Pricing power: Tesco versus Unilever

Marmite war is a timely reminder of a vital factor in stock selection

At a time when investors are still wondering whether an inflationary recovery or deflationary downturn will be the ultimate endgame after seven years of unorthodox monetary policy, the bitter battle between Tesco and Unilever is a timely reminder of one vital factor in stock selection, namely pricing power.

As legendary US investor Warren Buffett put it in 2010:

“If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10%, then you've got a terrible business.”

Unilever clearly feels it can push through the price increases it is demanding, due to the power of its brands such as Hellmann’s, Magnum, Dove, Knorr and Lipton’s.

Tesco clearly feels it cannot push through the price increases demanded by Unilever, because the supermarket is locked in a brutal battle for market share with price discounters like Aldi and Lidl.

While the two may seem to reach some middle ground, the share price performance of both stocks over the last five years shows which company ultimately has the stronger pricing power and therefore better earnings and dividend-paying potential – 

Tesco vs Unilever

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Remember that Tesco’s profits have collapsed and its dividend been cut to zero, even though it has nearly a one-third market share in the UK grocery business.

It is ironic that Tesco is a stock that Warren Buffett himself got spectacularly wrong, as the first thing the Sage of Omaha looks for when he assesses a company’s business model is whether it has pricing power or not. If a firm can charge what it wants to charge it should generate high margins, consistent earnings and robust cash flow, which it can then turn into the reliable and growing dividends which provide such a large percentage of long-term total shareholder returns, especially once they are reinvested.

By contrast, firms without pricing power – such as producers of commodities like paper, pulp or steel – tend to churn out more volatile earnings and more volatile dividends. As a result, their stocks also tend to enjoy lower long-term trend valuations than those firms with pricing power and the ability to provide consistent returns. Newspapers are another example – the ubiquity of free information and material on the internet is making it ever harder for print journals to charge for their services.

The question then for investors is how to spot a company with pricing power, especially in a world where the internet creates so much price transparency, making it easier for consumers and customers to compare the cost and products and services offered by rival providers. 

There are five good characteristics to watch for which give firms an above-average chance of having pricing power.

  • A technological edge. Apple is a great case in point here, especially as its key rival Samsung has just made a mess of a key product release such as the Californian firm releases the iPhone 7.
  • Strong brands. Unilever is an example of this, as are Reckitt Benckiser and Coca-Cola and the big tobacco companies (which is one reason by BAT and Imperial Brands continue to rail against the threat of plain packaging).
  • A feel-good factor. Luxury goods firms such as Burberry or LVMH or Richemont are examples of this. They offer clothes, perfumes, pens, bags or drinks which make people feel good about themselves and – better still – do it at a price point which only the plutocratic few can afford, potentially making them feel even better about themselves owing to the exclusive nature of their possessions.
  • An installed base. Companies able to implant costly kit at their clients’ premises can exploit an installed base to secure recurring revenues through product upgrades, maintenance and training, while an installed base can make it hard to switch suppliers. Halma is a good example here.
  • Market share. High market share can confer pricing power, especially in a consolidated industry. Sky is facing more competition than ever for content but it still has a hugely powerful position and an installed base of customers to tap for more money as it nudges up prices or offers new value-added services such as Sky Q.  

All of these help to establish the barriers to entry and product differentiation which can be the bedrock of a strong economic franchise, but even then nothing is guaranteed, as Tesco’s fall from grace despite its huge market share has proved. Even Sky’s shares have stumbled in the past year as BT has upped the cost of buying content with which to attract and keep subscribers.

Ultimately, competition, a refusal by customers to pay if prices go too high or intervention by the regulator or Government (as happens with utilities or drug prices) can still keep companies on their toes and their profit margins under pressure. 

A final way to look at whether a company’s pricing power edge is truly sustainable or not is to refer to Porter’s Five Forces.

In four books written between 1980 and 1990, Michael E. Porter of Harvard Business School devised a clear method investors could use to assess the competitive strength of and market position of a company. The first of the quartet, Competitive Strategy: Techniques for Analysing Industries and Competitors, outlined his Five Forces model, which analyses structural differences in supply and demand from industry to industry, and thus any given business’ pricing power and profit margin potential.

These Five Forces are:

  • Bargaining power of buyers
  • Threat of new entrants
  • Threat of technological change
  • Bargaining power of suppliers
  • Competition within an industry

Using this framework, investors can rigorously analyse a company’s business model and competitive position, to see whether a firm has the potential to churn out consistent profits and dividends – and therefore command a premium rating for its stock – or whether its earnings and shareholder payouts will rise and fall with the economic cycle and its shares merit a discount rating.

Patient, long-term investors may view the former as stocks to own, the latter as merely ones to rent or trade.

These articles are for information purposes only and are not a personal recommendation or advice.