US companies are testing the limits of their pricing power
Economy

US companies are testing the limits of their pricing power

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US companies are testing the limits of their pricing power

Alexander MacKay directs the Pricing Lab at Harvard Business School, a research center dedicated to studying how companies set prices. Since the pandemic, he has observed how businesses have become more willing to experiment with what they charge their customers.

Large companies that previously imposed a standard price increase per year are now raising their prices more frequently. Retailers are increasingly using digital price displays, which they can change with the touch of a button. Across the economy, managers trying to maximize profits are testing to determine what prices consumers will bear before they stop buying.

Huge disruptions in supply chains have driven up business costs during the pandemic and forced many companies to think more creatively about their pricing strategies, MacKay said. This reinforced the trend toward tighter pricing and showed many companies that they could play more boldly on price without scaring away buyers. Experimentation continues even if costs decrease.

“Prices could move more quickly than before,” he said. This can mean an increase or a decrease, although companies are generally more willing to raise prices than lower them.

Companies are trying to find a way to protect the profits they have generated since the pandemic. For large companies in the S&P 500 index, the average profit margin – the percentage of profit to revenue – soared in late 2020 and into 2021, as government stimulus and government interventions Federal Reserve emergency boosted consumer demand. At the same time, companies have raised prices so much that they have more than covered the higher costs of energy, transportation, labor and other inputs, which have recently started to fall .

Companies including Apple and Williams-Sonoma recently reported their highest margins on record for the third quarter, while Delta Air Lines said its international routes generated record profitability over the summer.

Margins softened somewhat last year, but have recently returned to levels that would have set records before the pandemic. Average margins in almost every sector of the S&P 500 are near or above 10-year highs, according to Goldman Sachs.

“Companies are maintaining or even increasing their margins because they are not passing these cost reductions on to consumers,” said Albert Edwards, a strategist at Société Générale, who called recent margin developments “obscene.”

Now, companies are trying to figure out how to set prices to protect profits at what could prove to be a turning point. High interest rates and savings make some buyers – but not all – more price sensitive.

Many companies might be able to protect their profits simply by keeping their prices stable as their own costs fall. But some still question whether they can further raise prices as demand cools and overall inflation eases.

“I don’t think companies have the monopolistic power to raise prices willy-nilly,” said Ed Yardeni, president of research firm Yardeni Research.

Many companies talk on earnings calls about how they prioritize profit margins, even if it means less growth.

Take Sysco, the food wholesaler. Its business in the local market has slowed recently, Kevin Hourican, the company’s chief executive, said during an earnings conference call in October.

But “Sysco doesn’t respond by pricing to gain share,” he said, referring to the tactic of cutting prices to gain more customers, which is commonly used during economic downturns. “We are instead focusing on profitable growth. »

Lennox, a heating and cooling company, works to perfect its pricing strategy based on years of data, Alok Maskara, the company’s chief executive, said this at an investor event this summer.

People in the industry are “margin-driven rather than revenue-driven,” he said, implying that fewer, more profitable sales are preferred over many, less profitable sales.

The emphasis on higher margins – even if it means selling less – is in some cases a departure from conventional wisdom in the years before and after the 2009 recession. At the time, some executives felt compelled to compete prices for cost-sensitive buyers. For hotels, that meant focusing on filling every room.

“If you remember the Great Recession, there was this idea of ​​lowering rates until people went to bed,” Leeny Oberg, Marriott’s chief financial officer, said in a statement. September meeting with investors. She added that “it wasn’t necessarily the right strategy at all times.”

Today, “the industry has clearly learned some lessons,” she said. In recent years, the company has sought a better balance between maximizing revenue and profits, she noted.

Retailers, who have been surprised by changing consumer tastes in recent years, are more recently talking about “inventory discipline,” or keeping fewer products in stock, to avoid selling products at low prices. clearance prices. The logic is that it is better to sacrifice some sales by running out of product than to be forced to reduce prices in a way that affects the bottom line.

Clothing chain American Eagle Outfitters has increased margins by “maintaining tight inventory and promotional discipline,” Jay Schottenstein, the company’s chief executive, said during a November earnings conference call.

Although consumers may forego certain purchases as prices rise, this is not universally true – hence the value of experimentation. Robert J. Gamgort, chief executive of Keurig Dr Pepper, said recently that consumers have little sensitivity to rising soda prices.

That suggests “the value was too good to begin with,” he told an investors conference in September, referring to the recent inflationary period. “It was undervalued.”

The company, which raised prices at its U.S. beverage unit 7% last quarter, highlighted “strong gross margin expansion” at the top of its report. latest earnings report.

Some executives also find that they can charge more to present something as a luxury product or experience.

“Despite the current economic environment, we continue to see consumers opt for higher-end equipment,” Melissa Thomas, chief financial officer of the Cinemark theater chain, said during a November earnings conference call.

Kellogg, the cereal company, has experienced substantial price increases without losing customers – a situation economists call low price elasticity. It’s like you snap a rubber band (raise prices) but it doesn’t respond (buyers keep buying).

But recently, consumers have started to back away from sticker shock.

“Price elasticity has had a pretty significant impact on the market,” Gary Pilnick, Kellogg’s chief executive, said on a call with analysts last month. “You may recall that there has been about a 35 percent increase in prices over the last two years for us, and the elasticities have been quite benign for a while.”

Price sensitivity is also showing up among brands that cater to lower-income consumers, like Walmart and McDonald’s, which have seen their business grow as wealthier people look for deals.

“We continue to gain market share among middle- and upper-income consumers,” Ian Borden, McDonald’s chief financial officer, said during an earnings conference call in October, while noting that the company was seeing its Low-income customers experience difficulties.

Even as companies get creative to protect margins, the economy has also held up better than expected. Overall growth remained rapid, consumer spending increased and a long-predicted recession remained at bay.

The question is whether companies will be able to protect their profits in an environment where this dynamic slows.

“Clients are rebelling,” said Paul Donovan, chief economist at UBS Global Wealth Management. “We have reached this point of resistance. »