Supply bottlenecks, labour shortages and energy crises are squeezing company margins. Businesses that use lots of energy or raw materials have been among the hardest hit, but in the UK, the combined effects of the pandemic, Brexit and furlough has cast a shadow over earnings everywhere.
One solution to this array of operating headaches is to raise prices. The issue for investors is that not all companies are able to do this and spotting those that can isn’t always straightforward.
Legendary investor Warren Buffett described pricing power as “the single most important decision in evaluating a business”. This statement is true in normal times – in periods of extreme supply chain volatility, it takes on even more weight.
The current crisis in the UK energy market is a perfect example of why pricing power matters in a free market. Since the start of this year, rising global demand for gas, coupled with reduced supply from the US and Russia, helped to push wholesale prices up over 250 per cent. Without the ability to raise prices because of government pricing caps introduced in 2019, numerous suppliers have failed in recent weeks. Money Plus, Utility Point, People’s Energy and PFP have already gone bankrupt and Bulb, the UK’s sixth-largest supplier, looks set to be taken over.
A lack of pricing power has always been an issue for utilities companies. In an industry where all companies supply a homogenous product, the only way to compete apart from customer service is through prices. In the energy market, providers were operating on razor-thin margins well before the government price cap or the recent spike in wholesale prices. In the UK, energy suppliers’ profit margins went negative in 2019 after a decade hovering around the 2 per cent mark.
The gas crisis is currently getting a lot of attention because it is a politically sensitive issue. But for business, it isn’t an isolated problem. As any investor who has read a company report this earnings season will know, serious margin pressure is suddenly at the forefront of executives’ minds.
Rising input costs…
One of the first and most notable warnings in this genre arrived in July, when consumer goods giant Unilever (ULVR) lowered its margin expectation for the year due to rising costs in shipping, energy and raw materials. Other sources of inflation have come from packaging companies such as Mondi (MNDI), which have faced higher paper prices thanks to spiking lumber costs.
Last month, LED lighting producer Luceco (LUCE) said it expected its total cost of goods sold to rise 15 per cent in 2021, citing higher prices for copper, plastic and shipments from its facility in China.
The latter issue has particularly hampered those companies reliant on international supply chains. This is a global issue following surging global demand, especially from the US, where the Biden government’s $1.84tn relief package – agreed in March and equal to about 8.8 per cent of gross domestic product (GDP) – included $1,400 checks to individuals. This helped GDP bounce back to pre-pandemic levels faster than in Europe and pushed US imports to a record $283bn in July.
This unprecedented demand has also contributed to sharp rallies in shipping quotes. Luceco pointed to a fivefold rise in the cost of deliveries from China this year, while paving slab supplier Marshalls (MSLH) has seen container rates for shipping sandstone from India jump 10-fold.
…labour challenges…
Alongside the rising costs of freight and raw materials, companies are grappling with labour shortages. In the UK, the most severe symptoms of this have been the recent scenes at UK petrol stations. A lack of HGV drivers – brought about by a range of factors including the pandemic and EU drivers returning to the continent post-Brexit – initially hit supplies to forecourts, with the problem and demand then exacerbated by panic buying.
The shortfall of lorry drivers may be acute, but there are labour supply issues across the economy. The most recent data from the ONS shows there were 1,034,000 job vacancies between June and August, the first time vacancies were above a million since records began and 31 per cent up on the first quarter of 2020.
Other than retail, which saw a slight dip in total vacancies, every other sector saw a rise. Most had vacancy increases of more than 30 per cent. Accommodation and food services had 5.9 vacancies per 100 jobs, a record, with job openings in manufacturing, logistics and construction all up.
Just as it is difficult to generalise about the causes of these labour issues, what comes next is uncertain. Bank of England governor Andrew Bailey recently suggested “a number of possible outcomes to this puzzle, which have different implications for the labour market”. With furlough now over, 1.7m employees will either restart their old jobs or struggle to match their skills to new ones. In both cases, vacancies could remain high, adding to upward pressures on wages. In July, there was wage growth of around 8 per cent and a continued shortage of labour would drive this higher.
Bailey sees two other outcomes as transitory and related to some companies which, having anticipated growing demand from a fast economic recovery, may have accelerated hiring ahead of their competitors. Those firms are either right about the economic recovery and slow hiring after the recent burst, or wrong and fail to fill their vacancies. The latter case is akin to forecourt panic buying, with labour in place of petrol. In neither case does Bailey expect a structural increase in wages.
…meet pricing power
Predicting wage, commodity and shipping inflation is incredibly hard, but one way for investors to shield themselves from higher costs is to look for companies with the ability to comfortably raise prices.
Nick Train, portfolio manager of Finsbury Growth and Income Trust, believes that pricing power has become “an important credential” for successful equity investment in the second half of 2021 and singled out luxury brands as a particularly strong example in a recent note to investors. “An important reason for our holdings in Burberry (BRBY) and Remy (FR:RCO) is that the premium/luxury nature of their products not only allows them to participate in global growth but also protects shareholders against the effects of inflation,” he noted. “Because the brands confer pricing power.”
The trouble with pricing power is that it is difficult to measure. One mainstay of economics textbooks is the Lerner Index, conceived in 1934 by the Russian-British economist Abba Lerner, which calculated pricing power as (P - MC)/P, where “P” is price and “MC” is marginal cost.
In essence, the formula shows how much above marginal cost a company sells its product. A firm that sells at marginal cost has no market power and score zero, while companies with a relatively low-cost product and strong customer loyalty should score highly. Luxury goods manufacturers are prized highly by Train because their value comes just as much from their brand as it does from the quality of the materials they use.
