Corporate Finance Advisors
It has been said that inflation is taxation without legislation. While there have been numerous discussions on whether inflation is transitory or permanent, we believe that there are arguments to be made on both sides. Each scenario has implications when considering business valuations and mergers and acquisitions (M&A) . To date, rising top-line revenue has kept up or largely surpassed rising costs, driven by the recovery plus companies raising their prices.
Wages and rent are two Consumer Price Index (CPI) components that impact most entities, typically falling into the sticky category. Rent is a big component of CPI and we have not seen sustained higher inflation, in North America, without rent being a contributor. And while wages are not explicitly a category of CPI, wages flow through to the end price in most industries. Both of these in either scenario will not move freely as other components that make up CPI.
If the inflation is found to be transitory, goods and services and by their nature industries relying on these items as inputs to supply end products will experience price reductions. Currently, there are numerous entities facing supply shortages that have resorted to manufacturing or sourcing material within North America, where previously they were relying on inputs from offshore jurisdictions. The supply shortages have resulted in higher prices for consumers and higher cost of goods sold (COGS) for these entities. For example, an equipment manufacturer that historically manufactured in Asia being forced to turn to local North American products over the last 12 months increased prices to consumers as shortages ease, the prices will likely decrease.
In some cases, M&A advisers and business valuators may see a rise or drop in margins due to temporary changing business models. The valuato must determine whether the consumer demand has changed temporarily or permanently. The margins may be affected while shortages persist leadin to unusual o eratin expenses that must be normalized. Brands will likely be able to maintain prices, on a relative basis, versus non-branded entities.
In the scenario that inflation is permanent, in the short run inflation can impact equity prices as rising prices and input costs crimp profits for corporations in the short run. This is especially true for entities that cannot pass on their rising prices to consumers. It is the job of the business valuator and M&A adviser to determine whether the subject entity can or cannot pass on rising input costs to its consumers. In the long run, the impact is neutral as corporations can pass along these costs to consumers. The equity markets historically start to see multiple compression when inflation runs over four per cent, which is roughly the level today.
The multiple compression may be relevant for sellers who are contemplating selling for at least the next 24 months. The compression in multiples may impact valuations that certain sellers are getting today. However, the supply and demand of great businesses for sale may keep some of the premiums intact. For corporate acquirers and buyers, certain sectorsoffer better protection than others. Historically, consumer discretionary, financials, real estate and commodities-related businesses benefit while consumer staples and telecom do not. However, again there will be exceptions as it will depend on the subject entity's ability to pass on rising costs to its consumers.
A key component that comes into play during inflation is that discretionary cash flow due to capital expenditures may become scrutinized by corporate acquirers. Typically, corporate acquirers prefer to acquire on the basis Of discretionary free cash flow as opposed to revenue or operating profit. Sophisticated corporate buyers have begun to shift expectations to account for capital expenditures and focus on businesses with minimal capital expenditures. In certain businesses as inflation increases the capital reinvestment required in subsequent periods, the discretionary free cash flow would decline relative to ones that do not require continuous reinvestment. Take an example Of a railroad or trucking business requiring constant reinvestment versus a distributor. With a focus on discretionary free cash flow, the best businesses to own, during inflationary periods, would be ones that do not require continuous reinvestment, all things equal.
Another issue that comes up for M&A advisers is the issue Of inventory and COGS as it relates to inflation. U.S. Generally Accepted Accounting Principles (GAAP) standards allow LIFO ("Last-in, First- Out") accounting, while International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprises (ASPE) standards, both of which can be adopted by private enterprises in Canada, prohibit I-IFO. Under U.S. GAAP, utilizing LIFO allows entities to deduct a higher COGS by using inflated current costs rather than lower historical costs. This lowers taxable income and the corresponding tax liability, which can help increase discretionary cash flow. It is the role of the adviser or business appraiser to properly gauge the risks that inflation brings to the table and guide clients.
Given the benefits of debt as a result of inflation, it can be viewed that certain governments are inflating their way out of their debt levels. Accordingly, one must pick their inflation battles wisely when determining the path of least resistance.
