Thread by @hkeskiva

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As costs are rising across categories, it’s important to understand the potential IMPACT OF INFLATION METRICS CPI AND PPI to business fundamentals.

Let's cover the basics and some concrete examples.

Best served with a cup of 🫖

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We’ve touched upon the topic of inflation before (when it was still below 2%) but from slightly different angle. In case you’ve missed it, you may find it here.

This time, however, we dive a little deeper with CPI and PPI.

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CPI stands for Consumer Price Index and PPI for Producer Price Index.

Both measure the overall rise of prices (inflation), only at different parts of the value chain; one at the producing and the other at consuming end.

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Interactive FRED database has time series of PPI starting all the way from 1914 and CPI from 1948.

Historically, producer prices (red) have been more volatile than consumer prices (blue).

PPI: fred.stlouisfed.org/series/PPIACO
CPI: fred.stlouisfed.org/series/CPIAUCSL

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More volatile producer prices make sense.

In many cases companies are ready to take a strategic hit on their margins on behalf of customer price stability.

This can build customer loyalty and capture market share from short-term oriented competitors with erratic pricing.

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Let’s take these dynamics to income statement through an example.

Here’s a company with revenues of 100, gross profit of 60 and operating income of 20. These numbers could belong to an excellent business.

Later, we alter the numbers to reflect different inflation regimes.

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Since CPI reflects the consumer price level, it’s fair to assume it impacts REVENUES. As price increases are universal, we also assume it lifts OPERATING EXPENSES.

PPI reflects input costs to producers, so it mainly impacts COST OF GOODS SOLD.

See added rightmost column.

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First, let’s add 3% CPI.

Since we assume it impacting revenues and operating expenses, the impact over time is net positive for the business (revenues grow more than operating expenses).

This requires pricing power from the business – otherwise its customers would flee.

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Of course, it’s unrealistic to assume that there would only be ‘consumer inflation’ but no ‘producer inflation’.

Replicating our math by adding 3% PPI, we see that example company with pricing power doesn’t need to worry that much as profitability holds nicely over time.

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Not every company can raise prices without fall in demand. This dynamic is generally captured by “price elasticity”.

Low elasticity means price impacts demand relatively little, e.g., electricity is bought even though more expensive. High elasticity means the opposite.

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Here’s an earlier example of company with fantastic pricing power, See’s Candies.

Nowadays, for example, Apple $AAPL is considered a prime example of pricing power.

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Back to our hypothetical example. What if PPI and CPI don’t go hand in hand?

We saw earlier that when CPI > PPI, it can be net positive for a company with pricing power.

What about when PPI exceeds CPI? Let’s try 6% PPI and 3% CPI.

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As costs increase at a higher rate than revenues, our example company suffers from lower gross and operating margins over time with these assumptions.

This is not optimal environment to do business in.

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If we consider the current inflationary environment, the numbers are in fact even higher with CPI at 7% and PPI at 20%.

Let’s plug in these numbers.

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It becomes clear why central bankers need to address this situation: if held constant for years, margins deteriorate quickly even for good companies.

Of course, this is extreme illustration just to highlight the point.

But this exercise is not simply theoretical.

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Our hypothetical example company is very similar to lubricant manufacturer WD-40 $WDFC with historical 50% gross margins and 20% operating margins, as visualized below.

Let’s see next how WD-40 has been impacted by current inflationary environment.

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Here’s WD-40 $WDFC 4Q21 earnings when PPI was roughly 20% and CPI 7%.

Income statement - YoY

- Net sales +8% (CPI 7%)
- Cost of goods sold +22% (PPI 20%)
- Gross profit -3% (margins squeezed)
- Operating expenses +6% (CPI 7%)
- Operating earnings -15% (margins squeezed)

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As we can learn from WD-40, different inflation regimes have a clear impact on its business fundamentals. Stock's down -35% from its highs year ago.

As an investor, these concepts also make it easier to understand what is happening now and what to expect from the future.

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To further study WD-40 $WDFC, see how its year-on-year changes in costs of goods sold have been tracking PPI nicely over the years.

This is obviously not true for every single company out there but especially so for certain industrial manufacturers.

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This issue has been widely noticed.

Fundsmith's Terry Smith had this example in his recent annual shareholder letter to make similar point by adjusting producer price inflation (PPI), aka cost inflation, for different type of companies.

fundsmith.co.uk/media/3wcngjie…

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If you crave for more walkthrough and examples, check out this great thread on inflation by the one and only @10kdiver!

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For further reading, Warren Buffett wrote this Fortune article “How Inflation Swindles the Equity Investor” amid the 10+% inflation spike of late 1970s.

tilsonfunds.com/BuffettInflati…

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And once you’re here to learn about inflation, these fintwitters are worth checking out as I’ve learnt a lot from them!

@qcapital2020
@ArneUlland
@Vivek_Investor
@daniel_toloko
@KirtanShahCFP
@PreparedRemarks
@hussmanjp
@breadcrumbsre

They share great insights for free.

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If you found this thread helpful, do hit ‘like’ or ‘re-tweet’ to the first tweet so that others may benefit from this too. This helps to spread the joy of financial literacy.

Thanks a lot in advance, much appreciated 🙏

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For more, follow @hkeskiva. I’ve earlier written on

- Capital allocation
- Incremental returns
- Buffett’s deals
- Market excesses
- Insurance float
etc.

You can find them all from the link below. Have a great weekend! 🤗