Leaders of the top US industrial companies gathered virtually this week for the annual Morgan Stanley Laguna conference. Unsurprisingly, much of the discussion centered around the rising cost of raw materials, labor and logistics and the increasingly diﬃcult challenge of getting enough supply to keep up with demand.
"The inﬂation is unprecedented," 3M Co Chief Financial Oﬃcer Monish Patolawala said at the conference, warning that the impact from higher input and freight prices on its 2021 earnings would now be at the higher end of the range the company gave in July.
Trane Technologies Plc's CFO Chris Kuehn echoed the sentiment: "Unprecedented is the word we'd use around the inﬂation side," he said. After a series of similar presentations, Morgan Stanley analyst Josh Pokrzywinski joked that attendees could check the word "unprecedented" oﬀ their bingo cards.
Of course, the current level of inﬂation isn't unprecedented — it is notable, though. The Federal Reserve Bank of Cleveland compiles a median measure of US consumer prices in an eﬀort to give a better snapshot of true underlying inﬂation. This gauge increased in August at the fastest monthly rate since early 2007, suggesting that consumer prices as a whole are continuing to march higher even as more dramatic escalations in used-car and airfare costs are tempering.
Prices are rising in a way that they haven't in more than a decade. But the US economy has in fact had it worse.
Whichever way you choose to slice and dice consumer price data — and there are many ways to do so and arrive at wildly different conclusions — no benchmark is even in the same zip code as the out-of-control inflation of the 1970s. But as my Bloomberg Opinion colleague John Authers wrote this week, inflation doesn't need to be unprecedented to have meaningful consequences for the economy and markets.
The stickiness of price increases is in some ways as much about perception and expectations as it is about the underlying numbers. And on that front, manufacturing CEOs are speaking a completely different language than investors, who on the whole appear to be betting that the rise in costs is a short-lived phenomenon tied to pandemic disruptions.
General Electric Co CEO Larry Culp isn't one for hyperbole. He calls it like he sees it and to him, the inflationary pressures are "increasingly getting structural in nature." David Petratis, CEO of lock maker Allegion Plc, expects inflation to stick around for an extended period of two to three years and is positioning his company to be prepared for that. "It's not a transitory situation," he said. Eaton Corp. was expecting the supply-chain bottlenecks that have fueled some outsize price increases to ease this quarter. "Much to our surprise, and to the surprise, really I think of everybody in the industry, we've seen that things actually got materially worse," CEO Craig Arnold said. "I'm hopeful that by the time we get to the end of this year, things have settled a bit," he added. "But I'll acknowledge as well — we got it wrong. I think we all got it wrong." Eaton now expects to fall slightly short of its revenue guidance for the current quarter because it can't get the parts it needs to meet demand.
Nothing to See Here
Despite some notable earnings warnings, overall estimates for the S&P 500 Industrial Sector have held fairly steady
Carrier Global Corp. has already raised prices three times this year in an effort to stay ahead of rising costs but the company expects to have to increase them again, perhaps as soon as early January. "The reality is there's more to come," CEO David Gitlin said. Aerospace and defense giant Raytheon Technologies Corp. — Carrier's former parent company — primarily relies on long-term contracts so it has less flexibility to raise prices in response to "real" inflation in commodity costs and the beginnings of pressures on the labor front, CEO Greg Hayes said. "I wish I could tell you exactly how long this transitory inflation was going to last," he said, calling the 5.3% year-over-year gain in the headline consumer price index in August "a big number" and "something to keep an eye on."
One reason this inflationary environment may feel unprecedented for manufacturers is that the current pressures extend well beyond commodity prices. Industrial CEOs are accustomed to dealing with volatility in raw material costs and in general, they still expect metal and resin prices to normalize by the end of the year or the first quarter of 2022. Indeed, spot pricing indicates commodity costs are already starting to plateau, Dover Corp. CEO Richard Tobin said. But in an increasingly connected world, semiconductors are just as important as raw materials, and chip shortages are showing no signs of easing any time soon. There's no relief on shipping costs and logjams, either, and that's affecting companies' ability to get their hands on supplies of even more mundane items. Data-center equipment supplier Vertiv Holdings Co. is suffering from a lack of semiconductors but also fan blades.
