#20: We’re Talking Tariffs (Again)
A stream of consciousness on tariffs, cash flow chaos, and survival strategies
Welp. More market volatility. More policy whiplash. Every day brings about a new challenge for consumer brand operators. And each challenge presents short, medium, and long-term implications that appear to work against each other. Let me explain.
Today, if you ship product from China to the US, you’re paying more than double the price you used to pay for the goods, thanks to the 145% tariff (ie a $10 product now costs $24.50). We discussed in ‘How Tariffs will Gut Consumer Brands’, the new tariff policy breaks the P&L. In many cases, adjusted unit economics (post-tariff) result in a loss, and that’s before you think about advertising.
If you’re an American brand sourcing your product from China, I believe the current trade war is a more disastrous scenario than the pandemic. For my finance crowd, strap in as you’ll like this one. For everyone else, stay relentlessly curious and keep reading.
The pandemic created an income statement problem. Demand dried up as the world shut down. However, a company with a strong balance sheet, inclusive of ample cash reserves, could weather the storm because it was only a matter of time until demand came back. Besides inventory delays and temporarily higher shipment prices, most healthy businesses stayed structurally unaffected.
On the other hand, the trade war creates both an income statement (P&L) problem and a cash flow statement problem (which will ultimately bust the balance sheet). When your inventory arrives from China, you must outlay 1.45x the value of the goods to Uncle Sam. In last week’s tariff breakout, this took your gross margin from 74% to 49% on a $10 COGS item that you sell for $50.
And that’s only touching upon the P&L. The tariff bill doesn’t create an asset (as inventory does); it’s simply an expense that eats at your cash pile. You’ll have to find a way to make this back. More on it later.
The consumer goods industry operates under a cash intensive business model, evident through long cash conversion cycles (ie how long it takes to get your money back). You may pay a factory in China to produce your goods today but not receive the product in the US for another 90 days. Then you must store it, market it, and ship it to the end consumer before you get paid. You may not see a dollar back until 90 to 180 days after you first paid. With that being said, it’s important to negotiate with your manufacturer as there are plenty of concessions they can make around a partial deposit, net payment terms, and pass-through cost reductions. However, this can be the topic of another post.
Fast forward to the product finally landing in the US. You just paid an arm and a leg for it and are ready to sell.
But shoot. If you stick to your old price, you’ll lose money on every unit. Raising prices will solve the problem. Straightforward, right?
Not exactly.
Unless you’re selling a truly price inelastic product (if you’re a consumer brand, trust me, you’re not), price increases are likely to decrease demand. Your unit velocity slows down, revenue falls, and storage fees start to increase since product is sitting at the warehouse for longer.
The negative effects associated with this scenario can snowball quickly because the cash you outlaid many months ago hasn’t been recouped. And this makes it tougher to invest in brand marketing campaigns or new product launches. Growth takes cash and if demand for your product falls, cash dries up. You’re stuck in no-man’s-land, trying to get back the cash from the overpriced products. As a result, your cash on hand continues to dwindle as you continue to pay employees, rent, and vendors. Unless you raise another round of funding to rehab the balance sheet (which you don’t want to do coming from a disadvantaged position), good luck trying to grow revenue year over year. The tariff spike exacerbates this scenario exponentially.
But here’s where it gets tricky. Is raising prices the wise, long-term play?
Hear me out: you raise prices today to slow down demand, allowing you to live on your current inventory stockpile for longer. It’s crucial to note that the tariff hike only applies to newly imported goods. All your inventory on-hand today is tariff hike-free. So, if you can delay having to place a purchase order from China for a few months, you may be in a much stronger spot (assuming tariffs fall). What you’re effectively doing is trading the news and making a bet that the US vs. China trade war will cool down.
Think of your inventory in vintages: like wine, the timing matters. The old vintage is what you have at the US warehouse today, and the new vintage is going to land at a much lower margin profile. Analyzing what you can do to prolong the old vintage may ease some existential pressure on your future self.
Short-term loss for a long-term win. You may be able to delay locking in a significantly higher per unit cost, allowing you to lower prices in the medium and long term and gain back that demand you lost from the price hike. This scenario creates optionality for brands that are currently sitting on excess inventory. And the consumer is only hurt in the short term, theoretically. It’s unlikely that China tariffs drop back down to 20%, so I’d expect some sort of price increase. But thankfully, the price increase won’t need to be as drastic, and brands won’t be as constrained on cash.
All this scenario analysis hinges on the outcome of the trade war. It could simmer down tomorrow. It could prolong for years. Right now, business planning for consumer brands is at the expert level. Know your financials, know your suppliers, and know your supply chain. But most importantly, volatility provides an opportunity to play offense while others are only considering defense.