By Sean Stannard-Stockton
"The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business." - Warren Buffett
When we look for companies to invest in, we look for companies that we think can maintain high levels of profitability over the long term. One key to a company being able to do this is it possessing the ability to maintain a consistent spread between their costs and the prices they charge customers. While costs are often difficult to control, a company with pricing power can consistently increase prices as needed to maintain a satisfactory spread over their own costs and therefore sustain strong profits.
Buffett attributes his purchase of See's Candy in 1972 as the deal that opened his eyes to pricing power. His partner Charlie Munger goes so far as to say "See's candy company was the first high-quality business we ever bought" and noted that the company demonstrated the value of building a "seamless web of trust" between a company and its customers.
A lot of investors have taken Buffett's comments to heart and embraced pricing power as a key attribute they look for in a company. However, we would argue that pricing power arises from two different situations, one that is unequivocally good and one that includes a hidden danger that will one day likely rear its head and wipe out an investor's profits.
In the See's Candy example, the company can raise prices because customers love their product. While there are other chocolate makers selling competing products, none of them sell See's chocolate. Whether a box costs $13.99 or $14.49 or $14.99 doesn't make that much difference to See's customers. While they need to exercise their pricing power judicially - certainly, customers would get annoyed if they ordered a box and find the price has jumped by $5 - their pricing power arises from the fact that customers love See's candy.
One real-time experiment in pricing power is Apple's (NASDAQ:AAPL) decision to sell the new iPhone X for a record high $999. Remember, it is competing against other smartphone makers whose devices are available for free as part of a new wireless plan. But current indications are the iPhone X is experiencing strong demand. Apple has always explicitly focused on "delighting" its customers. This delight is the source of its pricing power.
Writing about the power of Apple in the wake of Steve Jobs' death in 2011, marketing professor Ravi Chitturi argued that the company was poised to continue its monster success specifically because of its focus on "customer delight":
"Great products strive to delight their customers by design. The goal of achieving customer satisfaction is not, in fact, the driving force behind customer loyalty. It's delight. Delighted customers are loyal, significantly more loyal than satisfied customers, because in the end consumers do not buy products, they buy and consume emotion… Steve Jobs is gone, and I hope that he has not taken delight with him. Cook has to retain and enhance the emotion of delight in Apple products. This is the key to Tim's and Apple's future success."
In our portfolio, companies such as Apple, L Brands (NYSE:LB), Ferrari (NYSE:RACE), First Republic (NYSE:FRC), Nike (NYSE:NKE), Netflix (NASDAQ:NFLX), and Tiffany (NYSE:TIF) all command a certain level of pricing power due to their ability to delight customers.
But there is another way to command pricing power. A company can execute a competitive strategy that allows it to raise prices without hurting demand even as its customers scream and moan. The rise and fall of Valeant (VRX), the pharmaceutical company, caught a number of famous value investors on the wrong side of the trade, including decimating the world class track record of the Sequoia Fund, which was famous for having been the one fund that Buffett suggested investing in when he closed his partnership [Note: We continue to have deep respect for the Sequoia Fund team and admire their approach, notwithstanding the Valeant disaster]. But if Valeant had such strong pricing power that it could raise the price of many of its drugs by 50% per year, how was this not a wonderful business?
Because Buffett's comments have never distinguished much between pricing power that arises from delighting customers and the same power that arises from customers having no other choice and actively hating the company even as they pay the new higher price.
Let's say you live in a desert and your homestead includes the only freshwater well within a day's drive. You could run a pretty good business selling that water to your neighbors. Indeed, with no competitors around, you could in all likelihood increase prices without reducing demand. In fact, you might well be able to jack prices up by 50% every year and still your neighbors would come to your well. They'd all hate you, but they'd still buy your water.
The problem with this source of pricing power is that it comes with an off-balance sheet liability. A sort of "negative goodwill" that grows every time you increase prices. While the profits might roll in for a while, one day, the customers will revolt. At the very least, the perceived excessive pricing of the well water will create a huge incentive for customers to try any new competitor that comes to town. While the high pricing makes it look like the company has a competitive advantage, in fact, the excess returns are being created by a process that increases the likelihood of a successful competitive assault sometime in the future.
When companies exploit their customers by raising prices in the face of anger, they are mortgaging their moat, and someday, that mortgage will come due. On the other hand, companies which earn pricing power through maintaining what Munger referred to as a "seamless web of trust" with their customers can earn outsized profits for many years.
Of course, not every company either delights or infuriates their customers. Companies in our portfolio such as Broadridge Financial (NYSE:BR), Paychex (NASDAQ:PAYX), and Sensata (NYSE:ST) don't inspire customers to tattoo their logo on their arms (like some Apple customers), but they also don't infuriate their customers. Many companies can build solid, competitively advantaged companies with decent pricing power by offering a good product or service at a reasonable price. Especially if that price is small relative to their customers' overall cost structure, a company offering dependability, ease of use, and their customers' a sense that "it just works" can carve out a sustainable moat and solid pricing power.
But woe to the company which mistakes its ability to exploit its customers in the short term as a long term competitive advantage. These companies may appear to have Buffett's holy grail of pricing power, but it is a power that comes with a lurking liability that will one day come home to roost.
Note: The difference between a company charging top dollar for their valuable products can sometimes be difficult to distinguish from exploitive pricing. The key is to not stand back and pass moral judgement on what the "correct" pricing should be, but instead focus on whether it is the customers themselves who are unhappy or some other party who is complaining. This analysis helps explain why we hold positions in TransDigm, Luxottica and MasterCard, all of which have received negative attention related to their pricing at one point or another.
Clients, employees and/or principals of Ensemble Capital own shares of Apple, L Brands, Ferrari, First Republic, Nike, Netflix, Tiffany , TransDigm (NYSE:TDG), Luxottica (NYSE:LUX), and MasterCard (NYSE:MA).
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