Inflation Series: Pricing Power

As Tassilo discussed in our last newsletter (Interest rates in the time of Covid), we are still unsure whether the responses of governments and central banks to COVID-19 will drive   fundamental and long-lasting changes in the macroeconomic landscape. These changes could end up leading to higher inflation and, consequently, to higher interest rates. For now, we focus on ensuring that if that shift in the macroeconomic environment is ever to materialise, the companies in the Seilern Universe will be well equipped to weather such eventualities.

In an environment of markedly higher interest rates, the rate at which future cash flows are discounted will inevitably increase. This will reduce the present value of those cash flows and, consequently, the value of the companies that produce them. In such a scenario both quality growth and growth businesses, which derive a greater portion of their value from cash flows that are further out in time, will be more affected than the so-called value companies, which derive a greater portion of their value from those cash flows generated in the more immediate future. The trickier part in this equation, however, is to understand the effect that the corrosive power of inflation could potentially have on each of the value levers of a business and whether some of these businesses will be equipped to offset the taxation effect that inflation will pose to their cash flows.      

In the past, we have continually emphasised how important it is for companies to have pricing power. This is important for two main reasons. First, to improve our ability to forecast the growth of a business further out in time. Second, and more relevant for the topic we are discussing in this newsletter series, pricing power is one of the most important tools that companies have to protect their profits. It is key for companies to overcome the adverse effects of both inflation and deflation, enabling them to protect their cash flows and the value that is derived from them.

Increasing prices is the fastest and most effective way for a company to increase profits. According to a study carried out by McKinsey on the average company of the S&P1500, a price rise of one per cent, at stable volumes, will lead to an eight per cent increase in operating profits. The same study concluded that this had a 50 per cent greater impact than that of a one per cent fall in variable costs, such as materials and direct labour, and a more than three times greater impact than a one per cent rise in volumes. This means that if a   company is able to increase prices above the rate of inflation, that company will have a tremendously powerful tool that will not only allow them to offset labour and input cost inflation, but will actually allow them to generate growth in profits and cash flows above and beyond these higher costs.

Pricing power is directly linked to what economists call price elasticity. If customers are very sensitive to the price of your offer, a price increase will lead to the loss of many customers, meaning your price is elastic. The more commoditized a product is, the more elasticity of  demand one will find in that product. Pricing power is present in industries with inelastic demand. In other words, a company that enjoys pricing power has a customer base that is less price sensitive, and can therefore raise prices without worrying that this will lead to declining volumes.

Having a strong and durable competitive advantage is often linked to the ability of companies to increase prices over time. But there are also market conditions that are favourable and conducive to pricing power. Market structure, availability of substitute products, customer captivity, brand loyalty, innovation, and customers’ ability to measure the real value of the products or services they purchase, are some of the key factors for companies to be able to raise prices. Not all these characteristics are qualitatively the same, so we encounter different degrees of pricing power. For simplicity, we will classify them in three main categories: those that can raise prices above the rate of inflation, those that can raise prices in line with inflation and those that cannot raise prices at all.

Many companies in the Seilern Universe feature in the first category, encompassing those that are able to raise prices above the rate of inflation. Here, we typically find companies with a strong competitive advantage anchored on a superior product or service, a strong brand and or dominant market position. Of these, companies which are mission critical non-core (Searching for the (non) core) to their customers clearly stand out in their ability to push prices. Companies like West Pharmaceutical Services, Ansys or Rightmove are good examples of such companies. These companies will be well positioned to continue to grow their cash flows, even during periods of inflation.

Next, we find those companies that need to think a lot before raising prices because of the market structure or the competition, and also those that can only push prices through innovation. The latter are typically only able to increase prices when they launch a differentiated version or a brand-new product. These companies may only be able to raise prices in line with inflation, though they may be able to raise them ahead of inflation like the companies in the first category. This will depend on how advanced the innovation curve is in their industry: the more advanced the innovation curve, the less differentiated newer versions will be, and the less customers will be willing to pay for those innovations. Medical technology companies like Edwards Lifesciences, Stryker and Coloplast are good examples of such companies. These companies will generally require greater scrutiny.

The third category includes companies that cannot raise prices at all and are price-takers. This is the case for several reasons. The products they sell may be highly commoditised. They may be operating in a market which is regulated, mature or highly competitive. It may be simply because the underlying product they trade is so liquid that the prices are set on a pure supply and demand basis. This is typically the case for companies that deal with raw materials or banks which have little, if any, pricing power. These companies will see inflation squeeze their profits and erode their capital base. Their cash flows will ultimately deliver poor returns to shareholders during times of inflation. Needless to say, these companies have no place in the Seilern Universe.

Raising prices in line with inflation will often not suffice to protect a company’s future cash flows from the force of inflation. What we can conclude, however, is that those quality growth businesses that are typically able to raise prices above the rate of inflation will start from a very advantageous position when it comes to protecting their cash flows and returns to shareholders in times of inflation. There are many other aspects of a business that need to be analysed when considering how inflation will affect its future value. The cost base is notably one of them, but one must not forget the balance sheet, since the capital that these businesses require to continue to grow will increase in real terms and the assets booked on their balance sheets will be shown at values far below their true replacement values. This is something that my colleagues Marco and Quentin will address in the newsletters to follow in this series on inflation.

Fernando León

30th April, 2021

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