The Importance of Pricing Power: PEP, CPB

In May 2010, Warren Buffett met with staff from the Federal Crisis Inquiry Commission (FCIC) to discuss the financial crisis. During the interview, when discussing his investments in Dun & Bradstreet and Moody’s starting in the late 90s, Warren had this to say:

“Basically, the single most important decision in evaluating a business is pricing power. You’ve got the power to raise prices without losing business to a competitor, and you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you got a terrible business.”

When Warren said this, it reminded me of a story from Alice Schroeder’s book, “The Snowball.” In 1977, Warren met with British ambassador Walter Anneberg, who was the owner of Triangle Publications, the company behind the “Philadelphia Inquirer,” “TV Guide,” and “Daily Racing Forum.” When retelling the story of his visit with Mr. Anneberg, Warren says this about the “Daily Racing Forum”:

“It sold a hundred fifty thousand copies a day, and it had for fifty years. It cost more than two bucks [at a time when the Washington Post or the New York Times cost a quarter], and it was essential. If you were headed to the racetrack and were a serious handicapper, you wanted the Racing Form. [Anneberg] could charge whatever he wanted, and people were going to pay it. It’s like selling needles to addicts, basically.

So every year, Walter would go in and say ‘Mirror, mirror, on the wall, how much should I raise the price of the Racing Form this fall?’”

In economics, elasticity is a measurement that shows how changing one economic variable affects another; one particular measure, the price elasticity of demand, measures the responsiveness, or elasticity, of the demand for a good or service to a change in price.

The two extremes are perfectly elastic demand, and perfectly inelastic demand. With perfectly elastic demand, a small change in price has an astronomical effect on quantity demanded. The example generally cited for this phenomenon is the demand for commodity goods: if a farmer tries to charge 5% more than his competitors for a pound of sugar, the demand for his goods will completely evaporate; competitors will simply switch to another farmer, which offers the identical good but at a cheaper price.

On the other end of the spectrum are goods/services with perfectly inelastic demand, where a change in price has no effect on the demand for the product. An example is a life saving drug; if it costs 10% more tomorrow than it does today, patient with diabetes are still going to be willing to pay for their insulin. In the case of the Racing Form, the serious handicappers were going to buy it regardless of if it was $2 or $2.25, because there was no viable alternative and it provided a value that exceeded its cost.

In early September, I wrote an article about Campbell’s Soup (CPB), when CEO Denise Morrison had this to say about sales in the quarter: “Soup volumes and consumption were softer this quarter as we expected because price realization is coming through. We have 2 more quarters ahead where we will be cycling the heavy discounting activity. While we expect further volume declines, we will be competitive and we believe elasticity will normalize over time.” As can be seen in the quarterly filing, the company cut promotional spending in the U.S. Simple Meals category, which is essentially a price increase; as a result, volume/mix plummeted (down 11%), decreasing enough to offset the 3% increase in overall pricing. For a company like Campbell’s Soup, this is a testament to the fact that they are competing in a category with both private label and other branded products, where price is an important factor for consumer decision-making.

On the other end of the spectrum is PepsiCo (PEP); here is what CFO Hugh Johnston had to say in their most recent quarterly call: “Let me comment briefly on pricing. Our third quarter pricing actions were implemented as planned, and the elasticity’s we've observed so far are largely in line with what we'd modeled…” An example of this can be seen in the 10-Q in the Frito Lay North America (FLNA) division. Over the past 12 and 36 week periods, PepsiCo has increased their effective net pricing 4% and 2%, respectively. However, unlike Campbell’s, which saw volume fall off significantly as a result of pricing action, PepsiCo saw volumes decrease 1% over the 12 week period and stay essentially flat since the start of the year.

While this only covers a very short time frame, the example goes to say something about PepsiCo’s snack business. However, there is still must be a sense of reservation from management; as noted by PepsiCo Americas Foods CEO John Compton, share in traditional channels was down about 1 point on dollar share, most of which went to private label. This goes to show that while PepsiCo may have more inelastic demand in snacks than someone like Campbell’s does in soup, they still can’t price their goods like Mr. Anneberg did with the Daily Racing Forum.

For investors, the trick is finding good businesses that can raise prices without having to have a prayer session; finding businesses with pricing power is a great beginning to a successful long term investment.