Last year, Sam Ro, the managing editor of Yahoo Finance, tweeted: “Kit Kat and Reese’s Peanut Butter Cup customers won’t tolerate price hikes. For every 1% increase in pricing, volume drops 2.1% and 3.9%, respectively. – UBS”.
It stuck with me for two reasons. One being that I do like the mentioned chocolates. The second being my naive assumption that such globally recognised names would automatically have tremendous pricing power.
Netflix comes to mind. In December 2018, TDG tested price sensitivity toward monthly Netflix cost increases. Its survey of 1,940 U.S. adult broadband users revealed that at $1 more per month, 16% of Netflix subscribers are likely to either downgrade to a lower tier or cancel Netflix altogether. Benchmark, in a recent research note, noted that "Despite high customer additions and lower churn, we are concerned with mounting streaming competition, potentially restricted pricing power from a global economic downturn and surveys suggesting that streaming services are among the first household budget items to be cut with job losses."
Pricing power is firmly on the radar of every stock analyst, and rightly so. A note by Morgan Stanley referred to it as one of the key attributes of a quality compounder. In 2011, Warren Buffett famously called it the “single most important decision in evaluating a business”. Those are very strong words.
There are various dimensions to pricing power.
- Can a firm successfully maintain its premium price versus the competition?
- Can the firm periodically raise prices of its product or service without reducing demand?
- Does the firm have pricing leadership, in that it can hike prices and establish new anchors in the marketplace without losing customers?
- If a new entrant comes in with lower prices, can the incumbent continue to retain its higher price without losing market share?
- Is the firm’s pricing power sustainable? Does it work at improving the value it offers to customers?
Author and investor Gautam Baid introduced me to the concept of “Untapped Pricing Power”.
Investors hunt for undervalued or mispriced stocks in a bid to unlock significant value. He suggested being on the lookout for undervalued or mispriced products or services which have untapped pricing power.
Most businesses consistently raise their prices. How about looking for a business that has not raised its prices in a long time, causing its product/service to become underpriced and undervalued to customers? Now the business has a pent-up pricing power that can be released in the form of future real price increases for a certain period of time. Real pricing power indicates an inefficiently priced product or service. This undervaluation is a source of great potential value as the business begins to price its product or service more efficiently, i.e. raise prices in real terms.
A very recent post by Marcellus Investment Managers makes three observations when it comes to Indian companies.
1) Most sectors are highly competitive, and most firms have weak pricing power.
In the airlines sector, the bulk of airline passengers make their choices based on ticket pricing – cheapest wins. Changing a telecom provider in India has historically been decided by customers predominantly on the back of price – cheapest amongst the top 3-4 players has always won market share from others.
For such companies it is easy to understand why they have avoided price hikes for several years – price wars and price led competition doesn’t allow incumbent leaders with low pricing power to retain their market share whilst also hiking their product prices.
2) Most firms hike product prices to offset the impact of inflation in raw material costs and operating expenses. Yet, some curtail product price hikes for long periods of time.
- Bharti Airtel: Over the period FY07-FY17 (i.e. before Reliance Jio), Bharti Airtel retained its market leadership with a market share of 23%. Its ARPUs (Average Revenue Per Unit customer) declined at a CAGR of -8% over these 10 years.
- Interglobe Aviation: In the airlines sector, Indigo Airlines has grown its market share over the last decade from 15% in FY10 to 50% in FY20 with its ‘revenue per passenger’ growing at only 1% CAGR over FY10-20.
- Asian Paints: Asian Paints has dominated the decorative paints industry for several decades with its current market share being 50%. The firm has hiked its product prices on a like-for-like basis by a CAGR of less than 3% over the past two decades.
- Lal Pathlabs: The biggest player in India’s pathology diagnostics industry has not hiked prices of its diagnostic tests for over four years now.
3) When analysing companies, have a framework to assess price hikes, or the lack thereof, through the lens of pricing power.
Dr. Lal Pathlabs and Asian Paints have delivered ROCEs (Returns on Capital Employed) in excess of 25% for more than a decade with earnings growth above 20% CAGR – a sign of immense pricing power.
Bharti Airtel has delivered ROCEs consistently below 15% with non-existent earnings growth over FY07-17 – a sign of weak pricing power.
Just remember:
- Since pricing power has various facets, check the source of it, to understand if it can be sustained going ahead.
- Pricing power is often the difference between a company that succeeds and one that fails. Last year, when Morningstar analysts in Chicago suggested overpriced stocks to sell, they mentioned Gildan Activewear. The retail prices for its products could be as much as 30% lower than those of its competitors, which signals that the brand lacks pricing power. Not surprisingly, it reported lower growth margins than its competitors with superior brands, and it faces intense competition.
- Within a sector, look for players that have pricing power. A few years ago, Damien Conover, director of healthcare equity research and equity strategy for Morningstar, explained that in healthcare, most notably cancer drugs, HIV drugs, and MS drugs, exhibit a strong pricing power. The key to drug pricing power is innovation. The more innovative the drug is, the better, the stronger enabling pricing power that these firms will have.
- Strong brands are a well-known source of pricing power, but not every brand provides pricing power.
- As Saber Capital points out, real pricing power (raise prices in excess of inflation) is finite. At some point, the company’s ability to increase real prices without impacting unit volume comes to an end. So a history of real price increases doesn’t necessarily indicate future real price increases.
- Pricing power cannot be taken for granted. Richard Hilgert, senior equity analyst for Morningstar, in the past has written about the venerable Rolls-Royce and BMW brand names that command premium pricing. Consumers can easily switch to other brands like Bentley, Mercedes-Benz, or Audi, and a seemingly bulletproof brand image can tarnish quickly. But BMW has been able to consistently produce vehicles that command superior pricing as well as margin and to generate volume increases above global vehicle growth rates.
