The X’s and O’s of Tariff Management

Despite seemingly constructive talks between the US and China over the weekend at the G20 Summit in Osaka, the threat of further trade escalation looms. The initial rounds of US tariffs on Chinese goods were focused mostly on industrial products. But, if the US proceeds with tariffs on “List 4”–the remaining $300 billion of Chinese goods not yet tariffed–consumers are likely to feel the effects. The reason? This next and final round places a 25% tariff on predominantly consumer goods like toys, apparel, sporting goods, and sneakers, among others.

From an investment perspective, the biggest question is how companies can and will navigate the challenges of higher imported costs? Said simply, will companies absorb the financial cost or pass it on to consumers in the form of price increases. In a nutshell, we believe the impact on individual companies will be varied, depending on three factors—their products’ degree of necessity or differentiation, the overall category exposure, and their idiosyncratic ties to China.

The Fortunate

Auto parts were included in the first waves of tariffs, so they provide a compelling example of how “not-so-discretionary” products can weather the storm. Historically, auto parts have been able to withstand commodity price shocks or other manufacturing cost increases because of the necessity of the purchase for most consumers. When a car breaks down, an owner needs to fix it. In those situations, manufacturers pass the higher costs to the retailers, who then push it to the end consumer in the form of price increases. When this happens, sales revenue increases (because of the higher prices) while profit margins stay the same.

Highly differentiated and desirable products—like those with strong brand loyalty or high price points—we believe are also better positioned to weather the storm. To make the point, let’s walk through an example of a $100 high-end branded t-shirt sold through a department store. The store pays the manufacturer $70 for the shirt, but the product costs only $20 to make. So, of the $100 final price, only $20 would be subject to the 25% tariff. This comes out to a $5 tariff, or a 5% increase on the $100 price tag.

For the most part, customers of highly differentiated or high-end branded products are indifferent to a small–in this case 5%–bump. If the retailer decides to raise the t-shirt’s price, the cost would increase to $105, an indiscernible difference for someone willing to pay $100 for a t-shirt. And even if the full impact cannot be passed through as a price increase, the margins for many of these companies are incredibly high, so they can absorb any remaining pressure without too much of a profit hit.

For those goods that are not highly differentiated ($100 t-shirt), or of necessity (auto parts), the effect differs depending on the degree of category and company exposure.

Cross-Category Pressure

Some categories of goods are widely exposed to China—toys, for example (Display). If they decide to offset or minimize the impact of tariffs by raising prices, the category will collectively suffer because total volumes will go down as customers max out their disposable income set aside for these goods.

 

For instance, more than 80% of toys imported to the US are manufactured in China. If there is an import tariff on toys, then every company will experience the same cost increase and likely raise prices on consumers. Because one company is not any more exposed than another, market share will stay the same, while category sales volume will likely fall as consumers spend the same dollar amount on, now, fewer goods.

Individual Pain

While some categories may not be holistically hurt by tariffs, individual companies may. Companies with high relative exposure, especially those sourcing directly from China, may fare worse than their competitors. In this scenario, investors need to understand the percent of goods that comes from China, if a company uses an intermediary or goes direct, and how much flexibility it has in its supply chain.

Even if a company has high relative exposure, it still may have several levers available to lessen the blow. Some companies have the flexibility to reroute goods made in China to other geographic markets while they ship items manufactured outside of China to the US. They can also attempt to shift production to their other locales. Changing packaging to smaller sizes or lowering quality can also help mitigate the tariff impact.

How a company sources its products also plays a part. If a company works with a wholesale vendor who buys directly from a factory, the vendor can use their buying power to negotiate lower prices on behalf of their many customers. They can also spread the higher prices across their many customers, lessening the burden on any one customer. But if a company has no middleman, and sources products on its own, then exposure is worse. For a company that goes direct, it doesn’t have the same buying power, nor can it share the costs with others. As a result, the more vertically integrated a company, the more likely its margins will feel the brunt of the tariff cost or the more they will need to pass the cost increase on to their customers.

Hitting the Bottom Line

Margins are perhaps the most significant consideration when it comes to a company’s game plan. Companies with high margins can absorb price increases better than ones with compressed ones. For the higher margin companies that can eat the tariffs and not pass it to the end customer, they may be able to steal market share from their weaker competitors. Apparel retailers are a prime example. Traditional retailers have been overwhelmed with the movement to e-commerce. Already in a category “storm,” the impact of tariffs may drive certain retailers into deeper despair because their margins are already at compressed levels. For stronger retailers, the question is how much do they need or want to absorb?

A Tangled Web

Analyzing the impact of tariffs necessitates looking at second-order effects as well. For example, will the Chinese consumer “boycott” US-made goods or iconic American brands to retaliate against the tariffs? Or, will a slump in volumes because of the tariffs hurt the Chinese worker so that they are unable to buy US goods? Further, as US company management teams try to forecast their sales and margin expectations, their own lack of visibility may cause them to curtail investment, such as hiring or capital expenditures.

In this potentially prolonged period of uncertainty, understanding the idiosyncrasies of company exposure and the importance of management decisions is imperative.

For more on trends in the economy, markets, and asset allocation for long-term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.