In this video, Steve Johnson and Chloe Stokes discuss a topic that’s been top of mind for many investors: cost inflation and what it might mean for the future.
The impacts have been pretty widespread so far, Steve says. For example, supply shortages have resulted in product mark-ups from the likes of Installed Building Products (NYSE:IBP), while online beauty retailer Adore Beauty’s (ASX:ABY) customer acquisition costs have increased significantly as competition for its customers increases, and fast-fashion retailer Boohoo’s (LON:BOO) margins have taken a hit due to significant increases in freight costs.
So, what might these issues mean for equity valuations in future and are we seeing a longer-term regime change? Chloe says that forecasting has indeed become more challenging, but that only time will tell if longer-lasting changes are underway.
Hi, and welcome. It’s Steve Johnson here, Chief Investment Officer at Forager Funds. I’m joined today by Chloe, who’s a Senior Analyst on our International Fund. Both coming to you from a very, very, very wet Sydney. How are you, Chloe?
I’m well, thanks, Steve. How are you?
I’m well, thank you. I’m a bit sick of being in the house. After a long time of lockdown, we’re back working from home. Just because it’s so difficult to get to the city at the moment, but other than that, fine. Certainly, a lot of people around the world at the moment have it much, much worse than us. But we’re going to talk about something a little bit esoteric today, but I think it’s really come to the forefront of investors’ minds throughout this latest reporting season.
That is cost inflation around the world, really. We’ve seen a lot of it in the US. We’ve seen a lot of it in Australia and a lot of questions being asked about what that means for the future. What have you seen across some of your stocks, Chloe? Maybe starting with what I’d call traditional inflation issues, around prices of things just going up.
So, I think an interesting one is an insulation installer in the US, Installed Building Products. What we’ve seen from them is very straightforward cost inflation of their inputs. What’s basically happened for the past couple of quarters is that instead of buying their insulation materials directly from the manufacturers, they have been forced, due to supply shortages, to go out and purchase from regular consumer stores. Like home centres and other distributors.
Which, of course, involves a lot of mark-ups. That’s impacted their margins, as I mentioned, over the past couple of quarters. They’re expecting that to continue for most of this year.
Yeah, and that’s been pretty widespread across any sector, really, that’s dependent on commodities, oil prices, inputs, products that require a lot of shipping, where shipping costs are through the roof. Been really widespread, but perhaps most surprising throughout this last reporting season, is that the issues haven’t been limited to those more traditional types of businesses. We’ve seen it across the tech sector as well. I know it’s not in our international fund, but one that you follow closely is Adore Beauty.
Yeah. Adore Beauty has seen its customer acquisition costs, so the marketing that it spends to acquire new customers online, increased pretty significantly. In the first half of the 2022 financial year, to the end of December, their customer acquisition cost was up around 40% on what they were paying last year. Which means the lifetime value of the customer remains the same, but those costs to acquire it are increasing. So, the overall value of that customer to the company is getting lower.
Yeah, and that number is going up, because there’s simply more competition for their customers, who are mostly searching online. We’ve seen, across the whole online space, that that customer acquisition cost number is going up dramatically. Google has been the main beneficiary of that. There’s lots of money in the sector, there’s only a limited number of customers.
With a business like Adore, you’ve had some of its sleepy offline competitors, like Sephora and MECCA here in Australia, really shift their businesses online and start competing. Maybe the biggest one in this category for me is Redbubble. It was a business that didn’t make a profit for a long time leading up to COVID, simply because the cost of its traffic was going up as fast as its revenue was going up.
They made $50 million in one year, thanks to people wanting to buy masks off their website. Now, it’s back to not making any money again. I think, with that business in particular, I’m pretty confident that that trend is going to continue. Because a lot of their traffic is new to their website every year and they start with search.
I think if your business is dependent on search, then it’s highly likely that the value that is created by your product is going to end up in Google’s hands, or yours. What about another area of cost inflation, Chloe? I know that a lot of companies out there also dealing with logistics issues. Not the cost of creating the product, but the cost of getting it into customers’ hands.
Yeah. Hopefully this is a more short-term issue. One stock that we saw it in pretty heavily was fast fashion online retailer Boohoo, listed in the UK that we used to own. In their first half to August 2021, they actually talked about the amount of their costs that they dictated as short term in nature and COVID related. Most of which were due to increases in outbound freight cost.
