Letter number 152 of October 2023

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News : Round table: How are companies reacting to inflation?

For those of you who weren’t available in Paris, here is the transcript of one of the two round tables we hosted.



Thank you Matthieu Malige, Group CFO of Carrefour, for agreeing to take part in this round table discussion on how companies are managing inflation. We haven’t seen Inflation this high since the mid-1980s which means that most professionals still in business have never experienced it. What's more, Western economies have seen on a downward trend in interest rates for the past 40 years. This trend seems to have reversed since the 1er half of this year. How do you see inflation developing, and do you think this situation will last?


Matthieu Malige:

I'm going to answer from the point of view of someone who manages a company, as I'm not an economist. Two years ago, during the first debates on inflation, the general view was that tensions in supply chains caused by the post-pandemic economic recovery would ease and that, as a result, inflation would be transitory. However, from our vantage point as a retailer, we were already seeing high raw materials prices at the time, and our suppliers were asking us for significant price increases, sometimes in double digits. It therefore seemed very likely to us that this inflation would be passed on to consumers and to the real economy. Very early on, we therefore forecast high and lasting inflation in 2022. Time has proved us right.

If we look at the outlook for 2023, our suppliers are asking us for increases of more than 10% in their new price lists. As for our operating costs, here too we expect inflation in 2023. We have increased salaries this year, which will have an effect in 2023. In 2022, we took advantage of hedges on our energy purchases, which will have less effect in 2023.

This is why we expect inflation to remain high in 2023. Against this backdrop, we’re speeding up the transformation of the company to enable us to lower our operating costs and absorb some of this inflation.



Do you anticipate an inflationary spiral in wages and costs?


Matthieu Malige:

In the short term, we expect inflation to remain at high levels. In 2022, there were significant pay rises. This obviously creates carryover effects into 2023. And, as I said earlier, we think there will still be inflation in 2023, so we think there could be significant wage inflation again next year.

Having said that, if I compare the situation with certain Latin American countries, where Carrefour is present, and which regularly experience high annual inflation rates, in Europe we do not yet have the reflexes or psychological logic associated with high and lasting inflation. And that's a good thing. I hope that this will contribute to a rapid return to normalised inflation.



What is Carrefour's attitude to financing in this new paradigm? Are you waiting for interest rates to fall? Will you seize the first window? Do you want to lock in for fear that long term, interest rates will shift again, or go for a floating rate to take advantage of a fall in short interest rates with an inverted yield curve?



Matthieu Malige:

For three years now, we’ve been operating in very volatile markets. For example, in April 2020 the bond market and the short-term commercial paper market were closed for several weeks. These are extraordinary situations. It is therefore essential to have a solid credit rating and to be able to seize the right market windows. Against this backdrop, and given that we believe that inflation could last and that interest rates could rise further, we decided to refinance early.



So that's the attitude of companies. What is the attitude of consumers? You said that we’re not in an inflationary context like in Latin America. But are we seeing, and you have a front-row seat, a change in consumer attitudes?


Matthieu Malige:

Consumer behaviour is changing, and changing fast. In the summer of 2021, the consensus was that this wave of inflation, which we could see coming, would have little impact on household consumption. Today things have changed. Let me give you two figures: in October 2022, food inflation in France was 12%, while growth in the food market  (in price AND volume) was 7%. So there's a 5-point difference linked to changes in consumption patterns. In practice, customers are buying more on special offer or prefer private labels or deep discount brand products.



Has Carrefour taken any specific measures to manage this inflation and this change in consumer behaviour?


Matthieu Malige:

In these situations, it's our job to stand by our customers. This is a time when household purchasing power is under pressure, and supporting our customers by providing them with the right solution is also a guarantee of loyalty. At Carrefour, we have mobilised all our forces to provide concrete solutions for consumers, with the hypermarket format for example, which is a discount format, but also with our Carrefour products, which are of the same or better quality than the major brands and are around 30% cheaper. Of course, this costs money, so we need to reduce our operating costs. Firstly, by reviewing all the company's processes, eliminating some that are not essential or redesigning others. Secondly, by investing in reducing energy consumption, the cost of which has risen sharply, we are making progress towards our CSR objectives. It is also possible to use the Group's balance sheet to make 'tactical' purchases at good prices and pass on the benefits to our consumers.



