IP Capital Partners commentary for the first quarter ended March 31, 2017.

“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” – Warren Buffett

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Among many virtues that define a company’s profitability, pricing power is by far the most notable. Some factors help explain this phenomenon, but it mostly boils down to one word: differentiation. The more unique a company’s product or service, the harder it is to replicate its business. The stronger its competitive edge, the greater its capacity to increase prices and make extraordinary gains. Pricing power may also have a broader meaning: a company which retains its productivity and efficiency gains rather than passing them onto customers, is, in practice, indirectly exercising its pricing power.

IP Capital Partners

In addition to differentiation, other factors also contribute to pricing power, such as:

  • A demand structurally greater than supply (e.g. a property on Manhattan’s 5th Avenue).
  • An offered benefit disproportionately superior to the price charged (e.g. Amazon Prime).
  • A price representing only a small fraction of the value chain of a product or service (e.g. Visa and Mastercard).
  • An everyday and essential product or service in people’s lives (e.g. Colgate).

The emblematic examples of Chanel and Disney help put this concept into numbers:

  • In 1955, Chanel’s Classic Flap Bag cost US$220 (approximately US$2,000 in today’s prices). Nowadays, the same bag costs US$4,900, almost two and a half times the 1955 price adjusted for inflation. In a period of 62 years, Chanel increased the price 1.4% per year in real terms.1
  • In 1971, the entry ticket to the Magic Kingdom Park in Orlando cost US$3.50 (about US$21 in today’s prices). In 2017, the same ticket costs over five times more in real terms: a trifle US$110. In other words, Disney ensured an annual real price increase of 3.7% in its main park during the period.2

Who wouldn’t want to invest in businesses like these? The truth, however, is that this is a privilege for few. Rare are the businesses that possess such enormous advantages to allow the use of pricing power for so long. After all, how do you replicate Disney’s parks and characters or such an iconic and desired luxury brand as Chanel?

In the universe of good businesses there are different magnitudes of pricing power. In practice, competition, substitute goods, market potential and other forces ensure a limit always exists. Most businesses enjoy pricing power for only a while - understanding the company’s trajectory is vital to establish the evolution of its profitability.

This quarter, we decided to bring this topic to light. We have observed several companies – in Brazil and abroad –exercising pricing power and, in some cases, recklessly. It is natural for investors to view this strategy in a positive light and, therefore, little is said about when price increases are misused, undermining the sustainability and continuity of the business.

Consumers on one side, shareholders on the other

What is the purpose of a business? How does it create value for shareholders and society? In the excellent book “The Blue Line Imperative”3, the authors argue that companies should pursue two goals:

  • Generate happiness (or utility) for customers.
  • Obtain returns above the cost of capital.

The price lies in between these two goals. The company must attain returns greater than its cost of capital while selling a product or service for a price consumers are willing to pay.

By exercising pricing power, the company puts its products to the test in search of a new equilibrium between shareholders and consumers. However, to be well executed – so both goals above are still met – the price increase requires a counterpart. Customers must receive something in return if the strategy is not to be a mere value transfer between stakeholders. There are numerous alternatives: better quality products, improved purchasing experience, higher investments in research and innovation, segmentation or premiumization, etc. This is the only way to exercise pricing power in a sustainable way.

A good example is the case of U.S. railroads, as discussed in our 3Q144 report . The sector’s price increases as of 2004 accompanied a strong acceleration in investments. Since the industry’s deregulation, railroads generated a one-digit return on capital. After the sector’s consolidation and given their need to increase capacity, renovate the network and invest in more efficient locomotives, railroads increased freight prices to sufficiently compensate the major investments made in subsequent years.

In the Brazilian education sector, for instance, the situation has been different. Many institutions took advantage of the demand created by the government’s student funding program (FIES) to increase tuition prices without offering an additional benefit to consumers. In this case, the increase in profits was at the expense of not just one, but two stakeholders: the students and the government.

The Consumer Dictatorship

Even if a price increase makes sense and is well planned, there is no guarantee of success – everything depends on consumer acceptance. This issue is further aggravated once we acknowledge that at no time in history have consumers had as much power as today. Ubiquitous access to information on products and the frictionless comparison of prices makes it harder for consumers to accept price increases.

U.S. media companies, more specifically those that own content and cable TV channels, exemplify this reality. In this sector, charging more for content has been the standard for decades – increases which were always duly passed on to final customers. Fueled by the offer of new channels and more sophisticated - and expensive - content, more dollars per subscriber were extracted from consumers over time. In 2010, the pay TV ecosystem (which includes cable, satellite and telecom companies) reached its highest penetration in U.S. households – approximately 89%. Since then this strategy became difficult, especially with the rise of Netflix and other over-the-top content distribution platforms, such as Amazon Video and Hulu. Letting go of pricing power, however, is not easy and providers have kept increasing prices. As monthly subscriptions linger at around US$1005, a growing number of consumers are giving up the service. Pay TV penetration fell from 89% to 84% since 2010, and last year the sector lost 795,000 clients (0.8% of the total)6.

The Dark Side of Pricing Power

Although the power to increase prices is extremely valuable, its continued use may make companies vulnerable. Naturally, the higher the margins and returns of a business, the more alert competitors will be. This is the essence of capitalism: there will always be someone willing to charge less or bring more utility to consumers than you.

In the previous example, by rising prices, content companies are in fact helping new market participants. Luckily, many consumers still see TV and online streaming products as complementary. The price difference, however, is increasingly blatant – US$1,200 for pay TV versus US$120 on Netflix7 and US$99 on Amazon Prime – while the quality and content gap among the platforms has narrowed. With such an enormous price gap, exercising pricing power is dangerous.

Netflix currently has nearly 50 million subscribers in the U.S., more than twice the country’s largest cable TV company – Comcast – and over half of the total number of subscribers in the

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