The impact was almost 3% of margin. Which is pretty huge, considering in the first half of the last financial year, their margin was only around 11%. They talked about freight rates per ocean containers and air freight, up 400 and 300% respectively. That’s pretty huge, but hopefully more short term than the other increases.
Yeah, you would think this is one that does unwind over time. We’ve got some investments in the auto sector as well, but we’ve a lot of cars around the world that are just waiting for chips. There’s a lot of demand there. You think they’ll get sold and you’ll think the cost of shipping does come down. One of the big issues there is just airlines putting more flights on for passenger traffic, where they put a lot of cargo in the hold, it should make a big difference fairly quickly. One that’s maybe more permanent, and this is a huge, huge issue for the tech sector, is staff.
Yeah. I’ve actually noticed, with a couple of businesses, we’ll get really excited about some tech businesses, they’ll have really cash-generative businesses, the free cash flow yield looks amazing. But, a lot of reports that you read don’t actually include share-based compensation in their models. So, once we go through and add in the cost of that share-based compensation and deduct it out of the cash flow, the value of the business of that cashflow is virtually erased.
A really good example of that is one of the stocks that we own, Twitter. I was just looking today at the past five years and they’ve basically spent every dollar of EBITDA, earnings before interest, tax, depreciation and amortization that they’ve earned, on paying their staff in stock.
Yeah. Again, it’s a sector where there’s been an enormous amount of money raised over the past few years. High stock prices have contributed to that. It’s affected the cost of acquiring customers and it’s dramatically affecting the cost of employees as well. There are only so many people in this sector to go around that know how to code and build the businesses that everyone is trying to build. But the big question here, Chloe, is what does this mean for equity valuations long term?
Profits, as a percentage of GDP, have been going up around the world for most of the last 20 years. It’s been a one-way street in terms of the direction that has been going in. The cost of labor’s stayed low, thanks to a lot of offshoring companies managing very efficient supply chains, where they’re now starting to need to carry more redundancy in that supply chain. Are we seeing a change in regime here, that makes it much more difficult to forecast these companies’ profitability out into the future?
It’s definitely making it more difficult to confidently forecast profitability into the future. But, it’s hard to say right now whether we’re seeing a regime change. I think, maybe in 10 years, we can look back and determine whether that’s the case. But, we’re certainly seeing a lot more focus on it from markets and investors.
A lot of share prices are off, pretty significantly, with people thinking about how long these cost issues might last, whether they’re temporary or whether they might continue to exist well into the future. It’s definitely something we’re thinking about a lot more than maybe what we were a couple of years ago.
When it comes back to the stock specifics, this is a bit old fashioned of me, but I still really like the Porter’s Five Forces framework for thinking about a business. Particularly any business that you think has an enormous amount of intangible value. They’re becoming increasingly common, they’re becoming a much bigger part of the economy.
What I mean by intangible value is a business that is worth a whole lot more than it costs to create it. A lot of these tech companies, people have put in a few million dollars and a few years of very hard work and they’ve ended up with a business that’s maybe worth a hundred million or a billion dollars. I still think it’s really important in that space to say, “Okay, I’m assuming that there’s a whole heap of intangible value there. What right as a shareholder do I have to keep that value?”
I think what we’re seeing is that a lot of people, when there’s a big pie created, there are a lot of people involved in any business that want their share of that pie. That might be suppliers, Google being a really big one for a lot of these companies. But also, staff being the most important supplier for a lot of them. Having a lot of bargaining power around what percentage of the business they take here.
It might be substitute products. You’re seeing with Facebook that you’ve got TikTok come along, you’ve got Snapchat taking up a lot of people’s time and competing with Facebook’s main products. So, I think that old framework, although these businesses are new and we’re dealing with sectors. We are dealing with some very, very important trends in terms of shift to the cloud and things, that framework for thinking about businesses and who’s going in to end up with the value is very important.
If you’re paying a huge amount of intangible value for a business, you want to be really, really certain as to why any of these people that are sitting around the edge of the circle here are not going to try and take more and more of that pie themselves. It’s been a really interesting reporting season, Chloe. It’s not going to get any less interesting, I think, over the coming years.
We’ve got COVID unwind, we’ve got all these inflationary pressures. We’ve probably got interest rates going up. It’s going to be very interesting to see which businesses thrive and which don’t.
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