Tools of the Trade War
Middle market businesses can’t escape the effects of tariffs, but can they mitigate their impact and prevent them from slowing growth?
For more than a year, tariffs have loomed over the U.S. economy. From duties on steel and aluminum imports to retaliatory tariffs on agricultural products, the global market is constantly shifting and companies are trying to figure out how to respond.
Uncertainty about the long-term future makes the situation even more precarious. As trade negotiations continue, some tariffs get suspended, while others are called off or delayed only to be re-imposed soon after.
Still, products worth more than $120 billion in trade value are being affected, and middle market firms are already feeling the impact. Unlike larger companies, these firms have less capacity to absorb tariffs.
About one-third of mid-market companies report they are being forced to seek out new, lower cost suppliers for raw materials. Half plan to raise prices or reduce their business investments and more than a third are expecting their profit margins to fall.[i]
“It’s tough to manage a certain level of profitability when you don’t know what some of your costs will be,” notes TJ Monico, Managing Director for Industrial Investment Banking at KeyBanc Capital Markets.
Not All Tariffs Are Created Equal
The impact of tariffs hasn’t been uniform and largely depends on the industry a business is in, explains Phillip Gibbs, Director, Metals Equity Research Analyst with KeyBanc Capital Markets.
Take steel producers. When duties of 25 percent on imported steel were announced in mid-2018, a move meant to bolster the domestic steel market, U.S. steel companies did get a sharp boost in demand. But steel customers went on the offensive to stockpile those metals for fear of shortages.
“People were worried about supply, and they pushed out their lead times,” Gibbs says. “That gave the steel companies pricing power.”
More than a year later, demand has softened as businesses are working through their reserves. “We have had a bit of a hangover,” Gibbs says. And now a slowing global economy is also dampening demand for steel. As a result, steel companies are likely to see revenues drop in coming quarters, Gibbs predicts.
And with agricultural prices down following a period of retaliatory tariffs in China, farmers have delayed purchases of farm equipment, which further erodes metals prices–and ultimately cuts into profits.
Shifting Supply Chains
With costs rising on Chinese goods, the country is no longer the low-cost producer it once was. As a result, many businesses are exploring other regions for their production and input needs. Vietnam, Cambodia, India and locations in Southern America are benefitting from the shift. “But, depending on the size of your business, [moving production] is not something you can do overnight,” says Monico.
Most companies can expect a long lead time and possible business disruption as they look to secure new suppliers.
“If you’re going to shift your supply chain, you have to first set up a factory, bring in equipment, hire people and then train those people,” says Ron Friedman, CPA with Marcum LLP. “That whole process takes a year.”
And while some countries make the grade on cost, there’s the matter of quality to consider. It might take years to bring these new producers up to the standards that businesses and their customers require. Still, Monico believes that if managed well, new supply chains could be a net positive.
“Over the longer term, making sure that you’re not beholden to one country for sources of supply of key products is good for business,” says Monico. “You can’t ever have too many relationships.”
Even firms that are successfully finding ways to move their supply chains and sell into different markets are still nervous about what’s next. Uncertainty has been the key characteristic of this trade war. As international negotiations continue, it’s unclear what the final result will be and whether the damage companies have sustained can be reversed.
With so many unknowns, the retail businesses that Friedman consults with are holding off on deploying their capital. “Businesses are less likely to invest in research development, expansion or hiring,” he says.
Uncertainty makes projections difficult, which could impact financing and mergers and acquisitions.
“Managing your business with this level of uncertainty in your supply chain is really disruptive,” says Monico. “Let’s say you’re buying inventory that’s going to be sold at a future date—it’s hard for you to know how to price your product.”
Building a Resilient Business
If there’s a silver lining to the trade war, it’s the hard lesson that businesses can’t rely on just one market to drive their success. They must diversify their supply chains and markets to be ready for whatever global trade throws their way. “I had a client say to me, ‘In a way [tariffs] are good for me because I was too dependent on China,'” Friedman says. “‘It’s now forcing me to diversify.'”
And there are ways to take advantage of a trade war. Companies that go head-to-head with Chinese firms are in a more enviable position. “If you’re a sustainable product, you are probably doing very well,” says Gibbs. By the same token, makers of highly specialized goods can resist trade pressures too because their customers don’t have anywhere else to go.
To cope with the uncertainty, businesses would be wise to hold off on tying up too much of their capital in the near term.
For example, when he consults with retail businesses, Friedman recommends starting an expansion with a pop-up shop instead of a brick-and-mortar location. If a retail concept catches fire, the company can create a few more pop-ups before signing a lease. If it’s not successful, then the company hasn’t wasted too much money on real estate, overhead and inventory.
Cutting costs and raising prices can insulate businesses from the effects of the trade war in the short term. Operating a diversified supply chain and building a strong value proposition can set a business up for long-term advantage. But no matter how the current trade tensions shake out, every company needs to evaluate its current operations to identify its risks–and the opportunities ahead.
“Over the longer term, making sure that you're not beholden to one country for sources of supply of key products is good for business.”
– TJ Monico, Managing Director for Industrial Investment Banking at KeyBanc Capital Markets