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Pricing Power


Shane
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What metrics do you all find useful in determining pricing power?

 

Here is an example:

I have found a micro-cap snack foods company which has had it profit margin halved between last year and this quarter.  That was kind of expected for me because commodities had a run and they likely don't change the price of their goods on a quarterly basis.  However comparing that with Kraft, the profit margin actually increased. 

 

The manager of the micro-cap is likely to take my call, however KFT is not going to.  Can anyone point me to an article which could give me guidance on what investors look at when determining pricing power?

 

My first guess is that because the micro-cap is not in industry leader it is just matching the prices of the established brands and maybe had larger costs, however, if they management is just slow to act then it would be a good buy at 5x FCF with a long history of growth...

 

 

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Guest VAL9000

Hi Shane,

 

I don't know much about the food business, nor am I a guru when it comes to pricing power.  My recommendation is to take a look at Porter's Five Forces framework for industry analysis and see how it plays out for your micro cap.

 

My initial thoughts are that this company will have a hard time with pricing.  The reasons:

- In markets with several participants, smaller companies get worse prices on inputs.  That is, the people who sell sugar or tomatoes to the microcap will sell those same products to Kraft at a discount because of the volume that Kraft does.

- Passing price increases along to customers is difficult because grocers sit between the customer and the vendor.  Grocers have fixed space on their shelves.  Unless this particular food product is a hot seller (i.e. inelastic demand), price increases will keep variable profitability for the grocer fixed while reducing gross profitability via reduced volume.  Not good.

- Kraft can pass price increases along more easily because they have brand power and they represent a sizable % of food on the aisle.  Kraft says prices go up by 10%, what grocery store is going to refuse the price increase and stop carrying Kraft Dinner ?  That's an insane move, they need to carry that stuff to survive.  Now if XYZ Food Co tries to increase the price, well, it's much easier to find a different supplier because they likely don't have significant brand recognition.  Unless they do, in which case the price increases will come.  It greatly depends on the power of the brand.  Research WEB's experience with See's Candy to learn how this can go well.... but I wouldn't consider that to be the likely case.

 

As I said, I'm no expert in these matters, but that's my thought process spelled out for you.  Hopefully it's helpful in coming up with your evaluation of this company.

 

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I came to the same general conclusion VAL9000.

 

twacowfca - That is a good point, if management were maybe more dubious then the margin could return to normal.  Interesting point to ask management!

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The sneaky way to raise a price without rocking the retailer's boat is to cut the portion size.  Thus, we see the incredible shrinking candy bar when the price of a key ingredient increases.  :)

 

In the case of candy bars or, for that matter, most prepared food products that Americans consume in large quantities, the effect to society would be net positive. ;)

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"What metrics do you all find useful in determining pricing power?"

 

I am no expert at all, but I read + saved the following (my apology to whomever I learned this from,I can t remember who it was)-they are metrics for durable competitive advantage but some metrics maybe useful for your purpose. If a company is maintaining its advantage then either it has got pricing power or is able to manage its expenses to maintain the various metrics ie you re looking for good/great businesses:

 

 

Durable Competitive Advantage Summary

Income Statement

(d.c.a = durable competitive advantage)

 

Gross Profit Margin

>40% = D.C.A.

<40% = competition eroding margins

<20% = no sustainable competitive advantage

Consistency is Key

SG&A

(SGA as % of gross profit)

< 30% is fantastic

Nearing 100% is in highly competitive industry

Consistency is Key

Depreciation

(depreciation costs as a % of gross profit)

Company with moat tend to have lower %

 

Interest Expenses

(interest expenses relative to operating income)

Durable competitive advantage carry little or no interest expense.

Buffett's favorite consumer products have <15%

Company with lowest ratio of interest to Operating Income = competitive advantage.

Varies widely between industries.

Net Earnings

(% net earnings to total revenues)

Net earnings history >20% = Long Term moat

< 10% = in highly competitive business

consistency and upward LT trend

EPS

10-year period showing consistency and upward trend.

Avoid erratic earnings pictures.

Consistency = sign products don’t need to change.

Upward trend = strong

 

 

 

Balance Sheet

 

 

Cash and Equivalents

lots of cash and marketable securities + little debt

Test to see what is creating cash by looking at past 7 yrs of balance sheets

Inventory

Look for an inventory and net earnings that are on a corresponding rise

inventories that spike up/down are indicative of competitive industries prone to (boom/bust)

Net Receivables

consistently shows lower % net receivables to gross sales than competitors

d.c.a. no need to offer generous credit

Goodwill

increase in goodwill over number of years assume because company out buying companies >BV

d.c.a.’s never sell for less than BV

LT Investments

can have valuable assets on books at valuation < market price (booked at lowest price)

tells us about investment mindset of management

(Looking for d.c.a.?)

Intangible Assets

Internally developed brands not reflected on BS

 

Total Assets + ROA

(Measure efficiency using ROA)

Higher return the better (but: really high ROA may indicate vulnerability in durability of c.a.)

Capital = barrier to entry

ST Debt

financial institutions. Buffett shies from those who are bigger borrowers of ST than LT debt

 

LT Debt Due

d.c.a. need little or no LT debt to maintain operations

 

Total CL + Current Ratio

higher the ratio, the more liquid, the greater its ability to pay CL

d.c.a.’s don’t need ‘liquidity cushion’ so may have <1

LT Debt

LT debt load for last ten yrs. ten yrs w/ little LT debt = d.c.a.

earning power to pay their LT debt in <3/4 yrs = good candidates

Total Liabilities + Treasury Share-Adjusted debt to Shareholder Eq Ratio

If <.80, Good chance company has d.c.a.

 

Preferred + Common Stock

in search for d.c.a. we look for absence of preferred stock

 

Retained Earnings

Rate of growth of RE is good indicator

 

Treasury Stock

presence of treasury shares and a history of buyback are good indicators that company has d.c.a.

convert –ve value of treasury shares into +ve and add shareholder eq.

Divide net earnings by new shareholders eq. give us return on equity minus dressing.

Return on Shareholder equity

d.c.a. show higher than average returns on shareholders equity

If company shows history of strong net earnings, but shows –ve sholder equity, probably d.c.a. because strong companies don’t need to retain

 

 

 

Cash Flow Statement

 

 

Capital Expenditures

historically using

<50% then good place to look for d.c.a.

<25% probably has d.c.a.

Add up total cap exp for ten-yr period and compare w/ total net earnings over period.

Stock Buybacks

indicator of d.c.a. is a history of repurchasing/retiring its shares

Look at cash from investment activities. “Issuance (Retirement) of Stock, Net”

 

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Shane, you can always look and see what price increases the company is putting in for their products... There are a couple companies that I own that quote annually what their price increases have been. For instance I recently bought some WB.TO -on their recent earnings call indicated that they  increased prices on their resort tickets 10% in this past year without losing any visitors- It seems that UNH always quotes 7% price increase every year-they sometimes lose members but they remain profitable.

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