We read with great interest the Government's report, which stated that inflation had been passed on quickly without too much distortion in the value chain, i.e. that there were no players who had taken advantage of this mechanism to make ill-considered profits. Is that what you've observed, or do you think that some players have taken advantage?


Matthieu Malige:

We think it's very fluid. I was even surprised that people were surprised that there were no 'free riders'. As far as retailers are concerned, there is so much competition in all markets, so much price elasticity, that retailers are all making efforts to be competitive. In fact, if you look at profitability of the major retailers in Europe and the US in the first-half, you see a fall in profitability of between 30 and 80 basis points for companies generating around 3% EBIT. That's a significant drop. On the FMCG (Fast Moving Consumer Goods) side, which are the players with the most leverage in the value chain, it was good news to see that everyone had played the game.



More generally, what difference does it make for Carrefour to manage in a period of inflation? Is the manager's attitude different?


Matthieu Malige:

The economic and commercial model of a food retailer has historically been fairly stable. Usually, food consumption is fairly constant over time, and purchase prices are set once a year. In 2022, all that has been shattered. Consumers are adapting their consumption to inflation in a marked way. The selling price has to change regularly because supplier negotiations have become permanent. Costs also change regularly during the year, with energy inflation in particular. So the business model is constantly evolving. You have to anticipate and be responsive.

We have also made changes to certain management indicators. Sales, which are a key indicator in our industry, are heavily impacted by inflation and are therefore no longer sufficient to measure activity. We have supplemented it with the number of items sold, which is not subject to inflation. It's a whole organisation that has to monitor its activity differently.

So, as you can see, there's a lot of adaptation work involved in steering. And this is becoming a strategic issue: a company that adapts quickly in this environment maximises its chances of survival, and conversely, it can be a threat to companies that do not adapt quickly enough.



With the injection of liquidity by central banks, economists have often talked about asset price inflation. We have seen a correction since the start of the year, especially in the United States, but a little less so in Europe. In your opinion, is asset price inflation over now? Or are we still waiting for a correction?


Matthieu Malige:

This will depend on the environment and interest rates. What's interesting about this deflation of bubbles is that, even if it's painful to move away from an era of free money, it's actually quite healthy. By returning to a way of thinking in which money has a real cost, we are inducing a multitude of micro-decisions that are healthy. The most positive point for me concerns the issues linked to the energy transition. Until now, decisions concerning our environmental and climate objectives were implemented thanks to the responsibility of managers and directors who were convinced that the issue of global warming had to be tackled. Today, there is much greater alignment between financial and CSR objectives.



What leadership qualities are needed in a post-Covid crisis?


Matthieu Malige:

I believe that today, knowing how to deal with a crisis has become a basic part of a manager's 'toolbox'. To navigate in today's environment of crisis(es), I think you first need to be very clear-headed - and that's not always easy. Secondly, you need to be proactive, identifying the implications for your business at an early stage. Finally, you have to ensure that the organisation reacts very quickly.


Question from the public:

Are your information systems able to track, for example, sourcing, and for transport costs, the origin of products? Because you said that your supermarket manager used to look at turnover and now looks at volume, so does your information system take account of volumes, sourcing and things like that, and how can you adapt it?


Matthieu Malige:

There are many systems that integrate this, but not everywhere, so we need to develop and invest. At Carrefour, we are fortunate to have been present in Latin America for some fifty years. The first thing we did just over a year ago was to set up internal round tables, which enabled us to anticipate, including by investing in technology.


