From the June 2011 issue of Treasury & Risk magazine

In the Shadow of Inflation

Bracing for higher costs and interest rate hikes means rethinking just-in-time inventories, renewing cost-cutting and ramping up hedging strategies.

Ross Stores saw “pack-away” goods—those it buys and warehouses for six or more months—increase to 47% of consolidated inventories in February from 33% a year earlier. The company, which operates two off-price retail chains, also shaved its in-store inventories to run its business more efficiently. Both strategies will prove advantageous if inflation picks up, which seems likely given rising commodity prices and higher interest rates as governments seek to pay down enormous public debt. Hawaiian Airlines, which survived the 2008 spike in fuel prices, has also instituted a variety of policies to mitigate inflation.

Peter Ingram, CFO and treasurer of the Honolulu-based airline since 2005, says the company has implemented both operational and financial hedging strategies to smooth volatile fuel costs.

Ingram notes that airlines expect the aircraft they buy―enormous capital investments―to generate returns over extended periods, such as 25 years. Sudden leaps in the price of fuel, which comprises about 30% of Hawaiian Airlines’ expenses, can impact its ability to cover its costs related to acquisitions and remain in the black on a quarter-by-quarter basis.

“That’s where fuel hedging is beneficial to us,” Ingram says. “It’s absolutely the case that volatility from a management standpoint is more of a challenge than the high price levels. If prices are high for the next 10 years, a company can adjust its business to deal with that.”

Hawaiian Airlines, with 2010 revenue of $1.3 billion, has instituted operational strategies, including a project to centralize procurement, to deal not only with rising fuel costs but also other inflationary pressures.

On the retail front, pack-away goods may run contrary to the just-in-time inventory approach companies have touted recently. But if storage costs are low and consumer demand for the products has staying power, the goods can be sold down the road at highly competitive prices or at inflated prices for wider profit margins.

“A lot of manufacturers are looking to end the season clean and sell off products—[pack-away goods] tend to be basics, not trendy or fashionable,” says Bobbi Chaville, senior director of investor relations at Pleasanton, Calif.-based Ross, which had $7.9 billion in 2010 revenue.

More efficient store operations also add to the bottom line, which may otherwise be threatened by inflated costs. Ross Stores has pursued both business practices long before inflation fears arose, but its framework illustrates how certain industries—off-price retailers such as Ross and the larger TJX Cos.—may be well-positioned to deal with inflation.

“Relative to cost inflation, we have not seen a lot this spring,” Michael Balmuth, vice chairman and CEO at Ross, said in response to a question about its pack-away strategy in a fourth-quarter earnings call in March. “But certainly there is some coming, based on cost increases coming out of China, as we move into the back half of the year.”

More ominously, Ross’s pack-away success probably reflects the inflationary challenges already faced by other companies. Chaville notes that Ross buys mostly closeouts stemming from supply-chain disruptions and says such opportunities tend to increase as production costs rise. A vendor’s customers may shrink the size of their orders or cancel them altogether—a setback for the vendor but a boon for Ross.

“We found some terrific product—great brand names—that we thought would resonate with customers,” Chaville says about the pack-away increase.

Inflation, which has remained stubbornly low over the past few years, is now widely expected to accelerate as the rise in commodity prices is compounded by such factors as the growing cost of labor in China. Increasing pack-away inventory represents an operational strategy to mitigate inflationary risks. Some companies have applied financial strategies to prepare their assets and liabilities. However, both approaches carry risks and offer only short-term safeguards.

“In my 30 years in the business, I’ve never been with a company that strategically managed its business from an operating basis to directly mitigate anticipated inflation,” says Gary Silha, assistant treasurer at Tenneco, a manufacturer of automotive systems with $6 billion in 2010 revenue.

A company can “naturally try to get ahead of the curve on pricing” and perhaps source raw materials from less expensive suppliers, Silha says, but companies should always pursue those strategies.

Nevertheless, moves to mitigate inflation can at least smooth some of the cost bumps. Jeff Sica, president and chief investment officer for Morristown, N.J.-based Sica Wealth Management, which manages more than $1 billion in assets for institutions and family offices, says he’s seen warehouses along the Interstate 95 corridor in Maryland filling up since the start of the year. The highway feeds into much of the Northeast region, so it’s a strategic location to store goods.

Sica’s firm manages some of those warehouses for clients, who lease them to big-box stores such as Target and Costco, which appear to be pursuing a version of the pack-away strategy. “I’ve noticed they’ve been stockpiling,” Sica says. “They’re going into the non-perishables that can be stored, especially things like clothing and products that last and have been affected by rising commodity prices, such as cotton.”

Sica notes that excessive inventory becomes problematic if it’s not managed correctly. Still, it's less expensive to store goods in a warehouse than a store.

Kathee Tesija, executive vice president for merchandising at Target, noted in the giant retailer’s earnings call in February that it is seeing cost pressures not only on cotton, but also other fabrics, in addition to food and other products.

“Target’s goal is to maintain our gross margin rates within categories by addressing cost pressures in a variety of ways,” Tesija said.

In one approach, Target, with $67.4 billion in 2011 revenue, researched which features on store clothing brands, such as Mossimo and Merona, matter to customers. That’s enabled it to develop products “with features that add real value,” according to Tesija. For example, customers may not need pockets on a jacket, so Target can remove them to save fabric.

