Pricing Power and Playing with Payment Terms DAVID GUSTIN, Chief Strategy Officer, The Interface Financial Group March 12, 2019 8:00 AM | David Gustin is the chief strategy officer for The Interface Financial Group responsible for digital supply chain finance and is a contributing author to Trade Financing Matters. “When an inflation regime shifts, there’s only one question that really matters for your business model: Do you have pricing power?” — Ben Hunt, Epsilon Theory I wrote a popular piece many moons ago titled Why Walmart Does Not Delay Payment by One Day. With all this hoopla around big companies pushing out terms to suppliers, and big news media like the WSJ (Delaying Payments to Suppliers Helps Companies Unlock Cash) and Forbes occasionally picking up these stories, I thought it would be good to revisit this topic in light of the current economic climate. In my piece, I said: “Extending payment terms is only one of many variables that need to be examined. It’s why Walmart just does not go ahead and delay payment by one day — given their outstanding payables, it would have a large positive impact on their balance sheet, just changing terms by a day. Why don’t they? Because they can’t measure the impact on public relations, on a supplier pricing its merchandise, on supplier failure, etc. That’s why you don’t shoot yourself in the foot.” Essentially, a supplier is not a supplier, and counterparty relationships are typically much more complex, especially for big companies buying from big companies. Yes, what is referred to as the “long tail” can be put in a vise, and this is most certainly what the news articles are really referring to. What Does the Data Show? The source that most pundits turn to is the Hackett data. And its recent numbers show U.S. public companies are holding back payments for an average of 56.7 days, longer than any point in the past decade. For many large companies, extending terms is the easiest way to hold on to cash and make working capital your suppliers’ problem. There are countless examples of large public companies with terms that seem to go beyond common sense. Will this stop? Is this morally right? I’m not here to pass judgment, but what I would like to better understand is how will inflation impact a supplier’s ability to pass along price increases. You see, one thing that no one has any data on is how payment-term extensions impact future pricing negotiations with suppliers. Now, yes, if you are part of that long tail, I am sure many times you are competing for bids in a very competitive environment, and perhaps even through e-auctions, so this is not about you. Remember, we have been living in a deflationary world for a long time. Inflation occurs when sellers raise prices. As 1996 Nobel laureate William Vickery said, companies can do this profitably when the forces of competition are weakened by the differentiation of products, real and factitious; misleading adverting, obfuscating sales gimmicks and package deals, mergers and takeover, and the increasing importance of ancillary services, trade secrets, patents, copyrights, economies of scale, etc. He reminded us that inflation does occur in the midst of underutilized resources. So how do firms protect their margins and maintain pricing power in the midst of rising costs? Certainly, providing a useful service, product, ingredient, etc. is essential, but it’s more than that. I mean if you are commoditized in a rising cost environment, your margins will shrink, period. The fact is a long-term deflationary environment has eroded corporate pricing power and forced frustrated managers to look in every direction for ways to hold the line. So many factors have eroded corporate pricing power over the last few decades that the idea of increasing prices seems ludicrous. But creating a narrative around the changes going on in the industry can lead to opportunities, especially as inflation starts showing its head unexpectantly. We are seeing it in labor markets, the freight and logistics market, and some commodity markets. For example, if you look at the paper industry, an industry that has undergone tremendous changes over the last decade (paper, cardboard, etc.) the story is the growing opportunity that e-commerce has presented to containerboard. With regulation, the story is around how the Federal Trade Commission, is seen to be very pro business. For example, the approval of the Staples-Essendant merger sets a dangerous anti-competitive precedent and allows Staples to control the office supply wholesaling market and therefore its competitors. That’s pricing power. To maintain pricing power, suppliers need to account for their customer’s needs and value expectations on many levels. How do buyers and suppliers determine value, and how does that value translate into a price tag? How is the value of different products relatively determined? And what other factors contribute to fuel purchasing decisions besides price alone? Tying Supplier Pricing and DPO Extension So how do I tie this together with DPO extension? Remember, we have been living in a long era of disinflation. That era will come to an end, and it appears it may be ending now. Pushing terms out to suppliers who may have more pricing power than believed could have some implications down the road. Because we have no way of measuring the impact of term extension tied to future price increases, many look just to the working capital gains of large companies’ DPO extension. But as Warren Buffett once said: “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.” Just some food for thought as we dig deeper on this issue.