The following article appeared on Cuffelinks on August 29, 2019.
Hypergrowth and crushed expectations are usually the investing themes that capture the most flattering financial press. A much less visible but even more powerful lever for the long-term investor, though, comes in the form of pricing power.
Businesses with a confluence of a strong brand, competitive position, and customer loyalty are often able to push through price increases alongside or even above inflation. Even if only applied with prudence, the ability to grow pricing at healthy rates speaks to the potential to surprise investors with higher-for-longer growth than short-term-minded investors might expect.
Start by inverting
One of the fastest routes to identifying businesses with pricing power is by inverting and screening out the price takers. For example, just about every commodity-centric business, from mining to farming, lacks pricing power because its products aren’t materially differentiated, and most end buyers don’t care about the sourcing. You probably care about who manufactured your shoes – branding matters in footwear – but probably never stopped to ask where the rubber in them was sourced from.
There are gradations when it comes to pricing power with commodities, of course, mostly having due to the concentration of supply and how long it takes new supply to come online. But a steel manufacturer looking to buy a certain grade of iron ore doesn’t much care whether it was dug from the earth by, say, Rio Tinto or BHP Billiton, and the huge majority of commodity producers are price takers.
Retailers are another group that struggles to retain pricing power because barriers to entry are low and clever concepts are easily and quickly copied. The largest players can lean on suppliers for better terms, but even they struggle to flex pricing power with customers. They later resort to ‘investing in price’ in order to win back market share. Incidentally, shares of Woolworths today are no higher than they were six years ago.
Australia’s big banks are not immune to market forces either despite the oligopolistic nature of the sector. It’s a pain to change banks, thus they set their fees accordingly, but when it comes to setting rates it is largely set market forces that dictate their levels and the size of spreads.
Go positive on who has the power
So we just struck off financial, energy and materials businesses, which wipes away more than half the opportunity set by value of the ASX. Also, much of what was said above is applicable to companies in other sectors as well, all of which should give you a better feel for the rarity of true pricing power.
The first thing you should know when trying to spot pricing power is that most companies that have it don’t advertise the fact — even with investors — because doing so might rub customers, suppliers, and regulators the wrong way. Large consumer companies aren’t shy in discussing pricing – Procter & Gamble, for example – mostly because the prices themselves are public and the customer base is so diffused. Once you get past that low-hanging fruit it takes more thought and digging to spot pricing power.
The next best place to catch management discussing pricing strategy is to get on an analyst conference call. Almost every mid- and large-cap company, plus many small-caps, host a conference call after they release earnings results that investors of all stripes can listen to (details are usually found in the earnings release or announced prior). While a company might not be so brazen as to directly say how much increased prices contributed to their growth during the period, they often provide useful colour that can help investors get a sense of whether pricing power exists.
Beyond a company out-and-out saying pricing power exists, investors can read between the lines of some financial measures. For example, if a business has high and stable gross margins, consistent revenue growth, and is showing no signs of losing market share, odds are decent the business has some degree of pricing power. Netflix is a prime example. The price of its standard streaming plan in the US increased from US$9 in 2014 to US$13 in 2019, over which its gross margin expanded by around 5% to over 36% and total revenue more than tripled.
Take note that just because a business has a premium brand or higher gross margins than its peers does not mean the business has pricing power. A luxury automaker probably has higher gross margins than one more focused on value and volume, for example, but the luxury automaker also has a smaller revenue base over which it can leverage its fixed costs, plus automaking is an intensely cyclical and capital-hungry business. That is to say, even if a luxury automaker has relative pricing power, it doesn’t mean they have absolute pricing power. In fact, in the US, prices for new vehicles basically haven’t budged over the past two decades despite total inflation of around 50% over that time.
Another quantitative directional indicator is based on average revenue per customer. If it is increasing faster than inflation and without driving down customer-level churn, it means the company is effectively raising prices or leveraging an existing strong relationship to cross or up sell, or some mix of both. A good example that is close to home is Xero, where churn rates in the core ANZ region fell a touch year-on-year despite a 4.8% constant currency increase in average revenue per user.
When the price is wrong
Just because a business has pricing power does not automatically make its shares a buy, of course. Numerous factors go into that sort of analysis, and even within pricing power itself it is important to watch the key underlying trends. For example, if a company is able to broaden its supply base or its own market is concentrating behind fewer players, both those trends bode well for pricing power. Likewise, if a company has been flexing its pricing power too hard for too long it can open itself up to disruption by more efficient competitors who compete on price and value rather than brand and prestige.
All that said, we think pricing power is a valuable trait for a business to possess for the long-term investor.
Joe Magyer is Chief Investment Officer of Lakehouse Capital, and Portfolio Manager of two unlisted funds, the Lakehouse Small Companies Fund and the Lakehouse Global Growth Fund. This article contains general investment information only (under AFSL 400691) and has been prepared without taking account of the reader’s financial situation. The Lakehouse Small Companies Fund owns shares of Xero.