The retailer has also tried to standardize fabrics across multiple items and categories, allowing mills to achieve greater scale and reduce production costs. And Target is paying close attention to pricing to balance providing value to customers with remaining competitive and earning the gross margins it has defined for specific categories of products.

Nevertheless, Tesija said, “while these efforts will mitigate some of the impact, in some cases we will need to raise prices to offset higher costs.”

Some of Hawaiian Airlines’ competitors, such as Aloha Airlines and ATA Airlines, succumbed to surging fuel prices in 2008. Hawaiian filled the market void they left, which helped increase  revenues and offset its own soaring costs. That 2008 experience also prompted a series of cost-cutting measures that should help it weather today’s rising costs.

For example, the airline began a project a year ago to centralize procurement, eliminating redundancies caused by the operating units acting as silos. The company can now use its human resources—its second biggest expense item—more efficiently while focusing resources to procure supplies more cost-effectively.

“We’ve recently invested more in people to deal with the analysis of, and the negotiation with, vendors and to make sure from a contractual standpoint we have relationships that work for us and the suppliers,” says Ingram.   

Hawaiian Airlines also acquired fuel-efficient Airbus planes as fuel costs approached the 2008 peak and plans to eventually replace all of its older Boeing 767s. And it has begun bringing in fuel by tanker from lower-cost sources such as Singapore.

“With the benefits of our scale as one of the biggest fuel users at Honolulu International Airport, we have the buying power to justify an import contract,” Ingram says. “It allows us to access different fuel markets.”

When it comes to financial strategies, companies must consider how inflation affects both assets and liabilities. REI, a provider of outdoor clothing and equipment, is fortunate in that it has no debt. Corporate treasurer Russell Paquette says REI, with $1.7 billion in 2010 revenue, is “keeping an eye on the macro environment” but has “not made any significant or fundamental changes at this point in time.”

Nevertheless, he says, REI tends to marginally shorten the durations of its investments and take a laddered approach across the maturity spectrum. So REI, which is organized as a consumer cooperative, has a natural hedge if it needs cash. And the approach provides it with “the opportunity to participate in a rising rate environment should rates pop rather quickly or steadily in the months and years ahead,” Paquette says.

On the liability side, interest rates remain historically low, giving companies the opportunity to shift into low-cost, fixed-rate debt—whether by refinancing or using interest-rate swaps—to carry them through an inflationary period. FMC, for example, issued $300 million in 10-year notes in 2009, after the financial markets regained their equilibrium.

“We didn’t need all of the money at the time,” says Thomas Deas, corporate treasurer at the Philadelphia-based chemical manufacturer. “But our analysis showed that interest rates for the 10-year, even today, have been higher 95% of the time over the last 49 years.”

Sica recommends that clients maintain an active futures program, devoting a portion of their revenues to buying futures contracts on key supplies, particularly oil, which affects businesses more than any other commodity. “People who don’t want to spend money on gas won’t drive to McDonald’s,” he says.

The surge in the price of crude oil to more than $148 a barrel in 2008 “annihilated” a lot of companies, Sica says, and that may be why there’s currently a higher percentage of open contracts on oil now.

“It may mean investors are expecting that the price of oil could exceed the price it reached in 2008,” he says. “So even if they think there’s only a remote possibility it could happen, by hedging with futures, they won’t get caught again.”

Hawaiian Airlines hedges 40% of its fuel needs over the next 12 months, smoothing out price spikes that may occur. In addition to forward contacts, it buys call options that put a ceiling on the price it pays for fuel but allow it to take advantage of price declines as well.

“You pay a premium to counterparties, but we view that as an insurance policy similar to car insurance,” Ingram says.

Sica suggests that businesses calculate their potential losses from rising commodity prices and then devote a portion of their revenue to purchasing futures or other relevant derivatives contracts to hedge those losses. “You’re reducing your potential upside, but you’re also limiting the downside,” he says.

Treasury officials must actively manage such a derivatives program. “Hedging energy or other commodities is a short-term solution, because you’re only delaying the impact,” says Jeff Wallace, managing partner at Greenwich Treasury Advisors. “But you can smooth out some costs.”

Using derivatives to hedge inflation is difficult because price increases can take many forms, and accounting standards limit how companies can report financial hedges in their financial statements, potentially creating significant volatility in earnings that investors don’t like.

Current inflation concerns seem to have less to do with an overheated economy and instead reflect concerns about supply and financial contagion, says Ron D’Vari, CEO and co-founder of NewOak Capital Management, which advises banks and companies.

D’Vari cites the skyrocketing value of the yen after the tsunami amid expectations the Japanese will repatriate the currency to fund rebuilding. He describes such price swings as temporary in nature but says they require companies to consider currencies, commodities and other factors driving prices, and pursue diverse investment and hedging strategies.

“Companies have to figure out the world they operate in and how much of their business is driven by those factors—the risks in terms of cash coming in and going out—and then adequately hedge,” D’Vari says, adding, “The black swans are coming faster and more furiously.”

To read about how companies operating in China are coping with higher costs, see Defensive Tactics in China.

For a look at how accounting standard setters may affect companies’ efforts to cope with inflation, see Hedging Inflation and Other Risks.

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