By Greenwood Investors
What better day to discuss the power of price incentives on a business than Black Friday? There is none, and so let’s dive right in with our thesis: temporary price incentives undermine the quality of the demand for a company’s products and inflate near-term financials at the expense of the long-term viability of the fundamentals. We can also invert the argument that brands and companies that refrain from temporary discounting in order to clear inventory or make the “quarterly numbers” reinforce the strength of their brand and the underlying fundamentals of their businesses. For an analyst staying on top of the fundamental strength of his investment, he must keep a watchful eye on the pricing tactics the company uses in order to stimulate demand.
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Let’s take a few examples, starting with the more destructive elements of pricing.
When Ron Johnson assumed the helm of JC Penney, he laboriously analyzed the problems inherent in JCP’s business strategy, which was only able to drive traffic through incessant promotional activities. The sales were getting more comprehensive and deeper in the discounts, in order to drive incremental traffic. Coming from Target and then Apple, Johnson of course was foreign to this frenzied pace of discounting, so he moved to a “fair and square,” pricing that ultimately ended up driving comparable sales down as much as 30% at one point. Clearly the medicine needed more than a spoonful of sugar to help it go down.
He was transitioning the footprint of JCP to become the world’s largest amalgamation of specialty shops. The specialty shops were working marvelously well, but facing deep losses of same-store sales in the wake of the “fair and square,” pricing, the board hit the panic button and fired Johnson. It brought back a discount-focused CEO who resumed heavy promotions. The traffic has never returned to the same degree, and JCP is heading towards long-term obsolescence. The key was, as Johnson aptly noted, at some point you can’t keep matching the “world’s biggest sale,” with the “worlds biggest-er sale.” At some point profitability does dictate what a firm can do. If your traffic is only focused on promotional events, you don’t have a solid base of customers. That is, unless you’ve reinvented the business model, like Costco and Aldi, and can sustainably offer lower price points and reliably take market share on terms that are profit-enhancing and self-reinforcing. The retail industry is riddled with flame-outs that tried to ride a trend far too long.
Abercrombie & Fitch long held a no-discounting policy, and it drove brand perception and profit margins to industry-leading levels during much of the 2000s. In the decade leading up to 2007, it was a 10-bagger. And then the Great Recession happened. Facing a significantly weaker consumer in 2009 than he ever had, CEO and business-builder Michael Jeffries finally capitulated and started discounting products in order to try and reverse the same store sales declines. The following two years brought rebounding same-store-sales, along with a rebounding global consumer, but the effect fizzled shortly after the promotions began and the company was left with a significantly tarnished brand facing declining traffic and it had the discounts on top of these hardships which have proved incredibly difficult for the company to overcome.
Coach was facing a similar environment in 2014 when it admitted its frenetic outlet and online sales activity was destroying brand perception of its core customer. It had to eliminate heavy discounting activity, particularly in online promotions, and in doing so, faced a rough two years of significantly negative traffic and same store sales, down almost as much as JC Penney’s sales declines with Johnson’s attempted overhaul. But as opposed to the JCP board hitting the panic button, Coach’s board underwrote the strategy and the company and its brand has largely recovered. Brand perception is improving significantly, its same store sales are back in the black, and it has been one of the few positive stories in aspirational retail in the last year. Yet the stock has yet to recover to previous highs, as is also the case with JCP’s “turnaround,” largely because the former stock valuation levels were ignorant of the deteriorating underlying fundamentals and sales growth that was achieved at the expense of the long-term survival of the business. Thus, for both long and short-focused investors, tracking price and incentives activity is key to understanding the health of one’s business.
This pricing and promotional activity is very different from firms like Amazon, Costco, Aldi, and many others that have reinvented the business model such that price discounts are sustainable and inherently not temporary. A totally different example is Fiat-Chrysler’s localization of Jeep production in China. Prior to localization of production, Jeeps faced heavy import tariffs and sold for prices around 4x US prices, with starting MSRP’s in the $80k range. Now that the company is building certain models locally, it is able to offer the same vehicles at significantly reduced prices such that the total addressable market determined by the price-points has expanded over 5x. This is a sustainable market share growth, as the company is making these models at similar, if not better, profit margins than the imported vehicles. This may sound obvious, we just wanted to distinguish between certain types of pricing actions. Our assertions around negative brand and company repercussions revolve largely around promotional activity used to drive volumes and traffic.
Good luxury brands have done the opposite as the “aspirational luxury,” shops like Coach and Michael Kors. By sticking to very high price points without any meaningful discounting activity, great luxury houses like Hermes and Ferrari have been able to enjoy recession-resistant demand growth. These brands are rock solid because its key products will never be seen, like Abercrombie was, on programs like Jersey Shore that probably created negative publicity for A&F. Many of these luxury brands have been ingenious about pricing strategies and how they can impact the fundamentals of the brand in a positive manner. Patek Philippe raises price every year on even its most basic watch, the Calatrava. Because of this, there is fairly limited depreciation of the timepiece after sale, and many of its special edition watches actually rise in value. Readers who’ve been around for a while know what’s coming next.