Statistics : Operating risk and debt level

On Chapter 35 of the Vernimmen we explain that a company should not (and generally cannot) combine high operational risk with high financial risk. Thus, companies operating in an intrinsically high-risk industry (high fixed costs, low visibility on future revenues, high technological risk, etc.) will choose (or be forced to choose) a financial structure with low leverage.

A recent financial study[1] demonstrates this in practice. It shows a fairly strong negative correlation between the beta of the operating assets of companies' business sectors, which reflects their economic risk, and the proportion of enterprise value financed by net debt:


[1] M. Mauboussin, D. Callahan, « Cost of capital – A practical guide to measuring opportunity cost », Morgan Stanley Investment Managers – Counterpoint Global – Consilient Observer, 15 February 2023.

Research : Are mutual fund customers really smart?

With Simon Gueguen, lecturer-researcher at CY Cergy Paris University


Mutual fund clients are usually considered to be more sophisticated (or smarter) investors than those who simply deposit their savings in bank savings accounts or current accounts. The overwhelming majority of these clients are households (over 90% in the US market since 2000). Is their investment behaviour really more in line with the financial principle of rationality than that observed in the average population? Theoretical models almost always assume that competition between funds is based on their effective financial performance taking risk into account, in other words on the alpha generated by the funds over the long term. This should be the case if clients were rational. The article we present this month[1] provides strong empirical evidence against this hypothesis: mutual fund clients appear to be less than rational. They naively invest according to the absolute performance of funds without taking into account the effects of market movements, and ignoring valuation models.


The first part of the article looks at the criteria relied on by customers in their choice of investment. The two most closely followed criteria are the Morningstar rating and past performance. The performance effect is observed both in cross-section (clients move towards funds that have performed well) and in time series (amounts invested increase after a period of rising markets). In terms of time series, past performance explains 15.9% of pay-outs and is the only statistically significant criterion. In particular, the alpha generated by the funds has no impact on investments.


One particularly convincing element identified by Ben-David et al concerns the behaviour of passive fund clients. They reproduce the same movements linked to past performance, whereas funds simply replicate an index. In addition, flows to active and passive funds increase in tandem during periods when indices are rising. Clients behave as if they assume that past performance predicts future performance, whatever the market conditions or the risk taken, and even when the fund is passively managed.


When it comes to choosing between active funds, the Morningstar rating also has a significant influence. Having the highest rating (5 stars) counts for much more than the alpha obtained, irrespective of the assessment model used. In 2002, the Morningstar rating system underwent a major overhaul. After the reform, funds were rated according to investment style (value or growth, large or small caps), when previously, investment style had been ignored. This categorisation removes from the rating the effects of an investment style's outperformance over a given period. Ben-David et al show that the reform has had no impact on the way clients integrate the Morningstar rating into their investment choices. When the rating increases, the flows into the fund concerned increase as much as before (by around 0.5% per month), even though the calculation method has changed. If Morningstar's monitoring were merely the consequence of its correlation with the actual competence of managers, the reform should have changed the effect of ratings on investment behaviour.


The interest of this article lies in the fact that it takes a very clear, empirically-based position on an unresolved issue in the financial literature: do mutual fund clients base their investment choices on financially recognised performance criteria? For Ben-David et al, the answer is clearly no. Flows into mutual funds are explained by the least sophisticated signals: past performance and Morningstar rating considered independently of the methodology. Theorists who base their models on the assumption that investors are highly rational may have to rethink their approach.


[1] I. Ben-David, J. Li, A. Rossi and Y. Song, "What do mutual fund investors really care about?" Review of Financial Studies, 2021, vol. 35-4, pages 1723 to 1774.


Q&A : Recalculation of NPV and IRR during the investment period

I'm working on the financial plan for a plant construction project which started in 2017 and should be completed by the end of 2023. I would like to recalculate the project's IRR/NPV now that I have the project's actual construction costs. However, I don't know how to include the investments from 2017 to today in my calculation. Should I reposition myself in 2017 and calculate my IRR/NPV at that date, or should I calculate my IRR/NPV at 1.1.2024 by accumulating the investments made without capitalising them, or should I capitalise them at the risk-free rate or at the cost of capital until 31.12.2023.


