The Essence of Pricing Power of Asian Wide-Moat Compounders – Bamboo Innovator Weekly Insight
December 7, 2015 Leave a comment
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|BAMBOO LETTER UPDATE | December 7, 2015|
|Bamboo Innovator Insight (Issue 111)
The Essence of Pricing Power of Asian Wide-Moat Compounders
Having taught cost accounting at the university, I always find that the topic on “pricing” to create, communicate and retain value has been sorely neglected. Management tend to have fear of prices, especially when they need to increase them. The fear has one legitimate source: one can never know with absolute certainty how customers will react to a price change. If we raise prices, will customers remain loyal or will they run in droves to the competition? Will they really buy more, if we cut prices? As a result, managers invariably keep their hands off the pricing lever if they have doubt, turning their attention to something more tangible and more certain: cost management. But what is the underlying business model scalability, wide-moat competitive advantages, cost structure dynamics, and organizational system to support the pricing decision and pricing strategy?
The importance of pricing in investment fundamental analysis cannot be emphasized more. In fact, Warren Buffett once described “pricing power” as the most important factor in evaluating a business: “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business,” he said in 2011. In case of either inflation or deflation, value investors want to own companies that have pricing power — it will protect their earnings. Those companies will be able to pass higher costs to their customers during a time of inflation and maintain their prices during deflation without fear of volume decline or loss of market share.
Charlie Munger, the influential partner to Buffett’s success, also commented on the valuation effect of “untapped pricing power” for wide-moat compounders like Disney and See’s Candy:
“There are actually businesses, that you will find a few times in a lifetime, where any manager could raise the return enormously just by raising prices—and yet they haven’t done it. So they have huge untapped pricing power that they’re not using. That is the ultimate no-brainer. That existed in Disney. It’s such a unique experience to take your grandchild to Disneyland. You’re not doing it that often. And there are lots of people in the country. And Disney found that it could raise those prices a lot and the attendance stayed right up. So a lot of the great record of Eisner and Wells was utter brilliance but the rest came from just raising prices at Disneyland and Disneyworld and through video cassette sales of classic animated movies. At Berkshire Hathaway, Warren and I raised the prices of See’s Candy a little faster than others might have. You will get a few opportunities to profit from finding underpricing. There are actually people out there who don’t price everything as high as the market will easily stand. And once you figure that out, it’s like finding in the street—if you have the courage of your convictions.”
For instance, Disney’s Magic Kingdom actually saw an increase in attendance in all of the last five years except 2010 despite the fact that the price of admission also went up, even hiking to a 3 figure price tag of $105 for a one-day ticket to Magic Kingdom at Walt Disney World in Orlando. While tourism spending is a consumer discretionary item, consumers are increasingly more interested in spending money on unique and innovative “experiences” rather than on things.
At Costco, one of Munger’s favorite companies, member renewal and retention rates have not suffered much after membership fee increases, suggesting that Costco also wields meaningful pricing power over its customers. By selling several staples as loss leaders – fresh food and gas -Costco can preserve the market share it has already captured and fend off other discounters and online players like Amazon. Becoming “Amazon-proof” is an enviable position for any retailer, as the company’s online dominance has most major retailers such as Target and Walmart playing catchup.
The more conscientious students with intellectual curiosity in my accounting class find the various cases shared to be useful. Some of these cases include how JC Penney, once considered America’s most venerated department store chain, plunged over 80% in market value since Feb 2012 when then-CEO Ron Johnson radically altered its pricing strategy from frequent sales promotions at deep discounts off its higher list prices to an everyday low pricing model that eschewed sales and clearance discounting, dubbed “Fair and Square”. Launched without any consumer testing, the new pricing strategy failed dramatically. Customers voted with their feet, leaving the retailer in droves when they could not get products at the discounted price they had come to expect.
Parker Hannifin, the #1 motion & control company, rose 240% since 2001, outperforming the 55% rise in the S&P 500 index, when Donald Washkewicz introduced “winnovation” in integrating pricing into its innovation process, aiming to pinpoint and develop products that offer the most potential for price premiums. Parker Hannifin build upon basic “cost” information to think deeper about the pricing decision of its over 800,000 seemingly “homogenous” widgets, differentiating them and determining their prices by what its over 470,000 customers are willing to pay rather than what a product costs to make and using the straightforward cost-plus pricing.
Or the case of how Apple changed its pricing structure for songs sold through iTunes from a flat fee of $0.99 to a 3-tier price of $0.69, $0.99 and $1.29. The top 200 songs in any given week which make up more than one-sixth of digital music sales – songs by artists like Adele – are charged at the highest price of $1.29. Six months after Apple implemented the new pricing model, downloads of the top 200 tracks were down by 6%. However, because Apple’s iTunes costs – wholesale song costs, network and transaction fees and other operating costs – do not vary based on the price of each download, the profits from the 30% price increase more than made up for the losses from the 6% decrease in volume. Apple has also applied this new pricing structure to movies available through iTunes, which range from $14.99 for new releases to $9.99 for most other films.