Ferrari has managed to keep waiting lists for all of its models to 6-24 months, similar to the supply constraint Tesla found itself in the earlier stages of the Model S production ramp. Under these supply constraints, residual values were rising, as it was easier to obtain a used Model S for Ferrari 458 in the aftermarket than it was from the manufacturer. Ferrari’s limited editions have actually all outperformed the S&P 500, with the exception of the F40, which the company ended up producing on a much larger scale than the original intent. It was a useful lesson. Limiting supply relative to the demand as well as consistently raising price keeps former customers happier and more loyal.
Exhibit 1: Ferrari’s Limited Edition Value Performance vs. S&P 500
Robert Cialdini discussed the power of scarcity to drive craving tendencies in customers. Artists have long mastered this psychological trap, as limited supply on the market coupled with consistently rising prices means that artworks sold in the past become more valuable, creating more “collectors,” who will buy future artwork at ever escalating prices. It’s a virtuous circle that keeps reinforcing itself, and in Ferrari’s case has bread a cult-like following of nearly half a billion fans worldwide.
This pricing mental model is most applicable for consumer goods industries, as in certain other industries the price effect is completely different. In business-to-business transactions, healthcare and industrial businesses, economic value created or saved by a product is much more important. European healthcare reimbursement often takes into account the added benefit of a particular drug, and allows the pricing to reflect such added incremental benefits. Unsurprisingly, this has been more efficient than the US system from a cost-perspective, and Europe is almost always an afterthought for most drug companies. Similarly, when selling airplanes, helicopters, construction equipment, and almost any other capital good, total cost of ownership is almost always the primary consideration. Firms that make great products that have lower maintenance needs, higher reliability, and more efficient operations often win – even at higher prices. These higher prices lead to higher profit margins at these companies and these profits often get redeployed into R&D to make these products even better. So while the purchase consideration is completely different than a consumer, we end up with the same outcome: price gaugers often destroy the future durability of their own business.
The problem with using this mental model on every business or investment opportunity is that companies rarely want this data to become available. Customers, competitors and investors all want the data in order to use it for their own advantage. We’ve been digging through the internet archives in order to figure out some type of pricing index for a company we want to short, and it’s been a pain-staking process trying to confirm our thesis that the company has been destroying its luxury brand through irrational price behavior in order to stem the decline of its legacy products. Yet if we were forced to use only one datapoint in order to properly assess the health of a company or brand, we’d want to look at its pricing policy.
Another company we are short, Volkswagen, has been forced to ratchet up its sales incentives considerably, as purchasing intent for its namesake brand as well as Porsche and Audi have taken a pronounced leg down in the wake of the dieselgate scandal and onslaught of new product launches by its luxury peers. This is potentially disastrous for an automotive company reliant upon sturdy residual values in order to have competitive leasing rates. Additionally, at some point the sales incentives will have a more muted impact on propping up demand for its products, and it will either have to suffer production declines or further price erosion.
Exhibit 2: Volkswagen’s Sales Incentives in the US
Nearly half of Volkswagen’s profitability comes from China, which has also been going through its own unhealthy period of pulling forward demand through temporary sales tax incentives that expire in one month’s time. As we’ve highlighted in prior reports, the demise of the auto cycle has always started with a period of heavier government or manufacturer incentives that has pulled forward demand.
Exhibit 3: Chinese Auto Stimulation Pull-Forward & Looming Give-Back
Only because I’ve just finished Steve Jobs’ biography by Walter Isaacson (highly recommended), Apple provides another very useful example of virtuous pricing policies. Apple has almost never discounted its products, applying only very slight discounts towards the end of each products’ life cycle, and by doing this, it has forgone a considerable amount of incremental demand. Yet, Apple still earns well over 80% of the profits in the smartphone, tablet, and computer markets. It has also created one of the largest pseudo-luxury brands in the world by pricing substantially above its peers, and this profitability has often been redeployed into more R&D for the next great product breakthrough. Apple has also emphasized ownership of its distribution, or at least strict control of the retail channels. Because brands and companies can rarely force retailers and distributors to maintain price rationality, many company’s brands get tarnished by its own vendors who are trying to drive traffic in order to boost their sales. As JC Penney and many others have shown, this frenzied discounting activity has destructive long-term consequences.
So as we approach the holiday season, and you go out today to take advantage of the juicy deals on offer, or participate in Cyber Monday, remember that the discounts you’re receiving are eroding the very quality of the company who makes the product you are buying. But they are doing it on their own accord, or on the retailer’s accord, because they’re managing the business for the very short-term. Products that provide value, whether or not that’s perceived brand value or actual economic value, do not need to be discounted. Make sure your longs are virtuous pricers and your shorts are short-sighted and volumes-driven. And have a great holiday season!