Tariff Apocalypse: Trade Wars and Tariffs in Financial Models and Valuation

Tariff Model Definition: In corporate finance and valuation, tariffs increase the prices that companies pay for imported parts, materials, and supplies and make a “very negative” to a “close to neutral” impact on their profits and cash flows; they also tend to reduce companies’ values and make M&A deals more dilutive.

With all the recent headlines about the trade war between the U.S. and China (and seemingly every other country in the world) and the threat of tariffs everywhere, we thought it might be useful to look at their impact on financial models.

To be clear, this is not a policy statement or an article about politics.

As with any policy shift, tariffs will create winners and losers, and even though most companies will be worse off, you could argue that they will help workers, governments, and specific industries.

Here’s the short version of how tariffs affect financial models, valuations, and M&A deals:

• Contrary to much online discourse, tariffs are not a “consumption tax” but an additional corporate tax on imported physical goods/materials/supplies that companies often have difficulty passing on fully to customers, reducing their margins.
• Tariffs can be inflationary, but the impact varies widely by industry and company and factors like the sources of the raw materials, the degree of market competition, and the company’s position in the value chain.
• Tariffs tend to reduce corporate profits by pushing down Gross Margins, as companies must pay a tax on imported supplies, parts, and materials; this also reduces their Free Cash Flow and may even make the Change in Working Capital more negative.
• Tariffs increase the Discount Rate in valuation because they increase uncertainty and overall risk, which may push up the Risk-Free Rate, Equity Risk Premium, and other components of WACC.
• Because of the reduced cash flows and the increased Discount Rate, tariffs usually reduce companies’ valuations, but neutral and even slightly positive impacts are sometimes possible.
• From an M&A perspective, deals generally become more EPS-dilutive when both companies are subject to tariffs because it increases their expenses and reduces their Net Income and Earnings per Share (EPS).

Modeling the full complexity of tariffs is beyond the scope of this short tutorial, but we present below a few simple scenarios:

Files & Resources:

• Tariff Model – The Impact of Tariffs on Corporate Finance, Valuation, and M&A – Slides (PDF)
• Merger Model with Tariff Support (XL)

Video Table of Contents:

• 0:00: Introduction
• 1:30: The Short Answer
• 4:51: Part 1: How to Add Tariff Support to Models
• 9:35: Part 2: Three Common Scenarios for Tariffs
• 11:45: Part 3: How Tariffs Affect M&A Deals
• 14:47: Recap and Summary

Tariff Model Scenario #1: The Company Absorbs the Extra Costs

In this scenario, the company has little pricing power, so it absorbs the extra costs of tariffs and cannot pass on anything to its end customers.

If we assume a 20% increase in Cost of Goods Sold (COGS) per unit but no changes to Revenue or Operating Expenses, the impact might look like this:

The Gross Margin, Operating Margin, and EBITDA Margin all fall, but the impact is much worse than a straight 20% drop:

• Gross Profits fall by 36% (!) because Revenue stays the same, while COGS increases substantially.
• Operating Income falls by over 50% because the company has relatively low operating leverage, i.e., it has far more variable expenses than fixed ones.
• EBITDA also falls by 40 – 50% for similar reasons.

This outcome is most plausible in competitive markets with many substitutes where companies lack pricing power, and customers can easily switch to other vendors.

Tariff Model Scenario #2: The Company Passes Along the Extra Costs to Customers

This is the “unicorn” scenario for companies: They pay extra for their imported parts and raw materials, but they pass along these extra costs 1:1 to the customers.

In this scenario, there is no impact because Revenue and COGS both increase by the same dollar amount, so Gross Profit, Operating Income, EBITDA, and Net Income all stay the same:

So, in theory, tariffs could be neutral to a company’s profitability, cash flows, and valuation…

…but in real life, this scenario is unrealistic because few companies can pass on price increases 1:1 to customers.

If they try to do this, their unit sales often fall because customers are unwilling or unable to buy as much, and the company may have to reverse course and reduce its prices, which hurts its margins.

Tariff Model Scenario #3: The Company Passes Along the Extra Costs But Also Sells Fewer Units

That takes us to tariff model scenario #3, which covers this outcome: The company’s per-unit costs increase, it raises its per-unit prices, but it sells fewer units due to reduced customer demand.

Here’s what it looks like in Excel if we assume a 20% increase in COGS per unit, a full pass-through on the prices per unit, and a 20% decrease in unit sales:

In this scenario, the company might reverse its price increases or offer more incentives, such as discounts on long-term contracts or free bonuses.

Also, the company might attempt to cut its Operating Expenses by laying off employees or reducing outside contracts, rent, and other costs.

It would not work well in this case because this company (James Hardie Industries) has little OpEx – almost all its expenses are variable and show up in the COGS line.

Tariff Model: Are There Any Positive Scenarios?

In theory, a company might come out ahead if it can raise its prices without paying for additional COGS – or if it can raise its prices by more than the additional COGS while still selling the same number of units.

For example, if Companies A and B both import their raw materials and must pay a tariff on these imports, but Company C does not, something like this could play out:

• Companies A and B raise their prices to cover the extra COGS due to tariffs.
• Company C does not import its raw materials from other countries, so it is not subject to tariffs, and it has no reason to increase its prices.
• But since it sees Companies A and B raising their prices, it does the same thing and earns higher Gross Profits on the difference.

However, this scenario is not especially likely because there are very few markets in which some companies import everything while others import nothing – it’s almost always a mix of both due to the complexity of global supply chains.

Therefore, the bottom line is that tariffs are negative for corporate profits and cash flows and, at best, potentially neutral.

In the long term, there could be even more of an impact if companies “re-shore” their sourcing and manufacturing.

This might result in higher CapEx – but its overall cost structure would be higher in that scenario since they would pay far more for labor and materials.

Tariff Model: M&A Deals and EPS Accretion/Dilution

Assuming that both the Buyer and Seller in an M&A deal are subject to tariffs and treat it the same way – absorb the higher costs, pass on 100% of the additional costs, or pass on the costs but also sell less – the outcomes in M&A deals are as follows:

1. Worst Case: If both companies absorb the extra costs 100%, deals tend to get far more dilutive because of the reduced Net Income and EPS.
2. Middle Case: If companies pay higher COGS but increase their per-unit prices and sell fewer units in the process, deals become more dilutive, but less than in the first case. The exact effect varies significantly by the percentage changes.
3. Neutral Case: If both companies increase their Revenue and Gross Profits by the same dollar amount, there should be no impact on EPS accretion/dilution.

For reference, here’s the baseline EPS accretion/dilution for this $8.7 billion deal between James Hardie Industries in Australia and The AZEK Company in the U.S.:

These numbers are based on our revenue and expense forecasts for the companies, in line with the consensus view, and the likely impact of the additional Debt and Stock issued in the deal.

And here’s how the numbers change in the worst case and neutral case:

This analysis ignores the fact that the companies’ respective valuations might also change before the deal closes.

Depending on how the deal is structured, that could be very impactful because the number of shares issued could be fixed or linked to the acquirer’s share price, depending on the Exchange Ratio used.

Linking the Stock issued to the acquirer’s share price (i.e., a Floating Exchange Ratio) would make the numbers even worse by increasing the number of new shares required.

In this case, the Stock component in the deal is based on a Fixed Exchange Ratio, so this is not an issue, but it does create far more risk for the target company (AZEK).