A favorite Asian example is Japan’s Kyocera, the advanced ceramics company, working with the same material used to produce rice bowls. If a company sells one truckload of rice bowls for ¥1.5m, the profit is about ¥0.1m. However, if that company sells one truckload of IC packs, which are made of the same ceramic material, it can charge ¥50bn, making a profit of ¥15bn. The products are based on the same material, but the difference in profit is obvious. The secret of Kyocera’s success was in its ongoing commitment to resolving any problems of customers while overcoming technical challenges. It also experienced constant price pressure, with customers in effect saying, “If you don’t lower your prices, we won’t place any more orders.” In that situation, the company made all-out efforts to reduce costs, opening up the market for a fierce cost-cutting struggle. The basic requirements for a technology-oriented company to exploit its uniqueness are: (1) Choose a core technology and then improve and then upgrade it; (2) Exchange technical information while positively fostering human relations; and (3) When an obstacle is encountered, start to adopt an attitude of making every attempt cause a positive splash in the market and with customers. The inventions of Kyocera’s founder Dr. Kazuo Inamori, who was the first person in Japan to synthesize Forsterite, a kind of ceramic that played a pivotal role in electronic circuitry for TV sets, helped supported Japan’s global revolution in TV manufacturing in 1950s after WWII. Kyocera’s advanced ceramic materials also fostered the development of the semiconductor industry.
Pigeon Corp (Tokyo: 7956) – Stock Price Performance, 1988-2015
For Japan’s Pigeon Corp…
Read more about the pricing power strategy of Pigeon Corp and 3 other Asian wide-moat companies at the Moat Report Asia: http://www.moatreport.com/updates/
Pricing also intrigued the late managmenet guru Peter Druckerfrom an economics and also from an ethical perspective. He understood profit to be the “cost of survival” and sufficiently high prices to be a “means for survival”. Above all, he warned against the abuses of market power. He commented on price transparency and advocated fair behavior. The pricing abuse of pharmaceutical drug companies from Michael Person’s Valeant to Martin Shkreli’s Turing Pharmaceuticals has sparked public furore and threathened the going concern of their business. Pricing power to maximize profits become an inflmmatory phrase and lighting rod.
Hedge fund manager Bill Ackman compared “platform stock” Valeant to early-stage Berkshire Hathaway in early 2015; William Thorndike, author of The Outsiders, compared Valeant’s CEO Michael Person to Liberty’s cable billionaire John Malone. When Valeant’s share price collapsed in Oct 2015, many sophisticated institutional investors were hurt. Charlie Munger commented in March 2015 that companies like ITT Corp., made money back in the 1960s in an “evil way” by buying businesses with low-quality earnings then playing accounting games to push valuations higher. “Valeant, the pharmaceutical company, is ITT come back to life,” Munger said. “It wasn’t moral the first time. And the second time, it’s not better. And people are enthusiastic about it. I’m holding my nose.” Valeant relied on “gamesmanship” to run up its value and created a “phony growth record.” We noted various articles back in 2014 that shed insights about the corporate culture and accounting of Valeant: Valeant CEO Michael Pearson is known as an aggressive cost cutter. Valeant’s corporate culture is that it does not want to spend money on science and sees no wrong in substantially jacking up prices of drugs after acquiring them, violating the Drucker’s ethical principle on pricing power.
Value investors analysing the pricing power of business need to understand that a sustainable fair game between the seller and consumer in pricing lies in one word: value. Ultimately, the customer is only willing to pay for the value he or she gets. The challenge for any seller is to find out what this perceived value is and then price the product or service accordingly. It leaves the seller or manager/ entrepreneur three tasks which the value investor must know in order to understand the effect of pricing power on value creation: (1) Create value: The quality of materials, performance, and design all drive the perceived value of customers. This is also where innovation comes into play; (2) Communicate value: This is how you influence customers’ perception. It includes how you describe the product, your selling proposition, and the brand. Value communication also covers packaging, product performance, and shelf or online placement; (3) Retain value: What happens post-purchase is decisive in shaping a lasting, positive perception. Expectations about how the value lasts will have a decisive influence on a customers’ willingness to pay. The customer stays loyal only if the exchange with the seller cultivates a lasting sense of fairness. Customer satisfaction and loyalty is the only way to build and deepen wide-moats and compound long-term value.
An ancient Chinese business philosophy sums up best the essence of pricing power and sustainable value creation for value investors:
The Moat Report Asia
PS: We like to share our Investor Day Presentation held on 1 December 2015 for our shareholders. The presentation material is available for download on the ASX website:
A new monthly issue of The Moat Report Asia is now available!
Access the in-depth idea presentation:
Our latest monthly Moat Report Asia for November/December 2015 investigates Asia’s leading solutions provider for transmitting signals and power for wide-ranging, value-added end-applications, such as Amazon’s warehouse robots and drones, medical equipment, automotive, green energy (wind power generator/turbine and solar power), industrial control, communications products to internet-of-things. Clients are very strict about product quality as this product is critical in transmitting signals and power and hence they have to be highly reliable; shock-resistant; and withstand high voltage, fire, water, bending/extension, UV rays, grease, chemical solvents, and low temperature; in order to operate for extended periods of time, resulting in long-term customer loyalty and representing high market entry barrier. Customers are mainly global MNC leaders. Top client is GE, contributing 5.1% of sales in FY14. 70% of GE’s medical equipment already uses its products and solutions. Top ten clients account for <30% of sales and a well-diversified quality MNC customer base reduces the operational risk from dependence from having a single key client. New high-growth products include robotics products used in automated warehouses which have seen an increase in construction due to the rise in online shopping and customers include Amazon and Alibaba.
For a 19.4% ROE business with visible long run-way in higher-margin applications and solutions, the company has a reasonable valuation: In terms of EV/Sales, it trades at 0.99x, a 180% discount on average to its peers. In terms of EV/EBIT and EV/EBITDA, it trades at 11.5x and 9.6x respectively, a 42% discount on average to its peers. There is short-term downside protection with over a healthy net-cash balance sheet (~10% of market value) and consistently high dividend yield (4.5%). With the continued improvement in operating profit margin due to the higher value-add products and solutions, it has the potential to double its operating profit in the next 3-5 years, pointing towards a doubling in share price.