Answer Happy

Article Below
Pricing power is highly prized on Wall Street
economist.com/business/2021/11/06/pricing-power-is-highly-prized-on-wall-street
MCDONALD’S HAS employed a “barbell” pricing strategy for decades,
luring customers with low-cost items in the hope that they will
then splurge on pricier fare. This balancing act is now at risk. On
October 27th the fast-food giant said that, due to rising costs,
prices at its American restaurants will increase by 6% this year
compared with 2020. The burger chain says labour expenses have
risen by 10% at its franchised restaurants and 15% at its
companyowned locations. Add the rising cost of ingredients and the
result is higher prices for burgers and fries. For now, it seems,
customers can stomach it. Chris Kempczinski, McDonald’s boss, said
the increase “has been pretty well received”. After digesting the
news, investors have sent shares in the fast-food firm up by 6%. A
growing number of companies are raising prices as costs for labour
and raw materials rise, often with no ill effects. This summer
PepsiCo, an American food giant, lifted prices for its fizzy drinks
and snacks to offset higher commodity and transport costs; it plans
further increases early next year. Ramon Laguarta, the firm’s boss,
suggested in an earnings call in October that customers do not seem
bothered. “Across the world consumers seem to be looking at pricing
a little bit differently than before,” he said. In September
Procter & Gamble, a multinational consumer-goods giant, raised
prices for many of its products. The effect on demand was minimal.
“We have not seen any material reaction from consumers,” Andre
Schulten, the firm’s chief financial officer (CFO), told analysts
last month. 2/5 “Pricing power”, the ability to pass costs to
customers without harming sales, has long been prized by investors.
Warren Buffett has described it as “the single most important
decision in evaluating a business”. It is easy to see why. When hit
with an unexpected expense, firms without pricing power are forced
to cut costs, boost productivity or simply absorb the costs through
lower profit margins. Those with pricing power can push costs onto
customers, keeping margins steady. Today, firms are eager to flaunt
their price-setting clout. “We can reprice our product every second
of every day,” Christopher Nassetta, boss of Hilton Worldwide, a
hotel operator, told investors last month. “We believe we’ve got
pricing power really better than almost anybody if not everybody in
the industry,” boasted John Hartung, CFO of Chipotle, a restaurant
chain, in October. Companies such as Starbucks, Levi Strauss and
GlaxoSmithKline make similar claims. “We are a luxury company, so
we do have pricing power,” bragged Tracey Travis, CFO of Estée
Lauder, a cosmetics firm, on November 2nd. They are not alone. Of
the S&P 500 companies that have reported third-quarter results,
over three-quarters beat projections, according to Bank of America
Merrill Lynch. “This earnings season there was a lot of angst on
the part of investors that higher input costs would erode margins,”
says Patrick Palfrey of Credit Suisse, a bank. “In fact, what we
have seen is another spectacular quarter on behalf of corporations
so far in spite of input cost pressures.” According to Savita
Subramanian and Ohsung Kwon of Bank of America mentions of “price”
or “pricing” in American earnings calls—a proxy measure for pricing
power—increased by 79% in the third quarter from a year earlier. In
the second quarter, such mentions were up by 52% year on year. If
costs spiral out of control, the power to raise prices will become
ever more important. On November 2nd JPMorgan Chase’s global
purchasing-managers index, a measure of manufacturing activity,
showed that input prices in the sector increased in October at the
highest rate in more than 13 years. But the prices of manufactured
goods and services also rose at the fastest pace since records
began in 2009. A gap between input and output price inflation is
typically interpreted as a sign that firms are struggling to raise
prices and that margins are being squeezed. That isn’t happening
yet. Identifying firms with pricing power is crucial for investors.
Analysts tend to look for three things. The first is a big
mark-up—the difference between the price of a good and its marginal
cost—which only firms with market power can get away with. Big and
steady profit margins are another sign of pricing power. “If you
are a firm that is dominant in your market, you are much more
resilient to shocks,” explains Jan Eeckhout, an economist and the
author of “The Profit Paradox”, a book published earlier this year.
Size is another factor. All else equal, bigger companies with
greater market share have more pricing power than smaller ones. A
recent survey of American CFOs conducted by Duke University and the
Federal Reserve Banks of Richmond and Atlanta found that 85% of
large firms reported passing on cost increases to customers,
compared with 72% of small firms. 3/5 A “pricing-power score” for
companies in the S&P 1500 compiled by UBS is based on four
indicators: mark-up, market share, and the volatility and skew of
profit margins. The bank found that firms providing consumer
staples, communication services and IT have the most pricing power
and that energy, financial and materials companies have the least
(see chart 1). When UBS compared the financial performance of
companies with strong and weak pricing power, they found that the
former have delivered more profit growth since 2010 and generated
better stock returns, particularly during periods of high inflation
(see chart 2). 4/5 Firms that score well on this index have lagged
in the past year, notes UBS. This may be explained by cyclical
factors. When profit margins are expanding, the argument goes,
firms with pricing power tend to generate relatively low returns;
when margins are shrinking, they produce high returns. At the
moment, profits are still healthy. For now, demand is robust and
consumers seem relatively insensitive to price changes. But
companies are planning more price increases. A survey by America’s
National Federation of Independent Business, a trade group, found
that the margin of small-business owners planning to raise prices
in the next three months over those planning to lower them grew to
46%, the biggest gap since October 1979. This is a concern for some
central bankers such as 5/5 James Bullard, president of the Federal
Reserve Bank of St Louis. In October he noted that for years
companies have worried that if they raised prices, they would lose
market share. “That may be breaking down,” he says. ■