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Pricing Power – Understanding Company’s Trajectory and Profitability

IP Capital Partners – 1Q17 Quarterly Report

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” – Warren Buffett

  • Among many virtues that define a company’s profitability, pricing power is by far the most notable
  • The stronger its competitive edge, the greater its capacity to increase prices and make extraordinary gains
  • Pricing power has a broader meaning: a company which retains its productivity and efficiency gains rather than passing them onto customers is indirectly exercising its pricing power
  • In addition to differentiation, other factors contribute to pricing power:
    • Demand structurally greater than supply (e.g. property on Manhattan’s 5th Avenue)
    • Offered benefit disproportionately superior to the price charged (e.g. Amazon Prime)
    • Price representing only a small fraction of the value chain of a product or service (e.g. Visa and Mastercard)
    • An everyday and essential product or service in people’s lives (e.g. Colgate)
  • Emblematic examples of Chanel and Disney:
    • In 1955, Chanel’s Classic Flap Bag cost $220 (approximately $2,000 in today’s prices); nowadays, same bag costs $4,900, almost 2.5x the 1955 price adjusted for inflation (increased the price 1.4% per year in real terms)
    • In 1971, entry ticket to Magic Kingdom in Orlando cost $3.50 (about $21 in today’s prices); in 2017, same ticket costs over 5x more in real terms: $110; annual real price increase of 3.7%
  • In practice, competition, substitute goods, market potential and other forces ensure a limit always exists. Most businesses enjoy pricing power for only a while – understanding the company’s trajectory is vital to establish the evolution of its profitability

Consumers on one side, shareholders on the other

  • Companies should pursue two goals: 1) generate happiness (or utility) for customers; 2) obtain returns above the cost of capital
  • Price lies in between these two goals – company must attain returns greater than its cost of capital while selling a product or service for a price consumers are willing to pay
  • To be well executed, the price increase requires a counterpart – customers must receive something in return if the strategy is not to be a mere value transfer between stakeholders (better quality products, improved purchasing experience, higher investments in research, segmentation, premiumization, etc)
    • In the case of US railroads, since the industry’s deregulation, railroads generated a one-digit return on capital; after sector’s consolidation and given their need to increase capacity, renovate the network and invest in more efficient locomotives, railroads increased freight prices to sufficiently compensate the major investments made in subsequent years
    • In the Brazilian education sector, many institutions took advantage of the demand created by the government’s student funding program to increase tuition prices without offering an additional benefit to consumers; increase in profits was at the expense of students and the government

The Consumer Dictatorship

  • Even if price increase makes sense, everything depends on consumer acceptance – at no time in history have consumers had as much power as today
    • Ubiquitous access to information on products and the frictionless comparison of prices makes it harder for consumers to accept price increases
  • US companies that own content and cable TV channels exemplify this reality
    • Charging more for content has been the standard for decades
    • Fueled by the offer of new channels and more sophisticated content, more dollars per subscriber were extracted from consumers over time
    • In 2010, pay TV ecosystem reached its highest penetration in US households of approximately 89% – since then, with the rise of Netflix and other over-the-top content distribution platforms, this strategy became difficult
    • As monthly subscriptions linger at ~$100, growing number of consumers are giving up the service
    • Penetration fell from 89% to 84% since 2010 and last year, the sector lost 795,000 clients (0.8% of the total)

The Dark Side of Pricing Power

  • Naturally, the higher the margins and returns of a business, the more alert competitors will be – this is the essence of capitalism: there will always be someone willing to charge less or bring more utility to consumers than you
  • $1,200 for pay TV versus $120 on Netflix and $99 on Amazon Prime – while the quality and content gap among the platforms has narrowed, with such an enormous price gap, exercising pricing power is dangerous
    • Netflix currently has 50 million subscribers in the US, more than twice the country’s largest cable TV company – Comcast – and over 50% of the total number of subscribers in the US – it is no longer a small nuisance in the sector
  • For years, Oracle took advantage of its dominant position in the database business to offer its customers a high performance product but at an increasingly higher price; due to high switching cost, it was easy for the company to exercise its pricing power
    • Consequence has been Oracle’s outstanding historical results (annual growth of 12% in FCF/share over the past 15 years)
    • However, database market is changing, led by massive growth in open source solutions and cloud-based services
    • Even though Oracle is progressing in the transition of its App Division to cloud solutions, continuous use of pricing power in its core segment has put the company in a complicated situation – reducing prices to adapt to reality is hard decision for any CEO
    • Meanwhile, competitive edge continues to deteriorate; Amazon Web Services is considered its fastest growing product in history; Microsoft and Google have also advanced in the cloud segment

Premium = Power?

