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The companies able to charge more without hurting demand
Businesses and investors find themselves in a new and alien economic environment.
For decades inflation has been benign. However the so-called ‘reshoring’ of global supply chains, Covid and more recently the conflict in Ukraine have caused supply side shocks for fuel and food.
This has resulted in inflationary pressures continuing to build on both sides of the Atlantic. In the US the annual rate of inflation jumped again in March to 8.5% from 7.9% in February. In the UK inflation is currently running at 7%, up from 6.2% in February.
This places businesses in a precarious position. Rising costs can erode a company’s profit margins, and ultimately investor returns. Pricing power can help companies fight inflation and protect their margins by passing costs along to the customer.
Businesses with pricing power (the ability to increase price without experiencing a loss in demand) are likely to prosper in the current environment.
Conversely those without it may well be set for a challenging period as their margins and profitability come under increasing pressure.
In this article we identify stocks and sectors which have the ability to raise prices without an undue impact on appetite for their goods and services and flag four specific investment ideas from this rarefied stock market grouping.
PRICING POWER AN ANTIDOTE TO INFLATION
In an interview with the Financial Crisis Inquiry Commission in 2010, Warren Buffett, CEO of Berkshire Hathaway (BRK.A:NYSE), claimed ‘the single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to competition, you’ve got a very good business. ‘And if you have to hold a prayer session every time before raising the price by 10% you have a terrible business.’
With corporate leaders describing the current wave of input cost inflation as the worst they have seen in 30 years, investors are naturally searching for companies that can increase prices in the face of these rising input costs.
Terry Smith, founder and chief executive of asset manager Fundsmith, has echoed Buffett’s sentiments regarding the importance of pricing power. Smith maintains that one of the reasons that poor returns can persist is because companies with numerous competitors often lack control over pricing.
WHICH SECTORS HAVE PRICING POWER?
The ability to raise prices without backlash not only varies across industries but also within them. In some recent analysis investment bank UBS identified several stocks across US and European markets which benefit from pricing power. A selection of them are in the table overleaf.
In the food and beverage industry, drinks companies tend to pass along higher costs to consumers better than many food companies. This is because a few players with strong brand recognition dominate the beverage industry.
An example of this is Keurig Dr Pepper (KDP:NASDAQ), the producer of soda and single serving coffee pods. The company has a history of pricing power, particularly for its most popular soft drinks, which include Canada Dry, Snapple, and of course Dr Pepper.
The semiconductor sector also enjoys strong pricing power. Today semiconductors can be found not only in mobile phones and laptops but also in everyday household products like refrigerators and ovens. New cars can require as many as 100 chips.
The sector’s pricing power in part reflects the mismatch between soaring demand and limited supply, coupled with consolidation within the sector.
This has created a few dominant players with pricing power in specialised areas of the market. For example companies with proprietary chip designs like Broadcom, or Dutch chip component manufacturer ASML (ASML:AMS), are able to increase prices in an inflationary environment.
The rollout of new technologies, like 5G, artificial intelligence and cloud computing have further fuelled the world’s appetite for chips. In August last year, Taiwan Semiconductor Manufacturing (TSM:NYSE) disclosed that it would raise chip prices by as much as 20%.
HARD TO SHAKE THE HABIT
The tobacco industry is another example of an industry with pricing power. There are two reasons for this. First, tobacco is addictive which makes it hard for customers to quit. Consequently demand for cigarettes tends to be inelastic, meaning that the demand for the product doesn’t change in response to an increase in price.
Another explanation for the industry’s ability to raise prices lies in its market structure. Consolidation in the sector has created three dominant players in Altria (MO:NYSE), Philip Morris (PM:NYSE) and British American Tobacco (BATS).
With few competitors, these companies have been able to raise prices to generate more profits, even as cigarette sales volumes have fallen. Earlier this year, Altria increased its cigarette prices by 14 cents per pack, after raising them by 13 cents last November.
ECONOMIC MOATS AND PRICING POWER
At an internal presentation for Google, subsequently published on the ‘Talks at Google’ Youtube channel, Pat Dorsey, founder of Dorsey Asset Management and former director of equity research for Morningstar explains the critical importance of economic moats in creating pricing power.
The term economic moat refers to a company’s competitive advantage over rivals due to deeply ingrained benefits.
Dorsey explains: ‘Moats generally manifest themselves in pricing power. Any year if management mentions that due to macro reasons they are having soft realisations (weak performance), means the company doesn’t have a moat and pricing power’.
‘Will anyone pay 20% premium for a Samsung/Sony phone? If not, it is not a brand. If it comes with a new feature, it might get some premium for few months, but only until other mobile players replicate the feature. Whereas, Tiffany charges 20% premium for the same diamond. That’s a brand.’
