Inflation 101

Increasing oil prices, upward wage pressures, higher interest rates, the rising yuan — the effects of expanding inflation are impossible to avoid. But what does this mean to you as a multichannel merchant? Plenty.

From the top

Let’s start at the top of the income statement: sales. Presumably if inflation increases, you can increase prices. After all, isn’t that what inflation is all about?

But inflation is not a smooth process that hits across all categories at the same time or at the same rate. During the past several years we have seen increasing commodity prices with only modest price changes in finished goods, especially those imported from the Far East. If your business relies upon raw materials that have gone up in price, you may not be able to pass on those cost increases to your customers. (And don’t forget, postage is a raw material for mailers.)

If you have increased prices, then hopefully your profits have improved accordingly. If that’s the case — and even small increases in prices without a resulting decline in unit sales can lead to greatly improved profitability — it suggests that your product has a favorable inelasticity of demand. In other words, people want it or need it and won’t let a minor price increase stop them from buying it.

Unfortunately many merchants have not been able to increase prices — or perhaps more accurately, have not dared to increase prices. These merchants therefore have to cut costs, increase productivity, or take a hit to their bottom line. True, technology has helped improve productivity and enabled companies to save on labor. And imports from China have kept product prices low.

In a textbook inflationary world, increased profits or savings would pay for increased costs and keep “real price” profits constant. But that’s assuming there are no resulting declines in the number of units sold.

Riding the demand curve

It’s no secret that the demand curve works. The higher the price, the lower the unit demand. By raising prices you could end up with lower unit sales but the same or even slightly higher total dollar sales.

You might not see it as such, but this is a recipe for disaster over the long term. While dollar sales and profits may increase in an inflationary world, you must pay close attention to unit volume in order to 1) avoid giving up market share, 2) allow for new low-cost competitors, and 3) maintain economies of scale and volume efficiencies.

If your costs are rising, you must test whether your customers can absorb your price increases. What is their price elasticity of demand? If your customers are unwilling to pay more for the same items, then you are left with a very difficult choice: lower profits or lower unit volume.

Inflation also plays havoc with discretionary income, which in turn affects consumer demand. Without corresponding increases in income, rising prices will erode discretionary income. Just look at gas prices and how the run-up has hurt spending in other sectors. While demand for housing, heat, and food may not suffer, most of the items bought through direct marketing are discretionary purchases that can be deferred. So even if your prices don’t increase, your customers’ decreasing discretionary income can dampen demand for your products.

Lifetime value and company valuations

Now let’s look at what happens to customers’ lifetime value (LTV). If your costs increase but you can’t raise prices to compensate, then your dollar contribution won’t keep pace with inflation, and neither will LTV. In short, LTV will decrease. And if interest rates increase, as they typically do in an inflationary environment, then discount rates increase, which also lowers lifetime values. After all, the time value of money decreases the value of profits in the future.

Lower LTV generally means less prospecting. Why invest in customers who don’t measure up to the cost of acquiring them? Less prospecting means smaller house files, lower volumes, and ultimately fewer profits. Lower LTV, smaller house files, and higher interest rates will also translate into lower valuations for businesses. While market prices determine valuations for the most part, valuations are also driven in some degree by discounted cash flow analyses.

What is the future likely to bring? Will unit and new customer growth slow down as prospecting becomes less profitable? Yes. Will higher interest rates lead to higher discount rates and lower values for sales/profits/contributions further out in the future? Yes again. While an abundance of money is out there to purchase multichannel merchants, and there is a limited supply of attractive acquisition candidates, valuations have remained high. Still, multiples are already beginning to drop ever so slightly. If interest rates continue to rise, as it seems they will, valuations will come under pressure.

Clearly, controlling inflation is the mandate of the Federal Reserve. Its new chairman is determined to keep inflation under control, but not everything is within his control. Oil and commodity prices, China, and an improving world economy are all pressures on inflation. While you can’t control inflation, you can counteract its effects by making the necessary management decisions, namely selective price increases, careful cost containment in controllable areas, and close scrutiny of prospecting circulation plans.

Stuart Rose is managing director of Wellesley, MA-based investment bank Tully & Holland.

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