that I did homework on. They fall into two patterns:

1. Companies reacted to the supply shocks and expected future price increases by increasing inventories. They 'had to' increase operating expenses through wages, cost of energy, product costs, etc., and in come cases threw in some discretionary expenses as well. Regardless, they have levered up their current assets and current liabilities by 'investing' in inventory. This was a seemingly prudent move as COVID 19 subsided, the masks came off, and we were 'full steam ahead' in our economy.

However, now those companies have suffered weakness in sales and consumer demand. Their sales are not consuming the inventory, and now somebody has to pay for those inventories, and increased operating expenses. It looks like it will not be the consumer. So, they borrow more money, issue preferred stock, and the lucky ones can issue more common shares to pay for the losses.

However, once the common stock is down (say 80% or 90%) the dilution feels punitive. Once bonds are trading in the 70s, this means yields are in the 20s, and new debt is priced extremely expensively. The only thing to do is to cut expenses dramatically, or look for strategic options. This market feels full of companies looking at downsizing, strategic options, or BK.  With each earnings release, expect more of these to go public so long as inflation and energy prices remain elevated.

2. Companies continued to operate as normal. Good, solid performance year on year. Long-term contracts supplemented by spot sales. B2B and B2C can fall into this pattern. Solid business plans with little to change or improve. Steady Eddies. Some R&D, maybe a few new products. Selective hiring but nothing crazy. Most office workers work 'from home' and things remain status quo.

The inflationary cycle hits them. Costs increase, as they must. Labor costs rise, the occasional rent or capital expense increase, and of course raw materials cost more. Maybe costs only rise 6% vs. 8.3% for CPI and management seems satisfied that it is tightening its controls.

Now another factor hits them. Capital costs more. Debt for high yield companies keeps hitting new lows, which means yields rise. We track some debt yielding from 20% to 30%. Equity costs more too. Investors expect lower returns (Our model suggests 4.5% to 6%) so investors pay less for new shares, and require more of a share of the equity for every dollar invested. Where does a company turn to when it needs a hand up?

There are a few sources of funding (outside the pawn shops and payday loan businesses). Firms can turn to private equity, venture capital, specialized lenders / turnaround shops, and banks. Regular banks that hold trillions of US retail deposits. They may charge higher interest rates, but hopefully it will be lower than our default credit card rates of 29.999%. This hurts in another way too. We notice that firms that were healthy took on additional debt. That debt in many cases is variable rate, which usually means some index plus a mark-up, plus a percentage of unused borrowing capacity. As interest rates increase, their cost of debt rises immediately, from quarter to quarter. One company we looked at has no economic profit and interest costs of $200M/year. As rates rise, and their interest hits, say $300M, they likely will need to borrow to pay higher rates, or dig a deeper financial hole.

Finally, the impact of inflation and fears of recession play out in their consumer's minds and spending habits. Maybe spending only falls 5% or 10%, but that, with increased costs, means that profits evaporate and now the company has to cut further or dip into those expensive capital and debt markets.

Now, we turn to the consumer. The consumer is hit by layoffs from companies feeling the squeeze of inflation, and they have to pay more for items they absolutely need to live, such as food and energy. This is how economic downturns happen, and why inflation is so dangerous.

What does this mean in the stock market for investors? It means that you should not buy shares of stock in companies that are sliding towards bankruptcy. That is a slippery slope that only gets harder to leave over time.

Good luck in the markets. Sorry for the gloom and doom.
It comes with the territory of being a financial advisor and researching companies.

GLTA!