PRICING POWER PICKS
ASML (ASML:AMS) $554.10
Online access has become essential to our everyday lives. We shop online, we work online, we socialise online, we consume entertainment and education online. That makes digital tools (smartphones, laptops etc) indispensable and ASML’s (ASML:AMS) tools are crucial if microchip makers are to follow their development roadmaps to faster, smaller, cheaper chips. ‘We believe ASML has significant pricing power due to its near monopoly position in chip manufacturing tools,’ says UBS analyst Francois-Xavier Bouvignies. His data puts ASML at a more than 70% market share in legacy lithography products and complete dominance (100%) in next generation tools, called extreme ultraviolet, or EUV. In short, ASML provides essential kit to manufacturers at the heart of a structural shift to digital everything. Factor in company comments earlier this month confirming demand for its systems running ahead of its capacity to deliver them, and gross margins at around 50%, and ASML has a lot of pricing power even if this is reflected in a consensus forward price to earnings ratio of 32 times. [SF]
British American Tobacco (BATS) £33.71
Tobacco giant British American Tobacco (BATS) is a great example of a company with pricing power. There are two key factors responsible for its ability to increase the price of cigarettes without experiencing a fall in demand. Tobacco is addictive which people makes it difficult for people to quit. The tobacco industry also operates in a highly consolidated market with the four largest companies controlling over 80% of the market value. Given the strong position of its global brands British American Tobacco has been able to continually improve the price mix. Finance director Tadeu Marroco told Shares in 2021 that the elasticity of cigarettes across the world was still very benign at 0.4 to 0.6. Or in other words a 10% increase in price would lead to a 4% to 6% drop off in consumption. The strength of the cigarette business is built on the group having strong global brands at every price point British American has led the US market on price over the last two years with eight price increases with no change in demand. [MGar]
CRH (CRH) £31.94
As the world’s largest supplier of construction materials, Dublin-based CRH (CRH) is better placed than most to be able to raise prices to its customers. This was evident in the firm’s recent trading update, where strong demand for its products across North America and Europe enabled it to more than recoup the rise in input costs and raise its first half profit outlook. As well as enjoying robust underlying growth due to the strength of its markets, the firm invests part of its substantial free cash flow into expanding its market share through acquisitions, creating a virtuous circle of higher earnings and still higher cash generation. The shares’ current rating of just over 12 times two-year forward earnings implies little to no growth, whereas consensus forecasts are for double-digit increases in profits. That suggests the market is underestimating the firm’s ability to deliver growth, even before considering the upside from share buybacks. [IC]
LVMH (EPA:MC) €643.8
One European-listed name with enviable pricing power is LVMH (EPA:MC), the luxury goods conglomerate behind brands ranging from Louis Vuitton and Christian Dior to Givenchy, Hennessy cognac and high-end watch and jewellery seller Tiffany. Companies behind high-end fashion and drinks brands such as LVMH are blessed with pricing power and high margins. They can mark up prices to more than offset the impact of rising costs. Despite playing on the heritage of its brands, Paris-based LVMH, controlled by billionaire Bernard Arnault, is also highly innovative when it comes to product, which is critical to both pricing power and brand momentum. LVMH has reported (12 April 2022) a good start to the year with sales up 29% to €18 billion in the first quarter of 2022, despite a backdrop of continued disruption from the Covid crisis and the war in Ukraine. All parts of the business achieved double-digit sales growth save for Wines & Spirits, which continued to see supply constraints. Its qualities mean a rating of 23.5 times forecast earnings based on consensus estimates does not look overly expensive.
Attributes which support economic moats
1. Intrinsically low operating costs
Walmart (WMT:NYSE) thrives as a low-cost producer. It benefits from the reduced costs that come with scale, like buying in bulk. Walmart’s low-cost production also hinges on management of its stores as a network—not the raw number of individual stores.
The company limits costs through a management and distribution structure that serves multiple stores in a geographic area. The network of stores allows Walmart to limit its stock in any given store and share managerial expenses across the network. Efficiencies flow from a 5,000-store network.
2. Network effects
The network effect is a powerful moat. The primary goal is user acquisition. Profitability can be sorted out later, as was the case with WhatsApp.
WhatsApp focused on driving user adoption, and Facebook (now Meta Platforms (FB:NASDAQ)) bought the company in 2014 without knowing how to monetise users. Zuckerberg felt that any platform with a half-billion users had potential, even if that required a $19 billion bet.
In essence Zuckerberg was paying for the network-based moat.
3. Intangible assets
Although not always easy to quantify, intangible assets are one of the primary sources of strong competitive advantages for businesses and a key economic moat source.
These can include corporate intellectual property, such as patents, trademarks, copyrights and government licenses. Brands are another valuable intangible asset.
Starbucks (SBUX:NASDAQ), the leading specialty coffee retailer in the world, is a good example of a company with strong intangible assets.
According to Morningstar, the company’s attributes include its ‘brand strength (evidenced by pricing power), attractive unit-level economics, and successful international replication’.
4. Switching costs
Social networks are an example of businesses with switching costs. Twitter (TWTR:NYSE) and Meta-owned Instagram are powerful platforms for personal brand building. Followers are non-transferable capital that users store on the platform. Leaving – or splitting time to pursue fans on a new network – comes at a cost. That cost creates inertia that keeps users on an existing network and slows the growth of new ones.