What happens when a rational firm chooses not to raise prices? A lesson in tariffs and tradeoffs from Home Depot.
KEY TAKEAWAYS
MY HOT TAKES
Pick your poison. My regular followers know that I have an undying connection to certain, very basic economics concepts. Though I was exposed to many of them in my undergraduate, Freshman year four decades ago, they are so elemental that they still inform me in my analyses. One of those basic concepts is the theory of the firm, and the most basic of those concepts is that firms are rational.
You have read it right here many times, you have read it in my press quotes, and you have even seen me say it on national television. FIRMS ARE RATIONAL. That implies that a company will always do what is in its best interest. Think of it like a dog’s primordial quest for food. I don’t know about yours, but mine–Cavapoo Eloise–spends her waking hours thinking about and pursuing all manner of treats and food, only temporarily (very temporarily) diverting for a scratch or belly-rub.
Companies should, in theory, spend their waking hours pursuing profits. They should exploit every opportunity to maintain and increase profits, only constrained by law. Companies, though we sometimes attribute human qualities to them, are NOT human. They do not have emotion, and all decisions are rational and should aim to simply… increase profits.
As stock investors, we should take comfort in that notion, because it implies that corporate managers are working for us. Value for shareholders. We like that. Another even more elemental economic concept is monotonicity, or non-satiation in consumer theory. In plain terms, more is good. As consumers, we want more stuff, and as investors, we want more… well, profits. That is the basis for the bond we share with our investments.
All right, close your notebooks and put down your pencils. Let’s get to it. IMPORT TARIFFS ARE A TAX ON U.S. COMPANIES. I hope you have that concept down by now. Even though there is a 90-day truce between the US and China, there still remains a 30% tariff on certain imports. So, if a company imports laptops manufactured in China, it will pay US Customs a 30% tariff on those items. A keen eye would have caught the word “pay,” which quite clearly implies that those goods, to be resold to you and me will now cost the company 30% more.
A rational company will either seek a discount from the supplier or raise its prices to consumers in order to maintain margins. Rational companies do not care if it screws up your budget. A rational company may even attempt to pay its workers less in order to make up for the shortfall in margins.
As a consumer, you might be upset that the cost of the company’s product will go up. As a working person, you may be nervous that job cuts or pay decreases are coming.You expect this, because companies are rational.
However, as a stock investor, you are not nervous or upset, because you invest in a company with hopes that it will maximize your return. You want the company to be as profit-hungry as it can within the law–more profit is good.
So, what would you do if a company that you invested in just told you that its costs are going higher and that it won’t pass those additional costs to consumers? Well, I suppose you would be happy as a consumer but peeved as an investor. Should you even invest in a company that is not perpetually pursuing profits? This is your dilemma as a consumer and shareholder.
In the real world, Home Depot announced its earnings yesterday. The company missed slightly on EPS but beat on Revenues. To investors’ delight, the company maintained its full-year guidance. In its earnings call, Billy Bastek, EVP Merchandising said that despite increased costs from tariffs, the company “didn’t see broad-based price increases for [its] customers at all going forward.” In other words, the company will absorb the extra costs.
Well, if you are planning on building a new deck this summer, or maybe getting one of those snazzy new smokers, you would be pleased. As a shareholder, you are probably upset. Management is intentionally choosing to make less profit.
You’re thinking, “there must be some mistake.” There isn’t! According to some awesome analysis by my friends at Bloomberg, Home Depot is estimated to have a 7% blended tariff rate. That would ultimately decrease pre-tax earnings by 5.6%. As many use P/E multiples to value the company, there may be an impairment. If the company's PE stays the same, we can assume that the company will instantly be overvalued by 5.6%. That being the case, one of two things can occur. The price and price targets will go down, or the PE multiple will go up which implies that it is more expensive, which ultimately leads back to lower prices. You see, it is all a big mess.
You may be thinking, “the company should just do the rational thing and increase prices by 5.6%.” But wait, there is more to this story. Home Depot management also said that it would use this as an opportunity to gain market share. In that case, HD is banking on Lowe’s raising its prices to compensate for tariffs. As most of the company's products are commodities, rational consumers will simply buy the cheaper hammer from Home Depot. Wow, now stealing market share from a competitor is VERY RATIONAL. Rational? Yes, but overvalued at the moment? Also yes… unless Lowe’s also absorbs its additional costs. We will find out later this morning when Lowe’s has its earnings call. Lowe’s already announced results. It beat on both EPS and Revenues, bettering its competitor. It has a higher blended tariff rate than Home Depot, but it relies less on imports than Home Depot.
So where does this all lead us? We are either going to pay more for hardware store items, or we are going to have to accept that Home Depot’s stock is possibly overvalued. Are you thinking what I am thinking? Tariffs are simply irrational.
YESTERDAY’S MARKETS
Stocks took a breather yesterday after a 5-day winning streak spurred from a nearing tax bill, trade talk progress, and no spooky news from the economy. Though inflation is still a worry for investors on this slow economic release week, headlines from Congress are enough to keep things lively. Longer-maturity yields remain in a holding pattern, despite Moody’s downgrade, which appears to have melted into the broth of worry.
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