The Power of Pricing

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The power of a company to be able to price its own products, in my belief, is one of the most important factors of long term investing. The power to set prices on products allows the company to maintain a constant profit margin above the cost of production and administrative costs. This constantly stable profit margin allows the firm to plan into the future and not have to rely on borrowing when the rest of the market turns against it.

Cliffs Natural Resources (NYSE: CLF) is the perfect example of this. As one of the biggest miners in the world, Cliffs should have very good economies of scale and hedging contracts in place to mitigate some adverse commodity movements; however, the lack of pricing power can still affect the company.

During 2010 Cliffs sold a total of 3.3 million tons of North American Coal. This cost the company $467 million to produce and was sold for a total sum of $438.2 million; a loss of $29 million. Furthermore, during 2009 the company only sold a total of 1.9 million tons (60% less) for a total of $207million – costing $279 million to produce, another loss of $72 million.

<table> <tbody> <tr> <td> <p>$US MILLIONS (except per ton values)</p> </td> <td> <p>2010</p> </td> <td> <p>2009</p> </td> </tr> <tr> <td> <p>Revenue</p> </td> <td> <p>438</p> </td> <td> <p>207</p> </td> </tr> <tr> <td> <p>Cost of sales</p> </td> <td> <p>(467)</p> </td> <td> <p>(279)</p> </td> </tr> <tr> <td> <p>Sales Tons</p> </td> <td> <p>3.3</p> </td> <td> <p>1.9</p> </td> </tr> <tr> <td> <p>Sale price per ton</p> </td> <td> <p>$133</p> </td> <td> <p>$108</p> </td> </tr> <tr> <td> <p>Production cost per ton</p> </td> <td> <p>$142</p> </td> <td> <p>$147</p> </td> </tr> <tr> <td> <p>Profit per ton</p> </td> <td> <p>-$9</p> </td> <td> <p>$-39</p> </td> </tr> <tr> <td> <p>Iron Ore Price</p> </td> <td> <p>$150</p> </td> <td> <p>$75</p> </td> </tr> </tbody> </table>

 Source: Cliffs Natural Resources Annual Report

There are two things these results highlight – 1. Cliffs cannot become more profitable just by increasing production – 2. Cliffs is at the mercy of the commodity market and has no control over its own selling costs leading to unpredictable results.

This lack of pricing power and reliance on the open market to set prices for its products does produce an unreliable return for cliffs and its shareholders.

CLF Return on Equity Range, Past 5 Years

<table> <tbody> <tr> <td> <p>Minimum</p> </td> <td> <p>7.66%</p> </td> <td> <p>Sep 2009</p> </td> </tr> <tr> <td> <p>Maximum</p> </td> <td> <p>41.04%</p> </td> <td> <p>Sep 2008</p> </td> </tr> <tr> <td> <p>Average</p> </td> <td> <p>25.75%</p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

Power of pricing and ROE

The ability to price products is the definitive method of producing a consistent and profitable return on equity for shareholders. The constant profit margin that is produced allows the company to plan ahead and invest for the future, with creditors having a steadier income stream from which to rely on for interest payments.

The ability to price products above the cost of production also allows for a higher gross margin, and results in higher free cash flow. For example, Coca-Cola (NYSE: KO) would never sell the vast majority of its products below the cost of production, as Cliffs has been forced to do. Coke maintains a profit margin on its products significantly above the cost of production.

KO Gross Profit Margin Quarterly Range, Past 5 Years

<table> <tbody> <tr> <td> <p>Minimum</p> </td> <td> <p>59.22%</p> </td> <td> <p>Dec 2010</p> </td> </tr> <tr> <td> <p>Maximum</p> </td> <td> <p>66.23%</p> </td> <td> <p>Mar 2010</p> </td> </tr> <tr> <td> <p>Average</p> </td> <td> <p>63.02%</p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

On the other hand, Cliffs has no control over prices and cannot maintain a stable profit margin above the cost of production.

CLF Gross Profit Margin Quarterly Range, Past 5 Years

<table> <tbody> <tr> <td> <p>Minimum</p> </td> <td> <p>-3.00%</p> </td> <td> <p>Jun 2009</p> </td> </tr> <tr> <td> <p>Maximum</p> </td> <td> <p>50.67%</p> </td> <td> <p>Mar 2011</p> </td> </tr> <tr> <td> <p>Average</p> </td> <td> <p>26.80%</p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

As a result, Cliff’s shareholders get an unreliable return on their equity:

 

<img src="/media/images/user_14485/roe1_large.png" />

With unpredictable shareholder returns Cliffs has an unpredictable share price – under-performing the S&P 500 in 2009 and 2012, but outperforming the S&P in 2008, 2010, 2011. In contrast, Coke has outperformed the S&P 500 every year since 2008.

 

<img src="/media/images/user_14485/roe2_large.png" />

Not Just Resource Stocks

Just as basic materials companies feel the pinch from both ends with higher manufacturing costs rising faster than the price of commodities or sales costs, stocks in highly competitive industries also come under similar pressures. The best example of this can be seen in both railroad stocks and delivery stocks, both of which come under pressure from competition, higher fuel costs, economic trends, taxation, and supply side inflation. The problem is that the majority of these costs cannot be passed onto the customer. For example, take FedEx (NYSE: FDX) and its return on shareholder equity over the past 5 years.

FedEx Return on Equity Range, Past 5 Years

<table> <tbody> <tr> <td> <p>Minimum</p> </td> <td> <p>-1.74%</p> </td> <td> <p>Nov 2009</p> </td> </tr> <tr> <td> <p>Maximum</p> </td> <td> <p>14.78%</p> </td> <td> <p>Feb 2008</p> </td> </tr> <tr> <td> <p>Average</p> </td> <td> <p>7.99%</p> </td> <td> <p> </p> </td> </tr> </tbody> </table>

FedEx lacks the ability to be able to set prices across its product portfolio to account for all of the costs the company has to meet. Therefore, margins are low and return on equity is erratic as all the different factors eat away at the company's profit margin. 

FedEx has to grapple with making its product prices low enough so that it does not lose customers to competitors, but on the other hand the company has to account for rising wages, fuel, and taxes - all resulting in a lower profit margin. If FedEx could set prices and was a monopoly like Coca Cola then its shareholders would see significantly higher margins and returns on their equity.

Overall, the ability to set prices on products can be a significant factor when deciding where to invest. Being able to price products for constant profit is a luxury very few companies have access to; however, when a company does have access to this it can indicate very good long term returns for investors.

Data Source: YCharts

Chart Source: FOOL CAPS


RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends FedEx and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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