Pricing power is in high demand on Wall Street
MCDONALD’S A has used a âbarâ pricing strategy for decades, luring customers with low-priced items in the hope that they will then splurge on higher rates. This balancing act is now under threat. On October 27, the fast food giant said that due to rising costs, prices in its US restaurants would rise 6% this year from 2020. The burger chain claims spending on labor of work increased by 10% in its franchised restaurants and by 15%. in its company-owned locations. Add in the rising cost of ingredients and the result is higher prices for burgers and fries. For now, it seems, customers can handle it. McDonald’s boss Chris Kempczinski said the increase “has been fairly well received”. After digesting the news, investors pushed shares of the fast food company up 6%.
An increasing number of companies are raising prices as the costs of labor and raw materials rise, often without adverse effects. This summer, PepsiCo, a US food giant, raised the prices of its soft drinks and snacks to offset rising raw material and transportation costs; he expects further increases early next year. Ramon Laguarta, the boss of the company, suggested during an October earnings call that customers did not appear to be bothered. âConsumers all over the world seem to view prices a little differently than they used to be,â he said. In September, Procter & Gamble, a multinational consumer goods giant, raised the prices of several of its products. The effect on demand was minimal. “We have not seen any material reaction from consumers,” Andre Schulten, the company’s chief financial officer (CFO), told analysts last month.
Pricing power, the ability to pass costs on to customers without hurting sales, has long been prized by investors. Warren Buffett described it as “the most important decision in the valuation of a company”. It’s easy to see why. When faced with an unforeseen expense, businesses without pricing power are forced to cut costs, increase productivity, or simply absorb costs through lower profit margins. Those with pricing power can push costs onto customers, keeping margins stable.
Today, companies are eager to display their influence on pricing. “We can review the price of our product every second of every day,” Christopher Nassetta, boss of Hilton Worldwide, a hotel operator, told investors last month. âWe think we have much better pricing power than almost everyone if not everyone in the industry,â boasted John Hartung, CFO from Chipotle, a restaurant chain, in October. Companies such as Starbucks, Levi Strauss, and GlaxoSmithKline make similar claims. âWe’re a luxury company, so we have pricing power,â boasted Tracey Travis, CFO from EstÃ©e Lauder, a cosmetics company, on November 2.
They are not alone. Of S&P According to Bank of America Merrill Lynch, 500 companies that released third-quarter results are over three-quarters of expectations. âThis earnings season, investors were very concerned that higher input costs would erode margins,â said Patrick Palfrey of Credit Suisse, a bank. “In fact, what we have seen is another spectacular quarter for companies so far despite input cost pressures.” According to Bank of America’s Savita Subramanian and Ohsung Kwon, mentions of “price” or “pricing” in U.S. profit calls – an indirect measure of pricing power – rose 79% in the third quarter from the previous year. In the second quarter, those mentions were up 52% ââyear-on-year.
If costs get out of hand, the power to raise prices will become increasingly important. On November 2, the JPMorgan Chase Global Purchasing Managers Index, a measure of manufacturing activity, showed that input prices in the sector rose in October at the highest rate in more than 13 years. But the prices of manufactured goods and services have also risen at the fastest pace since the record started in 2009. A gap between input and output price inflation is generally interpreted as a sign that firms are in debt. hard to raise prices and that margins are squeezed. This is not happening yet.
Identifying companies with pricing power is crucial for investors. Analysts tend to look for three things. The first is a large mark-up – the difference between the price of a good and its marginal cost – that only firms with market power can get away with. Another sign of pricing power is large and stable profit margins. âIf you’re a dominant company in your market, you’re much more resilient to shocks,â says Jan Eeckhout, economist and author of âThe Profit Paradox,â a book published earlier this year.
Size is another factor. All other things being equal, larger companies with a larger market share have more pricing power than smaller ones. A recent American investigation CFOStudies by Duke University and the Federal Reserve Banks of Richmond and Atlanta found that 85% of large businesses reported passing cost increases on to their customers, compared to 72% of small businesses.
A âpricing power scoreâ for companies in the S&P 1500 compiled by UBS is based on four indicators: profit margin, market share and volatility and asymmetry of profit margins. The bank found that companies providing basic consumer goods, communication services and THIS have the most pricing power and energy, financial and materials companies have the least (see Figure 1). When UBS Comparing the financial performance of companies with strong and weak pricing power, they found that the former have seen greater profit growth since 2010 and generated better stock returns, especially during times of high inflation ( see graph 2).
Companies that perform well on this index have fallen behind in the past year, notes UBS. This can be explained by cyclical factors. When profit margins increase, the argument goes, firms with pricing power tend to generate relatively low returns; when margins decline, they produce high returns. For the moment, profits are still healthy.
For now, demand is robust and consumers seem relatively insensitive to price changes. But companies are planning further price increases. A survey by the American National Federation of Independent Businesses, a trade group, found that the margins of small business owners planning to raise prices in the next three months compared to those planning to lower prices rose to 46%, the biggest gap since October 1979. It’s a concern for some central bankers like James Bullard, chairman of the Federal Reserve Bank of St. Louis. In October, he noted that for years companies feared that if they increased their prices, they would lose market share. âIt may be falling apart,â he says. â
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This article appeared in the Business section of the print edition under the headline “Passing the buck”