There are two possible approaches.


1/ You simply want to update your forecasts in line with the passage of time. You are in the field of management control. In this case, the easiest thing to do is to go back to your 2017 calculations and replace your 2017 estimates with the actual figures you have seen since 2017. You could capitalise your past cashflows at the cost of capital to bring them down to 2023 values, but it is not our advice; as this will change your IRR, unless by some extraordinary chance it was equal to your cost of capital. But don't capitalise at the risk-free rate or at zero, as this would artificially and falsely give your IRR and NPV a huge boost, since you would be forgetting or underestimating the price of the time that has elapsed since 2017.

2/ You're wondering whether it's still a good financial idea to carry out this investment. You are more in the financial field. In this case, you make a calculation today by taking the future cash flows, discounting them at the relevant cost of capital, and you compare the figure you get, which is the NPV of the future cash flows of your investment, with the value you could get from selling your investment as it is. If it is higher, then from a financial point of view your investment is still worth making.


New : Comments posted on Facebook

Regularly on the Vernimmen.com Facebook page[1] we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest. Here are some of our recent comments.


Vedanta, a spin-off in an emerging country

This Indian conglomerate, mainly active in oil and gas, aluminium, mining (zinc, silver, copper, iron and lead) and the steel industry, with a stock market capitalization of $10 billion, has just announced a demerger that will give rise in a few quarters to 6 new groups, each focusing on its own business.

In countries where financial markets are underdeveloped and access to finance is difficult, listed conglomerates (Argos in Colombia, Reliance in India, etc.) are a more efficient form of organisation because they form their own internal financial market, with cash cow divisions supplying cash to divisions needing funds. Because of their large size and the lower risk induced by their sectorial diversification, they find it easier to attract local or international savings to supplement their own resources.

As the financial markets develop, their competitive financial advantage fades, and their shortcomings become more apparent: they are complex to analyse, even opaque, diversification is imposed on the investor, and there is a fear of internal misallocation of funds, as star divisions may be held back in their development if the conglomerate's funds provide too much support for divisions in difficulty that would otherwise have to be closed. 

In Europe, over the last forty years or so, Philips, Siemens, Schneider, Fiat, Générale des Eaux, CGE, General Electric plc, etc. have refocused on one of their core businesses, some with success (Schneider, Veolia) and others less so (Philips, Alcatel). In the United States, which accounts for 69% of spin-offs, the same trend has also taken place: ITT, General Electric, Gulf & Western, etc. which may not mean much to our younger readers. The same is true in Japan.

One of the justifications put forward by Vedanta for its demerger is easier access to credit for its various divisions, whose individual performances are difficult for lenders to analyse within this conglomerate. This argument may come as a surprise, since it is generally believed that the diversification of a conglomerate's businesses reduces lenders' risk. But it is true that when debt levels become high, as is the case with Vedanta, lenders prefer to clearly identify cash flows in a logic that is almost akin to project financing, which the break-up of the conglomerate will make possible.

Even if one swallow doesn't make a spring, we can't help thinking that if India is starting to do demergers, it's because it's changing!


Novo Nordisk illustrates one of the laws of breakeven


The publication of the half-yearly results of the Danish pharmaceutical group Novo Nordisk illustrates one of the laws of breakeven, which states that the further a company is from its breakeven point, the more its results vary in close line with sales.

With an operating margin in the first half of 2023 of 45.4%, Novo Nordisk is indeed a long way from its breakeven point, probably around 270% above it. In short, sales would have to fall by 73% (sic) for operating profit to cancel out, assuming that fixed costs remain fixed, which is a particularly conservative assumption when sales fall by three quarters! 

In the first half, sales rose by 29%, boosted by excellent results from its anti-obesity and anti-diabetes drugs. Operating profit grew by 30%, almost as much. For the year as a whole, Novo Nordisk has announced sales growth of between 27% and 33% and operating profit growth of between 31% and 37%. When you're excellent, it's hard to be super excellent!