Investors can add more nuance to this. In a 2018 paper, academics from the universities of Iowa and Indiana used the Lerner Index when looking for a correlation between companies’ pricing power and their future cash flows. Due to a lack of data, the authors used firms’ operating profit margin as a proxy based “on the assumption that average variable costs are equal to marginal costs” and found there was a positive relationship between operating margins and future cash flows.
The paper justifies the importance of pricing power in regards to future cash flows, but it also gives investors the framework to identify individual companies and sectors that have strong pricing power.
As well as having good Lerner Index scores, the researchers also found that companies with pricing power have lower profit margin volatility and a lower dispersion of analyst forecasts. The reason why their margins are more stable is because when costs increase they are easily able to raise prices accordingly. This then feeds through to the consistency of the analysts’ forecasts. If a company has a history of delivering consistent margins, it is easier to estimate their future earnings per share (EPS). When trying to predict the future, lower historical variability is a plus.
Stand-out companies and sectors
A report published by UBS in July created a pricing power scorecard for European equities based on the level and historical volatility of gross margin. It also accounted for EPS estimate changes and the change in gross margin in the past year. On an industry basis, it found that pharmaceutical, tobacco and construction material sectors had the most pricing power. At the other end of the spectrum, construction services, energy and retail had the worst ability to raise prices without losing market share.
Based on this quantitative analysis, UBS identified 32 large stocks with what it saw as the greatest pricing power in Europe. Top of the pile were luxury goods companies LVMH (Fr:MC) and Hermes (Fr:RMS) and pharmaceutical giant Bayer (Ger:BAYN). From the FTSE 350, construction materials specialist CRH (CRH), plumbing distributor Ferguson (FERG), Mondi and product testing business Intertek (ITRK) all made the list. Aside from LVMH and Hermes, each business on the list provides essential products – mostly to other businesses – suggesting that the sale of expensive handbags to the super wealthy isn’t a pre-requisite to strong pricing power.
Further analysis can help us build understanding of which companies possess the ability to pass prices on to their customers. By looking at the average size and variability of gross margins of FTSE 350 constituents over the past five years, Investors’ Chronicle found CRH was again among the best performers. Others in the top 20 included pharmaceutical companies Hikma (HIK) and Glaxo SmithKline (GSK) and B2B software technology outfits Sage Group (SGE) and RELX (REL).
Value businesses and essential products
When a company has pricing power, it can end up in a “virtuous circle” where better profit margins lead to higher cash flows and more investment back into the business, says Ben Peters, a fund manager at Evenlode. “To find these businesses you want to steer away from those with homogenous products [such as gas companies] and look to those that provide essential goods or services to other businesses,” he adds.
RELX is a good example of this. It placed highly on the scorecard and has an operating margin of over 20 per cent, as well as a return on equity consistently above 50 per cent. “It is a relatively low-cost service but getting that information is really important to customers, it’s not a discretionary spend,” Peters explains. Sage Group also benefits from these same forces.
Consumer goods companies such as Unilever, Nestle (Sw:NESN) and Reckitt Benckiser (RKT) are trickier to assess. They are currently in the eye of the storm with commodities and packaging costs rising but have historically been quite successful at raising prices, thanks to their recognisable brands.
Despite their ongoing challenges, Peters thinks this could still prove to be the case. “In the aftermath of the great financial crisis, as we came out of the deflationary episode there was a bout of inflation and Nestle, Unilever and Reckitt all increased prices and continued to see sales volume growth,” he notes. Against this, Peters points to the rise of digital marketing and social media influencers, which has diluted the strength of mainstream advertising campaigns since then. “They need to keep evolving their portfolios to stay relevant to customers,” he warns.
High margins aren’t everything
Gross margins aren’t the only indicator of pricing power, argues Alex Wright, manager of the Fidelity UK Smaller Companies Fund.
“A number of consumer staple companies with strong margins have issued margin warnings because they sell to large supermarkets that have strong negotiating power,” he says. Distributors, despite being very low-margin businesses, could instead be a good trade in this inflationary environment. “For distributors, the price of the good is going up but they don’t face the rising cost of the manufacturers,” he says.
Other intermediaries might benefit.
The semiconductor shortage is driving up the cost of cars, which makes Inchcape (INCH), a car dealership business, an appealing option. This is despite its operating margin of just 2.3 per cent. BMW and Daimler recently announced plans to limit the sales of their most premium cars and permanently lock in higher costs for their vehicles. If this was a trend matched by the wider auto industry, then Inchcape’s total sales might drop but their margins would be boosted given they receive a share of the sales of each vehicle.
Another business that Wright thinks could prosper thanks to rising car prices is commercial vehicle leasing business Redde Northgate (REDD). Although its operating profit is just 6.2 per cent, the company owns a lot of the vans it leases. “The cost of goods sold is the depreciation of those vans, the beauty of this is those vans have actually gone up in value,” notes Wright.
No one knows for certain how long supply bottlenecks and sudden episodes of spiking prices will last. Even just the threat of restricted supply in the future amplifies the issues in the short run. Crises are overt when cars are queuing down the road, but panic buying happens in more subtle ways.
This may well include the current labour market and what is happening behind closed warehouse doors: lots more companies are moving from just-in-time to just-in-case supply chains and bolstering their inventories to insulate from potential future disruption. Of course, if everyone does this, transport and shipping costs may well spiral higher, further stoking the problem.
There are lots of political and psychological forces at play in global supply chains. As ever, making investment decisions based on macroeconomic forecasts is a dangerous game. Picking companies with demonstrable pricing power, however, is always sensible. Now more so than ever.
