Using “market trends” is my way of drawing attention to the exact opposite – specifically, that many markets are behaving differently than our macro trends. Nevertheless, ITR Economics’ macro outlook can be helpful to all, as it sets the stage for longer-term planning and decision-making. Your market may not be behaving like overarching Nondefense Capital Goods New Orders (excluding aircraft). Making a 12/12 comparison between your revenue data and Nondefense Capital Goods New Orders (excluding aircraft) and against your specific industry trends will highlight which near-term path is the probable one for your firm.
There are markets that will experience a slowing rate of growth in the second half of 2022 and into 2023. Others will likely not, because they experienced a great surge in activity with a commensurate build-up in operations and inventory during the sugar high of 2021. Many in the latter group will be negatively impacted by the inflation-priced inventory buildup that is followed by dramatic slowing, or even decline, in demand. It is also important to expect deflation in some markets.
The former group, the ones with slowing demand who will live with disinflation and not deflation, will likely experience a reduction in unfilled orders and contend with inventory in a measured, non-frenetic way. Cash flow will be good as revenue benefits from filling what is usually a mound of unfilled orders. There may be margin compression and a reduction in free allocable cash, but there will likely be a solid stream of revenue-driven cash that will provide for payroll and payables, something that will not be found as easily in a company where revenue declines to below year-ago levels. This is the preferred and easier-to-manage path. But it will not be that way for everyone.
Firms in the latter group may find themselves in a situation where selling prices are falling while demand is waning. Prices are falling (deflation) in some markets as demand eases and supply improves. These waters are more difficult to navigate. Businesses holding expensive inventory will likely reduce prices to push product out the door on a dramatically reduced profit margin. The “blowout sale” will work if: a) buyers need the product now, or b) buyers don’t believe prices will fall further. For instance, a user of copper may not have the luxury of waiting for lower prices. They need the copper now; waiting is not an option, as product must be manufactured. Other would-be buyers can decide to wait for lower prices.
Here are some things to keep in mind:
- A decline in sales does not necessitate an equal decline in EBITDA. Sales measured in dollars decline with deflation, but so do some of your input costs. Careful cost management and previously implemented efficiency gains should help. However, a realistic view is that revenue is likely to move lower compared to last year (Phase D), and there is little you can do about it as pertains to this specific market. It is a result of deflation, which you cannot control.
- Volume may not decline, even as dollars do. It is easy to make decisions based on a top-line trend when we have been living in a no-inflation environment for years and more recently in an inflationary environment. Deflation causes a shift to a focus on units or throughput where possible.
- Cash becomes the greatest concern for a firm dealing with inflation-valued inventory and deflationary pricing pressures. The use of lines of credit or strategic reserves could become necessary. Do not assume the deflationary trend will last. Straight-line forecasting is always dangerous. Stay abreast of anticipated price changes at least one year out. We can help you with that.