Pricing power is the ability of companies to increase price (usually when input costs increase) and yet retain demand. Sectors and companies that have relatively better pricing power tend to do well in terms of profitability and cope better during weak economic conditions.
In a high inflation growth economy such as ours, it makes sense from a business and investment standpoint to understand some of the conditions and market characteristics that tend to favour better pricing power for companies. Here is a shortlist of favourable characteristics.
Low absolute price: It may sound counterintuitive, but goods and services available at a low absolute price possess better pricing power since an increase in price by a few rupees may not pinch the customer but it helps the company retain margins (in percentage terms) amidst increasing costs. Horlicks and Wrigley’s have managed to increase the price of their products almost every year..
High priority products/services: There are certain items customers are quick to cut corners for and certain others they do not want to. For example, as India’s middle-class grows in number and enjoys a better standard of living, healthcare and education are becoming two key services they are unwilling to compromise on. This provides players in these industries better pricing power, provided they meet quality expectations.
Non-discretionary/non-cyclical: Non-discretionary and non-cyclical products are usually customer essentials —products that customers do not want to cut spending on, irrespective of what’s happening to the overall economy. They often come at a low absolute price, like personal hygiene products.e the former has been able to fully tap its pricing power, the later has always been shy to do so.
Do not offer discounts: Companies with strong pricing power seldom offer discounts because customers are willing to pay the rack rate. This is a trend widely visible among baby products companies. Have you ever seen a discount sale by Mom & Me, Just Born or Johnson & Johnson?
Few players/entry barriers: The fewer the players operating in the market, the more consolidated a market is (in terms of large players), and the deeper the barriers to entry, the higher the chance that incumbent players have pricing power. The presence of too many players moves the market towards perfect competition where profit margins are minimised.
Regulatory environment/demand supply gap: A significant gap between demand and supply combined with a favourable regulatory environment for operators (such as limited licence regime) work in favour of pricing power. Wireless Telecom service providers in the country were able to turn themselves quite profitable when just a few were allowed to operate given a reasonable cost of spectrum.
Intermediaries working for commission: It is a common perception that only companies operating in the luxury goods segment can experience an increase in demand when they increase price, but as Charlie Munger points out, companies that can pass on a significant portion of their price increase to intermediaries can also experience a similar outcome. Financial services companies that offer higher commission to their brokers/agents can increase their sales despite the fact that it is usually the customer that eventually pays for it.
There is no guarantee that companies/sectors that possess a relative edge in pricing power could retain it over time. However, over the long term, businesses lacking in pricing power have a high risk of facing erosion in their ROCE (return on capital employed).
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