The following was published at RealMoney on April 19th, 2007:

portfolio management products

Pricing and Products

Do you think you can pass through price increases in the next year?

Questions like this can highlight management’s competitive strategy and how much excess of demand over supply exists in the current environment. Answers that involve no price increases or price decreases should also explain the reason for that, e.g., technological change.

For example, if you asked this question of a disk-drive manufacturer, he’d probably blink and ask of you, “Where have you been? This business has been so cutthroat competitive that we have been forced to innovate in order to create drives that store more, retrieve faster and at lower cost for more than 20 years! We’ll never get price increases! This business is like Alice and the Red Queen. We have to run as hard as we can just to stay in the same place. Our only hope is volume growth, and thankfully, we have gotten that.”

Answers that boil down to “demand is eroding” or “competitors are irrational” should contain some idea of what management is doing to combat the problem. Sometimes giving up market share to an irrational competitor can be the brightest move; market share can only be rented, never owned.

I can give examples from many cyclical businesses. All mature businesses are inherently cyclical, and stock price performance follows the pricing cycle. At RealMoney, I have already written about this dynamic in insurance, steel and cement. To give one more example, consider the airlines. As so many of them slipped into bankruptcy early in the 2000s, most of the bankrupt carriers were forced to shed capacity. As they shed capacity, pricing got incrementally better and then a whole lot better, leading to the outperformance of airline shares.

What are your plans for dealing with emerging substitute products?

Sometimes a market comes under threat from a new competitor with a new business model. Usually threats like this begin with simple products with relatively low returns on equity.

For example, when the steel minimills came into existence, they provided only the lowest-quality steel products. Over time they expanded their products to capture more of the value chain in the steel business, and this placed increasing pressure on the integrated steel companies, many of which crumbled under competition from the minimills.

Had the competitive threat been met early, the integrated companies could have minimized the threat by adopting the tactics of the minimills.

Do you have any complementary products in the works that open up new markets for you?

Much of the time, growth happens through a willingness to explore offering products and services that are one step removed from existing offerings. This could be a new marketing channel, offering the product internationally, extending the brand, offering services that complement the product, etc. Often a move like this precedes growth in profitability; it means that executives are looking for low-risk ways to expand the franchise.

Going back to my favorite insurance company, Assurant, Inc. (NYSE:AIZ), it’s constantly looking for new ways to create new products and services that lever off an existing core competency. For example, it’s No. 1 by a large margin in force-placed homeowner’s insurance.

When a homeowner with a mortgage doesn’t make a payment on his or her homeowner’s insurance, the mortgage company is at risk if a disaster happens. After a grace period of two to three months expires, the mortgage company buys a homeowner’s policy from Assurant, Inc. (NYSE:AIZ) or another carrier and bills the homeowner at their next mortgage payment. The development of force-placed homeowner’s insurance led to new product lines in force-placed auto insurance and renter’s insurance.

The first business developed as a result of relationships with mortgage lenders that wanted their interests protected if property insurance slipped out of force (not a good sign for the creditworthiness of the loan). The same applies to auto lenders. It also applies to large multifamily unit management companies, which want the integrity of their apartments protected. Those who live in apartments are much more likely today to damage the units than in prior decades, and increasingly landlords require it.

Full Disclosure: still long AIZ

By David Merkel, CFA of alephblog