Evaluating Earnings Quality as Inflation Bites

Inflationary pressures are threatening corporate profitability. As third-quarter earnings season winds down, we’re gathering intelligence to identify companies that will have advantages sustaining quality earnings and margins amid rising prices.

Whether inflation will be transitory or longer lasting, companies will be affected in diverse ways. For equity investors who target high-quality businesses, inflation must now be a key variable in fundamental research of portfolio candidates and holdings.

Across sectors and around the world, inflation was prominent in recent earnings reports. Yet even as many companies beat expectations, share-price reactions were often lukewarm amid concerns that company forward guidance is clouded by inflation risk. For both growth and value investors, the following inflation-related themes that surfaced can help frame the challenges ahead.

Rising Wages: How Are Companies Navigating Higher Labor Costs?

Tight labor markets are pushing up wages in many sectors. While technology and automation can sometimes be deployed to help reduce labor costs, it’s usually a long process. Look for companies with creative plans to cope with labor costs. For example, one semiconductor manufacturer said it is recruiting more aggressively at entry-level positions to replace older, more expensive employees. Companies that choose this route must ensure that productivity and the quality of goods or services isn’t compromised by replacing experienced workers with more junior staff.

Rising wages mean companies must work harder to retain staff. Companies that are better at workforce retention and skills development may have an edge. To evaluate ‘softer’ corporate practices like these, investors should engage regularly with management teams.

Of course, labor is just one component of a company’s cost structure. In industries that are less labor intensive, companies should consider whether cheaper inputs and alternative raw materials are available to lower production costs. We’re also looking for evidence that manufacturing processes can be streamlined. Outsourcing can help trim costs in industries that haven’t done so yet.

Pricing Power: Will Customers Pay More?

Some companies will be able to better cope with rising wages and other input costs by virtue of their pricing power. Competitive advantages, innovation and industry dynamics can all support pricing power.

Businesses that offer clear added value for essential services can raise prices without risking a customer revolt. For example, Robert Half, a leading global staffing firm, can charge more to customers who are desperately seeking new specialized employees in a tight labor market. The company’s broader coverage also gives it a larger pool of prospective employees, providing an advantage for clients.

Technology companies that sell essential services and software are also well positioned to raise prices. And transportation groups, from trucking to freight ship operators, are jacking up prices that customers are forced to accept given today’s supply chain bottlenecks.

Supply Chain Flexibility: Can Bottlenecks Be Bypassed?

Many global companies spent years honing production processes. This enabled sophisticated inventory management and lean manufacturing processes based on very precise schedules. Yet we now see that the smallest disruption to a vital component can derail the entire process. In the most familiar example, carmakers are struggling to deliver vehicles because they can’t get semiconductors.

In recent years, US-China trade tensions prompted some multinationals to rethink their supply chains and processes. Those that moved to Vietnam were stuck for months as factories shut down under aggressive COVID-19 restrictions, affecting products from clothing to furniture to electronic components.

Supply chain strategies may need another rethink. Adidas, for example, is reallocating production to other regions and securing additional capacity for its lines of sports apparel and shoes. Manufacturers that source raw materials and parts locally will be less vulnerable to disruptions. French luxury goods-maker LVMH, for example, said that it sources locally and hasn’t faced major supply chain issues.

Companies with more flexible and decentralized production systems are better placed to adapt supply chains. In contrast, businesses that depend on a specific location for access to specialized raw materials will be saddled by inflation.

Inflation Beneficiaries: Is the Underlying Business Sound?

In industries like energy and commodities, many companies benefit immediately from rising prices. Still, long-term investors should resist the temptation to increase blanket exposure to these industries without evaluating the underlying business quality.

For energy companies, short-term gains could mask long-term expected demand declines. Investors should study an energy company’s position for these shifting market dynamics, their role in enabling the transition from fossil fuels to renewable energy sources and the sustainability of earnings. And since it’s nearly impossible to predict the course and duration of inflation, shares of commodity producers that are riding the current wave could disappoint in the future if inflation subsides.

Think creatively about inflation beneficiaries. They aren’t just the usual suspects. For example, Herc Holdings, the US-based equipment rental company, is benefiting from higher steel and commodity prices as the replacement value of its equipment fleet has risen sharply. Replacement value sets rental rates and, combined with increased demand for equipment, has allowed Herc to increase prices and expand margins. Ashtead, a UK company in the same business, has also seen healthy price increases for its range of construction equipment.

Denial Is Not an Option

Management quality is perhaps the most important element to devising and executing a strategic plan to combat inflation. Flexible corporate cultures will adjust more easily to necessary changes.

Companies can’t afford to be in denial about inflation. We expect to hear management recognize vulnerabilities in cost inputs and present clear plans to address them. The good news is that efficiencies developed in response to inflation will bolster a long-term investment case by contributing to earnings quality long after price pressures subside.