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Pricing Strategies: Upside Capture Versus Downside Protection

January 18, 2024 Print

A major theme that surfaced during our EAFE large cap team’s research trip to Europe was the attractiveness of a company’s chosen pricing strategy as a key profitability driver and risk mitigation tool.

While often dictated by market dynamics, pricing strategy is also influenced by the business’s competitive advantages and management discretion. How a company prices their products or services not only has important implications for its ability to capture some of the value it creates, but also how it manages risk through lessening vulnerabilities in the business. That interplay—of capturing value and mitigating risk—is why we think taking a closer look at pricing is important. From a bottom-up perspective, a company’s pricing strategy can help reveal insights into how a company's business model works, its sensitivity to elevated inflation, and why certain pricing strategies work better than others in different operating and economic environments. 

Common Pricing Strategies

While the following is certainly not an exhaustive list, we’ve highlighted some of the more prevalent pricing strategies we tend to come across when analyzing business models. The attractiveness of a chosen strategy ultimately depends on the specifics of a company’s situation, which we’ll explore further with a few examples from the EAFE large cap investable universe spanning the “good,” the “not-so-good,” and the intriguingly labelled “uncertain.”

Commodity pricing is common when products tend to lack differentiation, so prices are largely determined by the market (supply and demand). While a lack of management discretion in setting prices is often an unfavourable dynamic, it can still be profitable for a low-cost producer with a wide cost advantage over the industry's high-cost producers.

Cost-plus pricing entails applying a specific mark-up to the product/service cost which is agreed to with the customer. Pricing set as a multiple of the cost can limit the profit upside for the producer, but often comes with reduced downside and lower volatility, which is attractive when a company’s margins and capital intensity are low.

Value-based pricing is when a company sets pricing as a function of how much value customers derive from its product or service. This strategy is attractive when the value a company provides its customer is large and ideally growing, because as the utility of the product for the customer rises, so too, generally, does their willingness to pay higher prices.

Regulatory-based pricing entails what the name suggests—pricing determined by regulation. For example, power utilities that provide an essential service and are often in a monopolist or oligopolist environment usually must abide by a regulated pricing regime. This strategy was often attractive when inflation was low but may become inflexible with higher inflation. A regulated pricing framework can also stifle innovation since the company is often restricted from charging more and thereby capturing some of the benefit to consumers generated by the innovation.

While the holdings in our EAFE large cap portfolio (and broader platform) span the spectrum of pricing models, there is an over-representation of value-based examples, given we tend to favour companies in “low-cost to produce, but high-value for the customer” niches (i.e., value-based pricing). That said, we also think cost-plus companies are currently where some under-appreciated quality may exist at attractive valuations.

The Good: Compass Group, BAE, Intercontinental Hotel Group

On the cost-plus side, our UK caterer, Compass Group, and British defense company, BAE, share economic similarities that we think form the most attractive part of their investment cases. If you were screening for high-quality companies based on earnings before interest and taxes (EBIT) margins, neither would stand out positively, with Compass around 6%-7% and BAE at 9%-11%. However, minimal tangible capital requirements mean return on net operating assets for both are consistently >40%, and often infinite.

In defense contracting, BAE’s government customers often provide the capital.* In catering, Compass occupies the client's site, only has to make small investments in equipment and receives attractive payment terms from their suppliers thanks to Compass’ enviable position as the largest food buyer in the U.S.. Low margins but high returns mean that organic growth creates a lot of value, and both of these businesses enjoy strong growth tailwinds.

A key risk with low margin businesses can be earnings volatility that might require a business to hold net cash to manage weak periods. A cost-plus pricing strategy is attractive here, given it limits even temporary downside and allows a business to hold some debt in their capital structure.

Another example of a good pricing strategy is exhibited with our British hotel franchisor, Intercontinental Hotel Group. They own leading brands such as Holiday Inn, Crowne Plaza, and the namesake, Intercontinental. They utilize a royalty-based pricing model that provides resiliency and, thanks to regulation, enjoys limited price-based competition. Over 90% of earnings relate to contractual royalty payments their hotel owners make for the right to participate in franchise programs. This structure is asset-light which allows the company to grow while returning cash to shareholders and generates high margins with Intercontinental enjoying EBIT margins of >50%. This high-margin structure helps to shield the company from downturns in demand, as was experienced during the COVID-19 pandemic. Due to U.S. franchise laws, Intercontinental must publish the royalty rates they charge franchisees and are unable to deviate from these rates. New franchisees are attracted based on the quality of Intercontinental’s brands and the royalty rate they must pay is not a point of negotiation. In inflationary times, fixed royalty rates also benefit the franchisee as rising hotel room rates flow through to them.

