Warren Buffett and Pricing Power

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Feb 19, 2011
Warren Buffett was quoted as saying in his testimony to the Financial Crisis Commission that “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. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business"…. and also "The extraordinary business does not require good management. ”

This should come as no surprise.

Buffett loves firms with pricing power and specifically ones with the market power that enables pricing power. Though he neglected to say Moody’s (MCO, Financial) operates in an oligopoly which also makes its very attractive. Coca-Cola also operates in a duopoly with Pepsi (PEP, Financial) and this provides an valuable “moat” around the business.

What does come as a surprise is the history of Coca-Cola (KO, Financial) pricing. You’d think a brand such as Coke operating in a duopoly with Pepsi to be consistently raising prices, but this couldn’t be farther from the truth. Prices for a 6.5 oz of coke remained stable at a nominal price of 5 cents from the years 1886 to 1959. From then on to today, the price for a Coke has trailed the rate of inflation. This seems paradoxical as you’d think of such a prominent brand as Coke to exceed the rate of inflation.

This phenomenon is reiterated in the price elasticity of demand of Coke. This is a measure of change in demand resulting from a change in price. As the link will show Coke’s elasticity of demand is -3.8 which means a price increase of 2% would result in a decrease in demand of 7.6%. By contrast the general soft drink market is between -.8 and -1 which would indicate consumers will not reduce consumption nearly as much for a similar percentage price increase. This point should be clarified by the fact that Coke commands a much higher price than unbranded colas. Thus a 2% increase in Coke would be a several percentage point hike in an unbranded cola. But it remains that Coke does not have the ability to simply raise prices without losing customers.

What Coke does have going for it, is its significant mark-up to their unbranded rivals. And assuming a similar cost structure, even though Coke may very well have a much better one than its rivals, Coke will also have much larger margins (its latest net margin has exceeded 20%). When Pepsi was first released in 1934, they offered a 12 oz bottle for the same price as Coke’s 6.5 oz bottle. Clearly a premium existed in Coke even during its stagnant price period.

The margins also serve as a buffer. If sugar prices were to rise, the unbranded colas which have much more narrow margins would have to increase their prices at a much higher percentage than Coke would need to in order to sustain the previous margins. Coke also has the option of simply riding out cost pressures while their competitors will likely have to raise prices or watch profits (and possibility the business) disintegrate. This seems to be the strategy most consistent with Coke’s pricing history.

Josh Zachariah