Saturday Thoughts on Inflation, Recovery and Business Model Disruption

V shaped recovery, flattening of the curve, second wave, travel bans, reopening plans and the new normal have all become topics of daily conversation.  I have been traveling recently on planes and by car.  As I see it, the world is not back to normal, but it is recovering as fear subsides.  Financial people love models and predictions and from this price discovery happens.  On this Saturday in July here are some thoughts I have on the next few quarters.

I prefer to look at six-month time periods rather than quarters, but that is a personal preference.  In my business experience it is more productive to plan around a six-month cycle than three month quarters or years.  If I could wave a magic wand and change company reporting requirements, I would make companies report monthly pro-forma set of numbers and six-month GAAP numbers, but that is a personal preference. I mention this because we are on the cusp of earnings and the guidance and modeling of the forward quarters will be important.  How will companies guide the future with respect to the recovery we anticipate seeing?  This is kind of the $64,000 question.

Inflation:  The general consensus is that the Fed destroyed inflation by 1984 and it has not been seen in any material way since.  I know there is a FX component to inflation with regard to the USD and inflation, but it seems unlikely there will be any significant move in the USD over the next year.  I can see commodity prices and the retreat from globalization being inflationary.  I think supply chains are in flux and that is a product of shifting manufacturing centers as well as geo-political tensions.  There is a lot in play, and it is not a benign environment.  The US election is also play a role this year, but I would I argue that type of recovery we are going to have will matter the most.  A lot of people are thinking a V shaped recovery and I am not so certain.  Many things were broken beyond repair.  We have never told people to stop working, stop learning, stop playing sports, stop enjoying the arts, stop buying stuff, stay at home, don’t bother paying your bills and see you in six months when all is well.  Our political leaders decided that the velocity of money was unimportant versus the need to manage health care capacities, and I suspect the impact will be unrepairable for much of it and that leads to the question of what will a recovery look like?  I am not confident that inflation remains benign in the out quarters and some inflation is good, a lot of inflation is probably bad and how the Fed reacts to signs of inflation is really an interesting risk assessment in relation to the market structure we are in as that structure is the product of the Fed.

Recovery:  Is it a V or not a V?  Is it a slow grind upward after an initial pop?  One former PM wrote to me “Looked like a V, will be upside to consensus for Q2 (only because cut to bone), Q3 and Q4 will have to go up for same reason…BUT the shape of the curve is really flattening.  In fact, worse than flattening, might be going back down a little bit…”  We know the stimulus is really a joke.  It gives some people some needed cash, but this does not replace the income flow prior to Covid-19 and it certainly does not provide the capital to sustain consumer spending.  We are halfway through the summer and not much closer to being back to February 1 than we were on April 1.  School, sports, arts, travel and work are all very much in question.  What we have is some sports without fans, limited arts, no concerts, no shows, no travel except for the brave (yours truly included), some retail, but capacities have been greatly reduced at restaurants, beaches, theaters, airlines, hotels, etc.  If any of you have spent time in hotels recently, they are empty.  Limited food service, no shuttles, empty parking lots.  If you drive around the outskirts of any major airport the outer long-term parking lots are shuttered.  Buses are parked in storage.  Terminal E in ATL has no food services.  The cheaper hotels are just closed.  Does anyone think this just snaps back in a V recovery?

American Collegiate Model:  I have a teenage daughter who is a couple of years from starting the college application process.  Luckily for us she has been in on-line school for more than a year.  That was a choice she made because she wanted to focus on skating and the schedule of a brick and mortar school did not fit into a normal school day.  That decision turned out to be a lucky choice in the era of Covid-19.  I have plenty of colleagues and neighbors who are struggling with what school will look like in September.  Much of this discussion morphed into what college is going to look like going forward.  This is where we come back to that inflation and recovery discussion.  I graduated high school in 1987.  For discussion purposes, I am going to use Boston University which I think is a fine school.  In 1987 it cost $16,700 a year to attend BU.  In my family, I was the first generation to attend college after high school.  My father got his EE degree at night from Northeastern after fighting a war, starting a family and working a full-time job.  The $16,700 to attend BU in 1987 is equal to about $38,837 today, but the cost to attend BU this year is ~$54,000.

In the years leading up to Covid-19, student debt and cost of college were frequent topics of conversation.  What the American Collegiate Model was probably not planning for was a complete disruption to their business model.  Most colleges do not have an endowment large enough to absorb the fiscal shock they are encountering with Covid-19.  Some colleges have taken on debt to fund the upgrade of facilities to compete.  Tuition rates have steadily climbed as colleges have been able to pass through 4-6% annual tuition increases on the back of consumer incomes, ample federal aid and benign inflationary world.  Faculties have become increasing progressive with tenure and they are not exactly receptive to the changing of the business model.  The Rhode Island School of Design (RISD) advertises a tuition of $50,000, which is on par with BU.  RISD has an endowment of ~$350M and they laid off their full-time faculty.  Link is here.  I think many colleges are going to be operating materially in the red in terms of OPEX for some time and they will struggle to find donors or students to pay full rates to fund the cost structure that has been created.  International students typically pay full tuition rate and Covid-19 has disrupted that model.

Fundamentally, American colleges tend to have a large fixed cost business model and have never, ever faced a demand shock.  What might be worse, is they could be facing a secular technology disruption as well.  Would someone pay $50K a year for online classes?  Bloomberg had an article here on MBA students asking if the $150K they spent on their MBA was worth the money.  Industries that are unprepared for a demand shock tend to find a way to survive, although the business size and focus area often changes (see Nokia and Blackberry).  Industries that face a demand shock and technology disruption face a far more uncertain future.  How many colleges will survive?  Will tuition rates collapse?  Will the Federal Government have to bail out colleges?  Will this affect the diversity academic majors?  Who will fund the tuition burden?  Will academic staffs face salary and job cuts?  Will universities sell real estate, which will be problematic because the RE market is clearly weakened as well by Covid-19.  There are a lot of questions, but I know if we do not have a V recovery, the American Collegiate Model will not look like 2019-2020 in 2022-2023.

As always, my thoughts on these matters might be completely wrong.