The ISM's gauge of supplier delivery times has eased from May's multi-decade high but remains elevated on a historical basis. Readings above 50 indicate slowing deliveries.
"Things like that scare us because the industrial complex overall buys literally millions of disparate [stock units] of supply components to make their end products," Melius Research analyst Scott Davis said in a video update to investors. Manufacturers operate on carefully coordinated schedules and the knock-on effects of a delayed part are arguably more meaningful than the direct inflation impacts of shortages and rising freight costs.
"You can only make so many half-built units and put them in the parking lot," Dover's Tobin said. The best economic decision may be to shut down a plant until things normalize, but many of the company's products are components for larger systems and its customers are depending on it to deliver, Tobin said.
Dover is also mindful of compromising future demand by turning away orders. So it has to find a way to make it work. "We are forcing the product out the door, but it's costing us a lot to do it," Tobin said. "It's chicken-and-egg to a certain extent."
On a final note, one thing to keep in mind is that there's been a lot of turnover in the industrial leadership ranks over the past few years. The average CEO of an S&P 500 Industrial company was born in 1963. So they were alive during the gangbusters inflationary period of the 1970s but they weren't running businesses. Is the industrial inflation environment unprecedented? It depends on your perspective.
Arnold made those comments as part of his presentation at the Morgan Stanley industrials conference and the sentiment was echoed by Caterpillar Inc. CEO Jim Umpleby in an interview with Bloomberg News at a Las Vegas mining conference. In other words, the larger, brand-name manufacturers at the top of the food chain are having an easier time attracting workers than the lesser-known entities that supply them. This makes sense: The bigger companies have more resources to compete for scarce talent. But if one supplier can't get the workers to make a key part, the whole manufacturing enterprise is thrown off. So the supply chain's hiring problems are the big companies' problems, too. Both Eaton's Arnold and Dover CEO Tobin said they expected the labor availability issues to plateau soon, without elaborating on how or why they think so.
Deals, Activists and Corporate Governance
Canadian Pacific Railway Ltd's $31 billion takeover of Kansas City Southern is back on track. The two railroads formally agreed this week to a stock-and-cash deal after rival suitor Canadian National Railway Co dropped its pursuit.
This was something of a formality; the Surface Transportation Board effectively killed Canadian National's chance at a transaction in August when it rejected that company's proposal to use a voting-trust structure to speed the financial close of the deal. But it's a moment of vindication for Canadian Pacific CEO Keith Creel, who kept his head and declined to match Canadian National's higher offer, betting that a cleaner path to regulatory approval would ultimately be more valuable than a few extra dollars. The $300-a-share price Kansas City Southern agreed to this week is the same offer that the railroad rebuffed in early August when the Canadian National merger still looked like a possibility. Canadian Pacific and Kansas City Southern still need to receive final antitrust signoff for their combination, but the STB has already agreed to review the deal under older, more permissive standards and has approved their use of a voting trust. The drama isn't over for Canadian National, however. It will pocket a $700 million termination fee and get a refund for the $700 million it paid to cover the breakup fee owed to Canadian Pacific when Kansas City Southern first switched its allegiance. But Canadian National shareholder TCI Fund Management Ltd. plans to continue a push to oust CEO Jean-Jacques Ruest and several board members over the pursuit, arguing it was "ill-advised" and reflects a flawed understanding of the industry. Canadian National on Friday laid out a plan to trim spending and costs and ramp up share buybacks.
American Airlines Group Inc agreed to acquire a $200 million stake in Brazilian carrier Gol Linhas Aereas Inteligentes SA. The two airlines will also expand their commercial partnership with an exclusive code-sharing agreement that lasts for three years and connect their loyalty programs so passengers can enjoy reciprocal awards. Recall that earlier this year American launched a marketing partnership with JetBlue Airways Corp. that allows passengers to book flights on both carriers in the same itinerary and makes their frequent-flier programs compatible.
Trane agreed to buy Farrar Scientific, a maker of ultra-low-temperature control systems for the biopharmaceutical industry. Trane will pay $250 million upfront and then an additional $115 million if Farrar attains certain financial milestones by 2025. It's a smart deal in a market niche that's likely to grow in importance with the introduction of mRNA-based vaccines.
Brooke Sutherland is a Bloomberg Opinion columnist covering deals and industrial companies. She previously wrote an M&A column for Bloomberg News.
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.