Novo Nordisk is Europe's largest market capitalisation.  


Reverse auctions


Exor, the listed holding company that groups together the investments of the Agnelli family, has announced a share buyback of 5% of its share capital using the reverse auction technique for €750m, and ordinary purchases on the market over time for €250m.

It is true that family investment holding companies are not very popular on the stock market at the moment, with discounts to net asset value (NAV) of between 38% (GBL) and 57% (Peugeot Invest). Exor, which has registered the best performance in recent years, has a discount of 43%. For an investor, these vehicles, which allow families to play a more important role in their investments than they would be entitled to if they were limited to their own funds, are unattractive, hence the discount. Who would think that Exor would keep its stakes in Ferrari, Juventus or Stellantis, solely on financial criteria, without the historical attachment to the companies playing an essential role?

The announcement of this reverse tender offer was combined with a 23% rise in NAV over the first half, compared with half that for the benchmark stock market index. It is therefore difficult to attribute the 5% rise in the share price that day to either of these announcements with any certainty. For a company with a market capitalisation of €20bn, we believe that the performance effect had the greatest impact. This transaction, which will reduce NAV by around 3% but the number of shares in issue by 5%, will result in a 2% increase in NAV per share, which may explain part of the 5% rise in the share price.

The reverse auction technique, more rarely used in Europe than the simple fixed-price offer, simply means that shareholders interested in selling some of their shares in this way will indicate the price at which they are prepared to sell what quantity of shares, within a range of between - 3% and + 10% of the market price. Exor will set the price at that which will enable it to buy back €750m, starting with the lowest prices, hence the term "reverse auction". 


Euronext, mission: impossible?


The withdrawal of Planisware's listing, for price reasons, on the eve of its IPO (12 October), is a major blow for Euronext, which lists fewer and fewer companies (1,212 in 2008, 857 in 2023 in Paris).

Planisware, which specialises in SaaS software for businesses, had everything going for it: strong growth (+20% a year), 25% net margin, no debt and net cash flow thanks to a subscription model, and dividends of 40% of net income. Its valuation at the bottom of its IPO range gave a multiple of 30 times 2022 operating profit. That's not cheap, but with a growth rate of 20% a year, it's only 21 times for 2024.

The IPO was intended to enable the private equity fund Ardian to sell its 20% stake, with the management keeping its 80% stake in a company whose market capitalisation was expected to be €1,100m.

And that's probably where the problem lies. Why would a private equity group that is selling 100 % of its stake agree not to maximise its selling price to enable the new stock market recruit to get off to a good start on the stock market? An entrepreneur looking to the long term can reason in this way (like Jacques Veyrat and Neoen, for example). But not a private equity fund that is able to sell its stake to another private equity fund or a family office, without reducing the carried interest of its partners.

On the other hand, stock market investors often think that if a private equity fund floats one of its holdings on the stock market, it is because it has not found a better deal among its peers and industrialists. And it's true that when we look at the IPOs of companies that have raised at least €200m since 2018, all the former private equity fund holdings have done less well than the market, which has risen by 40%: Verallia +30%; OVH, Antin Infrastructure and Believe have seen their share prices divided by 2 or 3....  This is enough to dampen investors' appetite for private equity funds, as Planisware had paid the price in a terrible geopolitical climate, but with a stock market that was OK (down less than 1% over the week).

Since 2018, at this size, private equity funds have accounted for half of all IPOs. Euronext must succeed in convincing private equity funds to leave money on the table for the benefit of the first stock market investors if it is not to kill off the market for IPOs worth a few billion. Otherwise, this segment will continue to languish, even though it could attract long-term candidates for top indexes. 

Our sympathy goes out to Planisware's financial management team, who have been working very hard for months to ensure that everything was fine and was told to cancel everything at the last minute. 


[1]  Like it here