The Not-So-Good: Sonova, Vestas

Swiss hearing aid company, Sonova, prices based on value. Management believed they should lead on pricing in 2022 given their number one market share in many markets. Historically, Sonova’s large R&D investments enabled it to have product quality advantages relative to competitors, especially on Bluetooth connectivity and rechargeability. The issue for Sonova was that by 2022, competitors had caught up on some of these product features, their newest platform launch was more evolutionary than revolutionary, and they experienced a few product quality issues. Given these challenges, raising prices ahead of peers was a mistake as the value for customers was not there. Sonova has since mostly rectified the situation; competitors have caught up on price, and some of their soon-to-be-released innovations look like they will again differentiate Sonova’s products, enabling them to reassert their pricing power. 

As another example on the not so-so-good side, some business models for renewable wind energy on both the project owner and supplier sides have been broken by inflation. Vestas, a Danish wind turbine producer we follow but currently do not own in the portfolio, talked about how three-plus decades of deflation left them unprepared for high and volatile inflation. They let customers lock in prices one to two years ahead of delivery, which became a big issue once input costs spiked. This is a situation where 5%–10% historical EBIT margins and minimal tangible capital are unattractive, given that margins went negative in 2022–2023. On the project owner side, electricity prices are often locked-in with customers before construction starts. Project cost overruns due to inflation have substantially lowered the expected returns given the prices were already set and could not adjust upwards. This is a double whammy when the weighted average cost of capital is increasing due to rising interest rates.

Uncertain: Iberdrola, Coloplast

We chose to gain exposure to renewables through a Spanish utility, Iberdrola, which is relatively more insulated from these detrimental cost and pricing dynamics. Iberdrola primarily invests in their own regulated utilities at rates of return which are prescribed by regulation. These rates of return ensure prices flexibly adjust to new cost situations, making the business relatively lower risk. Management and the culture at Iberdrola also appear to exhibit strong conservatism with their current chairman (in place for 20 years), steering the company through many of the pitfalls peers have experienced.

Despite the positive results for Iberdrola to date, regulatory-based pricing remains what we would deem as the question mark for Iberdrola going forward. This concern is in part based on the experience of another company , Coloplast, a Danish niche chronic medical devices company we follow but currently do not own in the portfolio. Coloplast has created substantial value operating under a regulatory pricing reality, but their operating environment has changed, and the strength of a regulatory pricing regime has been challenged.

Coloplast’s prices are mostly set by government healthcare authorities. The company gained a 30%-50% market share across urinary catheters and ostomy bags through having the best products and management. Typically, new products were launched within existing reimbursement structures so while they did not enjoy a price premium, they did achieve market share gains. This was satisfactory when inflation was low and stable. Now, they are launching clinically differentiated products with data to support their superiority. Examples include an ostomy bag with sensors to detect leakage preventing skin irritation as well as patient embarrassment, and catheters with 800 holes instead of two, ensuring full bladder discharge which can prevent infection. Management noted they are not sure if the government regulators will pay a premium for it. If they do not, Coloplast was clear the innovations will be discontinued.

We’re monitoring their success here given the upside case is higher prices and likely faster market share gains. However, an inability to achieve premium prices would be especially concerning today as higher inflation is a headwind for margins. Additionally, “fast risks” do exist with regulatory-based pricing, as the regulator has the discretion to abruptly adjust pricing and growing government budget issues raise this risk today.

As we continue to analyze Coloplast and monitor how their regulatory pricing situation evolves, we believe there will be important lessons we can extract that may be applicable to Iberdrola, too.

Conclusion

A company’s pricing strategy can reveal much about its overall business strategy, risk management, product differentiation, and competitive momentum. It's also a helpful reminder to investors that the macro regime a company faces can change, and to keep this in mind when judging historical financial results. In other words: strategies that worked well under one regime may struggle in a future one.

Take inflation, for example: it’s a risk to some organizations, but presents an opportunity for others. That’s why it’s important for investors to consider how management teams keep cognizant of the broader economic environment and adjust their strategy when the facts have changed. Ultimately, competent management teams can add value to a business and in turn a stock’s performance through a sensible pricing strategy.


*Note: There is a small simplification on the contract mix for both Compass Group and BAE, but non cost-plus contracts still have risk mitigations built in. Compass Group's revenue mix by contract type is around 40%-60% cost-plus pricing with the remainder as fixed price or profit and loss (P&L). Fixed-price contracts involve the customer making minimum volume commitments and P&L allows a company to control pricing. BAE's contract revenue mix is around 45% cost-plus and 55% fixed price. Fixed-price contracts typically reprice every 1-2 years with commodities hedged, and longer-term contracts often have indexations for input and labour costs.


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