How Trade Wars Affect Corporate Performance

- Oct 09, 2018-

BOTH CHINA AND THE United States are in a tariff war with China imposing tariffs of $110 billion on U.S. goods and the U.S. imposing tariffs of $250 billion on Chinese goods. This is the biggest trade war in human history in terms of the value of goods affected, one launched by the world's biggest economy against the second-largest.

In preparing for launching more tariffs, the office of U.S. Trade Representative recently hosted a hearing on manufacturing companies.

Paul Czachor from American Keg Co. in Pottstown, Pennsylvania, says, "[Section] 301 tariffs would be effective in eliminating China's bad practices while having no economic harm to U.S. interests. It will effectively allow the U.S. to bring more jobs back and spur growth by allowing companies in the U.S. to be competitive making stainless steel kegs."

[See: 7 Ways to Shelter from a Trade War.]

Alternatively, Michael Kersey from American Lawn Mower Co. in Indianapolis, says, "We agree with the administration's primary goal with regards to tariffs. However, believing that tariffs on our products, electric lawn and garden tools will help USA manufacturing or USA jobs is like believing you can help a dog that was just run over by a car by putting your car in reverse and running over the dog backwards."

These dramatically different opinions about the tariffs are rooted in how a company is positioned on the export and import matrix, the company's position within the supply chain and on its global size.

If a firm is an importer, relying on parts, ingredients or chemicals imported from China to manufacture its products or providing services, then the company faces increases in the cost of the goods sold. Some of the companies can pass the higher cost to their customers by charging a higher price without harming sales. But not everyone can afford to do so. For companies operating in a very competitive market, their customers would switch to cheaper alternatives.

Molson Coors Brewing Co. (ticker: TAP) CEO says the company's market share would be "hammered" by just a 50-cent increase on a 12-pack beer cans. These firms will have to find ways to digest the hiked cost of goods. If not, their profit margin will go down, which will reduce their cash flows and limit their ability to invest and grow top lines. In the worst scenario, for firms with already thin profit margin, the tariff could push them off the cliff and out of business.

If a firm does not import from China but instead competes with Chinese companies who export similar products to the U.S., the firm could benefit in the short run as Chinese products become more expensive due to tariffs. This is true for American steel companies such as ArcelorMittal (MT), which says the tariffs the U.S. has slapped on steel imports are allowing it to charge higher prices. Likewise, the president of Southwire Co., an electrical wire, cable and cord manufacturer, says tariffs on certain cables would allow the company to remain profitable. Without the fierce price competition from Chinese products, those firms are able to charge a higher price.

[See: 9 ETFs for Nervous Investors.]

What happens to these companies will have a ripple effect along the entire supply chain, with different impacts on their distributors and customers. On the positive side, some may benefit from the improved production of the U.S. steel or cable companies, as they would demand more shipping and transportation service. But there would be negative spill-over effects for companies who use steel as raw material.

For example, Caterpillar (CAT), General Motors Co. (GM), and Harley-Davidson (HOG) – all heavy buyers of steel – say tariffs are cutting into their profits and forcing them to raise prices. And as Caterpillar raises prices, it will keep rippling down to its downstream companies who buy heavy machinery and cut into their profits.

What if the firm is an exporter? The whole point of this trade war is to reduce the trade deficit and increase U.S. exports to China. So how does this work for the beef industry? The cattle ranchers and the food processing companies will be happy if we ultimately succeed. But in the short run, they are the ones who got caught in the cross-fire and suffer most. China has issued retaliatory tariff on beef and pork of 25 percent in response. Tyson Foods (TSN) already cut sales forecasts and profit estimates due to foreseeable reduced exports.

But the biggest risk lies somewhere else. After a breakout of mad cow disease in 2003, U.S. beef was banned from the Chinese market and the ban was just lifted in 2017. During the 13 years of U.S. absence from China, South American countries become the largest suppliers to the rapidly growing Chinese market, such as Brazil and Uruguay. With the trade conflict in full swing, the ranchers and beef exporters may lose the growth opportunity in the Chinese market once again while other countries further solidify their market share in China.

Globalized firms will be hit most, but they also have the most flexibility to adjust. For global companies who have a convoluted supply chain over the globe, figuring out the impact of trade war is not easy.

Of course, the global firms are not going to be sitting ducks. They have more capability than domestic firms to adjust to the trade conflict by strategically redesigning the supply chain. For example, Steven Madden Ltd. (SHOO) announced in response to the 10 percent tariff on handbags from China that it will relocate plants to Cambodia. Similarly, Harley-Davidson announced it will move production sites overseas to avoid the high tariff on Chinese steel.

[See: 7 Small-Cap ETFs to Help You Win a Trade War.]

Those planning to relocate obviously don't believe the conflict is going to be resolved soon, as relocation is expensive, but cheaper than doing nothing. It involves lumpy capital expenditure and potentially higher labor cost that could hurt the profit margin. If the company increases prices to offset the downward push on bottom line, they may be able to keep their profit margin intact, but the impact on their top line is less promising.

Consumers will find substitutes unless the brand loyalty is high.

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