November 10, 2022
In this Serial Acquirers Update, you'll find links to our recent interviews, a note on working capital's codependent relationship with inflation, and a reference to Buffett's view on conglomerates.
Inflation and working capital
Inflation is a headache.
What we call a dollar today will be like a different currency in a year. And we mix these “currencies” in accounting.
So, losses from inflation aren’t obvious when nominal numbers look fine.
And hey, inflation eats everyone’s money. That feels better than if rats only ate yours, the case for drug baron Pablo Escobar (the article image was an AI generated attempt at "Gustav Klimt painting of rats eating money")!
These accounting and psychological factors make inflation risky.
Silly competitors that price too low can force rational-intended players to follow suit.
For example (as on page 27 in the serial acquirer book), managers incentivized on EBITA may not increase prices enough when inflation jumps.
EBITA becomes artificially high because accounting depreciation increases slower than inflation, as only a portion of PP&E is replaced yearly. But replacement CAPEX (the “economic depreciation”) increases with inflation.
What’s worse, the firm in the book example didn’t have to bother with working capital.
Inflation makes capital more expensive while forcing most firms to tie up more of it. And the opportunity cost for “investing” in working capital doesn’t show up in accounting!
In other words: a firm requiring working capital, and keeping sales volume constant, will need to increase prices more than inflation to grow FCF with inflation when inflation increases.
That was a mouthful.
Let’s see how working capital impacts firm value when inflation jumps permanently to 10% from a base of 0%. Our key assumption for this stylized example will be that the firm ties up 20% of nominal sales increases in net working capital.
And our example firm *only* increases prices with inflation while keeping its sales volume constant (zero real growth). Further, costs rise with inflation, the tax rate is zero, and the firm doesn’t have fixed assets.
The firm's absolute value change would be the same whether its initial FCF margin was 40% or 5%. But the relative value destruction from inflation hits low-margin and working capital-reliant firms harder (as seen in the graphs below).
“A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the ‘bad’ business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings - no matter what penalty such a policy produces for shareholders.” – Buffett (1981 Letter)
Our example firm had conventional pricing power (the ability to pass on operating cost increases). But true pricing power also incorporates capital cost increases.
The simplified example assumed a permanent hike in inflation. If inflation had instead been expected to fall back to 0% in year five, the firm value would have decreased by 6%.
Buffett on conglomerates
Public markets don’t always provide the best governance contact surface for putting intra-firm capital to its best use.
Notwithstanding the market’s savviness in valuing how (in)competently that intra-firm capital gets allocated!
A HoldCo is a lever on judgement. You can find Buffett’s thoughts on conglomerates on pages 29 to 33 in his 2014 annual report.
P.S. Gustaf Douglas (effectively controlling the acquisitive Securitas and Assa Abloy) noted that a flat organization had been difficult to implement in the US, "Questions received the answers that respondents thought were being sought rather than opinions." Source: Med blicken på stigen
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