The Tariff Shakeup

The tariffs that the U.S. has imposed on China have featured heavily in the media. This retreat from the notion of globalization – a tenet that has guided trade discussions for the past few decades – is harming the relationship between the U.S. and China, and is creating immense uncertainty for companies. Less well-understood is the precise impact on U.S. firms that import input materials from China. While executives from many businesses have argued that they can offset tariff impacts via price increases, is it really this simple?

The U.S. has imposed tariffs on more than $250 billion of Chinese goods. The 10% tariffs that took effect on September 24, 2018 were previously scheduled to increase to 25% on January 1, 2019. While the trade discussions from the G-20 summit in Buenos Aires brought about a 90 day delay to the ramp up of these tariffs to 25%, firms must still address the 10% increase in cost of goods imported from China. Furthermore, it is not a given that these tariffs won’t still increase to 25% if discussions between the two sides break down.

Source: US Census Bureau; via BBC research

Tariffs were a commonly-discussed topic during the earnings season for the third quarter of 2018. Many firms sought to outline the extent to which they were impacted, as well as highlight how they were going to deal with the tariff impact. A frequently-cited response was that the firm would raise prices to offset the inflation resulting from the tariffs, and in effect preserve its existing margin structure. While such commentary might serve to reassure investors that the margins of firms falling within the ambit of the tariffs won’t collapse, we remain sceptical as to whether many of these companies will be able to affect these price increases.

Firms need to consider the elasticity of their products, and the potential volume loss that could result from raising prices to maintain margins. While we saw many firms argue that their peers would also raise prices, given they too imported some of their input materials from China and were slapped with tariffs, it is likely that for most companies these price increases would precipitate a loss of sales volume. If prices get high enough, some consumers will simply choose to close their wallets.

Perhaps the bigger issue at play is the risk that retailers push back on any proposed price increases, or choose only to institute a partial price increase. The result of this would be for the retailer to maintain prices (and thus its own sales volume with end consumers), and leave it to the manufacturer of the product to absorb the margin impact from the tariffs. This is certainly a possibility, given that many manufacturers and distributors in the U.S. sell into concentrated end-channels: that is, markets that are dominated by a small number of large retail players (e.g., Walmart).

Take iRobot (Nasdaq: IRBT) for example. In a September 5, 2018 presentation at the Citi Global Technology Conference, IRBT management fielded a question about how the company would respond to tariffs, given that all of its robotic vacuum cleaners are produced in China. IRBT CEO Colin Angle made the following remarks: “So iRobot, we are covered by group 3 of the tariffs, which would result in up to a 25% rate applied to our products. That same tariff code would apply to all of the competition and would be unambiguously detrimental to the growth rate of robot vacuuming. The current proposals basically will increase the price of products at Walmart by 25%.” [emphasis added].

In talking to the IRBT management team after these comments were made, they clarified that the comment was made generally about prices increasing by 25% at Walmart. In effect they were backing away from the characterization made by the CEO that IRBT would be able to push the full 25% input cost increase through to a retailer like Walmart. It seems highly improbable that a retailer as large and powerful as Walmart would be willing to accept a full 25% price increase from a manufacturer like IRBT.

In doing so, it would be the equivalent of Walmart executives saying “I’m going to accept the full 25% price increase from you which will cause us to lose sales volumes and possibly be less competitive compared to other retailers. But that’s okay, because at least you’ll be able to keep your margin”. As manufacturers of consumer goods know, Walmart is notoriously fierce when negotiating with its suppliers. All price discussions with Walmart are a negotiation, and for a company as small as IRBT, Walmart holds most of the negotiating power. Consider this: IRBT’s sales are around $1 billion, compared to Walmart’s sales of over $500 billion.

If pushing through price increases that fully recover the cost impact isn’t an option, what other levers are available to offset the tariff headwind? Firms are able to pressure their suppliers in China for price concessions, which we’ve heard numerous reports of. Companies might also consider shifting their manufacturing out of China. G-III Apparel recently announced that it was shifting production of almost all of its leather clothing from China to India. Could IRBT do the same?

The answer is no, at least not in the short- to medium-term. IRBT management has considered plans to shift production to Malaysia. The labor rate in Malaysia is lower than in China, but IRBT would still need to ship components from China to Malaysia, the transportation costs of which would make this prohibitively expensive. Could IRBT shift manufacturing back to the U.S. instead, in line with Trump’s plan to bring about an American manufacturing renaissance? This is extremely unlikely, with IRBT management communicating that the U.S. is one of the highest cost jurisdictions.

The Montaka team saw the executives of a number of companies put on a brave face and reassure investors that the tariff impact on their business would be minimal. The next earnings season will be the true test of this, given that it is the first full quarter of these tariffs coming into effect. We remain doubtful that some of these businesses will be able to navigate future quarters and keep their margins intact.

Montaka is short the shares of iRobot (Nasdaq: IRBT) and Walmart (NYSE: WMT)

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George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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