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Inflation, Debt and Shortages Pose Challenges Despite a Strong Economic Recovery

Date: Sep 23, 2021 @ 07:00 AM
Filed Under: Industry Insights

Did Someone Say, Pandemic?

Despite a year disrupted by a global pandemic that spurred a 34 percent drop in the S&P to 2,237, an unemployment rate of nearly 15 percent, and a horribly low labor force participation rate of 60 percent – consumers still managed to pay down credit card debt and set the stage for robust economic growth.

According to Experian, from Q3 2019 to Q3 2021, credit card balances fell 24 percent, the first drop in credit card debt in eight years. Consumers are flush with cash and have the highest savings rate since WWII. Interest rates are at historic lows, and money is easy. The U.S. government injected a massive amount of cash into our economy, and most businesses found Payroll Protection Program (PPP) “loans” to be a generous equity infusion from Uncle Sam. As a result, and in spite of Covid-19 and the surging Delta variant, our consumer-driven economy is humming along with robust GDP growth and commercial borrowers boasting strong balance sheets and healthy backlogs.
After suffering bad Covid-19 symptoms in the spring of 2020, equities markets have since shown incredible immunity. By September 2021, the S&P had hit more than 52 highs and, even as I write this, it sits at 4,537 – yet another all-time high. Equities prices have remained on a steady upward climb, doubling off the low (March of 2020) faster than after any other correction even in the face of ongoing pandemic-driven uncertainty. During this boom, the S&P 500 has not seen a single drop of five percent or more since November 2020.

Yet, our firm has seen a significant uptick in conversations with distressed companies and some people, me included, see reasons to think that many businesses are headed for a rough patch. How can this be? What could possibly go wrong that would lead to defaults for some of your credits?

There are potential boogiemen appearing in the paths of businesses and lurking around corners to soon rear their ugly heads. Their names are:

  • Inflation
  • Reduced liquidity (consumer and corporate)
  • Excess corporate debt
  • Shortages (labor and materials)

Consumers are in for a Reality Check

Stimulus check savings are gradually being spent down and consumers are falling gradually back into old patterns (no surprise, that’s why they are called “old patterns”).  In the G.19 report on August 4, the Fed revealed that the highest jump in household debt in 14 years occurred in the second quarter. Consumers are showing a willingness to use credit cards for luxury items, like vacations, dining out, and new furniture. A survey found 44 percent of people willing to take on debt in the second half of 2021 for non-essential purchases. This all bodes well for the short term; there will be spending – and a lot of it. But we all know what follows periods of frothy spending.

Many Businesses Aren’t in the Clear...Yet

Low interest rates and relatively easy money have led to a lot of borrowing over a long period of time. Currently, massive amounts of debt are held by non-financials at very low interest rates. At the same time, we are experiencing inflation, some of which is certainly, as the Fed likes to say, “transitory,” and some of which is likely not. According to Forbes, for the last three months, consumer inflation as measured by the CPI has crept up from five percent in May to 5.4 percent in June and July compared to a year ago.  

Economic cycles being what they are, high levels of debt and inflation lead to rising interest rates and, eventually, a recession. Simultaneous to this eventual pressure on interest rates for businesses, consumers will start to feel some other pressures. The stimulus checks will have been spent, rents will have to be paid as the eviction moratorium fades, and credit card debt will creep back up reducing purchasing power.

Rising rates will cripple those businesses with too much debt. And it may happen at the very moment there is less demand for their product. PPP funds have given businesses staying power, but all those funds will be spent down by the end of this year. Many businesses will be left with a cash cushion, but it won’t last forever.

In the meantime, even with very healthy backlogs and eager customers, many companies are struggling to capitalize on this surge in demand. They can’t hire enough labor and/or they lack product and face long lead times. This is a challenge for nearly every business manager. As reported by the Federal Reserve Economic Data St. Louis Fed, with information sourced by the Organization for Economic Co-operation and Development, by May of 2021 there were approximately 9.2 million unfilled job vacancies in the U.S., up from just over seven million in February of 2020. With shortages on everything from coffee to cars, computer chips, plywood, shipping containers, and even food ingredients, much of the pent-up demand we are all banking on will go unfulfilled.  

These supply chain issues create substantial cashflow challenges for many businesses. For example, a small manufacturer that used to buy raw materials “just in time” with 30-day terms, is now having to buy large quantities of materials, often COD (cash on delivery) or even cash in advance, for orders or work still months out from being completed and billed. By the time this hypothetical business gets, converts, and sells products and collects the related accounts receivable, it may have a cash cycle of five or more months versus the one or two months it is accustomed to. Velocity and cashflow, of course, are critical to the health of most businesses.

Additionally, many smaller debt-laden manufacturers do not have the resources to retrofit facilities to operate in a Covid-safe manner and to attract workers back into the plant. Nor do they have the resources to automate to fill the gaps left by workers unwilling to physically return to work due to associated risks, or worse, that have moved on in the Great Resignation.

A Plan for Forward Movement

For those businesses stuck in this negative paradigm, there exists an urgent need to consider one of the following plans:

  • Acquire debt financing that is flexible enough to get the business through this transitory period.
  • Raise or infuse equity to help with the balance sheet and liquidity. The market remains crowded with private equity looking to allocate resources.
  • Sell the business to a financially stronger suitor before it hits the cash flow wall or loses customers because it is unable to keep up with orders. Sellers are enjoying historically high valuations.

The good news for these stretched thin companies is that the readers of this publication are in a position to step in and help. Many asset-based lenders are getting creative and stepping up with increasingly creative and flexible offerings – presumably motivated by their own economic interests and a desire to best serve their borrowers.

Of course, with raging demand and low interest rates, most businesses are well-positioned to thrive in the near term. They do have the liquidity to deal with these potential challenges and opportunity abounds. These stronger organizations will:

  • Invest to further automate, attract quality human capital, keep workers safe, and use technology to make sure the business operates smoothly even when some workers will need to stay home
  • Develop multiple sources for product, build safety stock, and move from “just in time” to “just in case” inventory management.
  • Grab market share by promoting shorter lead times and more stable pricing options, while enjoying the healthy margins they can demand.

Reader Be Warned

A word of caution that comes to mind when we combine past observations with current conversations with management teams expressing frustration and struggles around inflation and shortages:

Businesses must be careful about overreacting and stocking up on product(s) at high prices or going too deep into futures contracts. It can be difficult to compete profitably if prices fall and competitors are later buying materials at a substantial discount on what the aggressive hoarder paid. We see construction companies stockpiling certain materials at soaring prices, and agricultural businesses and big fuel consumers stretched in hedging positions facing margin calls or potentially pricing themselves out of competition six to 12 months out.

For those business owners that are considering an exit in the near to medium turn, this is a time to think about when, not if, we are likely to see higher interest – and hence, lower multiples for sellers – and when, not if, the next downturn is likely to come.

The pressing question for these leaders is: How can we best position to sell before that recession?

Credit officers, underwriters, and workout lenders will be well-served to evaluate each credit with an eye towards how the management team is responding and preparing for the likely threats ahead, and if their financial statements indicate the wherewithal to thrive through them.

Ken Mann
Managing Director | SC&H Capital
Ken Mann is a Managing Director at SC&H Capital, a leading investment banking and advisory firm, where he spearheads the Special Situations team in providing distressed M&A advisory to private company business owners and offering appropriate, innovative solutions for even the most complex circumstances. With more than 25 years of experience, Mann leads the team’s go-to-market strategy, lender and attorney interface, offer and purchase agreement negotiation, and everything in between to earn the trust and respect of the entrepreneurs with whom he works.
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