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In the last few months, the effects of increasing inflation are evident…increasing oil prices, upward wage pressures, higher interest rates, and the rising Yuan.  So what is the impact of expanding inflation on multi-channel marketers?

Inflation:
Let’s start at the top of the income statement − SALES.  Presumably, if inflation increases multi-channel merchants can increase prices.  After all, isn’t that what inflation is all about? However, inflation is not a smooth process that hits across all categories at the same time or at the same rate.  In the past several years we have seen increasing commodity prices, with only modest price changes in finished goods, especially those imported from the Far East.  If your business relies upon raw materials of items in which prices have increased, you may or may not be able to pass on those cost increases to your customers.  (Don’t forget, postage is a raw material for multi-channel marketers, and we know its price is increasing.) If you have increased prices, then hopefully your profits have improved with the price increases; if not, then you must find other places to decrease costs, increase productivity, or suffer decreased profits.

So then, if you are able to increase prices, there is still much to understand. On the positive side, small increases in prices without resulting unit decreases can lead to greatly improved profits, and demonstrate your products’ favorable inelasticity of demand.  Unfortunately, costs have been increasing, but many merchants have been unable in the past few years to increase prices, or, perhaps more accurately, have not dared to increase prices.  Expenditures such as postage and freight need to be absorbed by lowering costs of merchandise, reducing labor, and/or improving productivity.  Technology has helped on improving productivity and achieving labor savings. Imports from China, fortunately, have kept product prices low. In an inflationary world, the increased profits just pay for increased costs and keep “real price” profits constant.  BUT, please note the qualifying language – without resulting unit decreases. 

Demand Curve:
It is no secret that the demand curve works.  The higher the price, the lower the unit demand. You may raise prices, but end up with lower unit sales resulting in the same or slightly higher total dollar sales.  This is a recipe for disaster over the long term.  While dollar sales and profits may increase in an inflationary world, you must pay close attention to unit volume so as not to: 1) give up market share; 2) allow for new low cost competitors; and 3) maintain economies of scale and volume efficiencies.   If your costs are rising, you must test whether your customers can absorb your price increases.  What is their price elasticity of demand?  Will your price increases lower unit volumes while keeping dollar volume and profits constant? 

If your customers are unwilling to pay more for the same items, then you are left with a very difficult choice― lower profits or lower unit volume.

Inflation also plays havoc with discretionary income which affects consumer demand.  Without corresponding increases in incomes, rising prices will erode discretionary income.  Just look at gas prices and how much the run up has affected spending in other sectors.  While demand for housing, heat, and food may not suffer, most of what is bought through direct marketing are discretionary purchases that can be deferred.  So, even if your prices don’t increase, your customers’ decreasing discretionary income can hurt demand for your products.

Lifetime Value:
Next let’s look at what happens to LIFETIME VALUE (LTV). Lifetime value is the net present value of the contribution of a group of customers over an extended time period. Two things happen with inflation.  First, dollar contribution must continue to increase to keep pace with inflation or lifetime value decreases.  The lower profits of the first scenario – increasing costs without increasing your prices― destroys contribution and lifetime value. Second, if interest rates increase, as they will in an inflationary environment, then discount rates increase, which also lowers lifetime values. After all, the time value of money decreases the value of profits in the future.

Lower LTV generally means less prospecting.  Why invest in new customers that do not measure up to the cost of acquiring them?  Less prospecting means smaller house files, lower volumes, and ultimately fewer profits.

Lower LTV, smaller house files, and higher interest rates will also translate into lower valuations for businesses.  While market prices determine valuations, valuations are in part driven by discounted cash flow analyses.  What is the future likely to bring?  Here we have several factors in play.  Will unit and new customer growth be slowed as prospecting becomes less profitable?  Will higher interest rates lead to higher discount rates and lower values for sales/profits/contributions further out in the future?  Yes, to both questions.  While an abundance of money is out there to purchase multi-channel merchants, and there is a limited supply of attractive acquisition candidates, valuations have remained high. (Supply and demand even works at the enterprise value level). Still, multiples are already beginning to drop ever so slightly.  If interest rates continue to rise, as it seems they will, valuations will come under pressure.

Conclusion:
Clearly, controlling inflation is the mandate of the Federal Reserve.  Its new chairman is determined to keep inflation under control, but not everything is within his control.  Oil and commodity prices, China, and an improving world economy are all pressures on inflation. While you can’t control inflation, you can counteract its effects by making the necessary management decisions, namely selective price increases, careful cost containment in controllable areas, and close scrutiny of prospecting circulation plans.

Stuart Rose is a Managing Director at Tully & Holland, Inc. and a regular contributor to Multichannel Merchant.  Tully & Holland are specialists in corporate finance serving retailers, direct marketers, and consumer product manufacturers, and is a member of FINRA, DMA and NEMOA.