  • Tendency to believe that exercising pricing power is natural in products and services aimed at the premium market; many believe high-income consumers are less sensitive to price increases making the strategy even more enticing
    • In practice, it does not matter if a product costs $10 or $10,000, what matters is that stakeholders are satisfied with the equilibrium
  • In the US credit card market, American Express has been challenging this balance
    • Competitors have narrowed the gap and replicated most of the company’s positioning in the premium card market – AMEX’s differential in terms of status, rewards and services has decreased in that period
    • Chase Sapphire Reserve card was so successful that the bank’s 4Q profit was hit by $200 million charge due to massive adoption (100,000 introductory miles won by customers booked as marketing cost by the bank)
    • AMEX increased the benefits of its Platinum card by offering a monthly credit of $15 on Uber and five times more miles for airline tickets purchased through Amex Travel; along with the benefits came an unwelcome surprise: annual fee jumped from $450 to $550

Don’t provoke the big bad stakeholder

  • Hard to imagine an industry which has increased prices more than the pharmaceuticals in the US
  • Several factors encourage the exercise of pricing power, such as patents, market consolidation, regulatory barriers, distorted incentives and low price transparency along the value chain
  • According to a survey by Express Scripts, price increases of brand-name drugs in the US averaged 208% from 2008 to 2016
    • Including generics, overall drug prices rose 29%, twice as much as period’s inflation
  • Apart from obvious harm to patients, sector’s price increases created an unnecessary conflict with its paying sources, particularly the government
    • US drug expenditure per capita is twice the average of that of OECD countries
    • Problem for pharmaceutical companies is that the government’s retaliation arsenal is vast
    • Nothing a legislative stroke of pen can’t solve to return part of the price increase to the government and the population

The opposite is also true: shareholder value is also created by lowering prices!

  • Retail sector has numerous business models and various forms of differentiation and positioning
  • Many competitive advantages are apparent and replicable – but not all of them
    • In a universe of many losers, there are few winners with such extraordinary advantages that serve as a lesson for companies in all sectors
  • Cash & carry segment deserves attention: differentiation through low prices, limited assortment, scale, simple store formats and exclusivity via an annual fee
  • “I will pass on virtually all productivity and efficiency gains to my customers, but my increase in inventory turnover will more than offset this, ensuring a high return on capital”
  • Costco has best incorporated this concept: “A typical retailer might look at this hotdog and say ‘Gee, I’m charging five bucks for this. I wonder if I can get five and a quarter for it.’ We look at it and say: it’s $1.50 and is there any way we can reduce the price?”
    • This is Costco’s model: it forfeits pricing power, creates great value for customers and shareholders and drives the competition crazy
  • Costco’s operating margins is 3.1% lower than that of its main competitor – Sam’s Club – but its revenue per square meter is 77% higher
    • Gross margin is 13% and return on invested capital is 13%
    • In the last 10 years, shares have appreciated by 286% vs. 103% for S&P – including reinvested dividends
  • Persistently lower prices attract more consumers; the more consumers, the greater the company’s scale and bargaining power; with more scale, even lower prices are possible and thus, the cycle continues
  • Amazon: one of the most curious aspects of the company’s strategy has been to pass on to customers most of its operating gains of scale – through lower prices and greater benefits
    • While vast majority of CEOs would not have resisted the temptation to seek heftier short-term margins, Bezos continues to bet on accelerated growth and total domination – with the option to indirectly exercise some pricing power in the long run

At the end of the day, enjoy in moderation

  • Gillette: a company that became inebriated by its pricing power, selling razors at an exorbitant cost
    • Between 2007 and 2016, company’s volumes contracted 1.4%, while its average price rose 34%
    • During the same period, market share in the US razor segment fell from 70% to 54%
    • In addition to the Dollar Shave Club (acquired by Unilever), there is another new market participant making a lot of noise – like Harry’s and its 5 million customers
    • Even in a business with such strong competitive advantages, Gillette’s price increases paved the way for the barbarians to reach the gate
Image Source: Video & Audio Center

 

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