Monday, February 21, 2011

Buffett On Pricing Power

During an interview with the Financial Crisis Inquiry Commission (FCIC)*, Warren Buffett had the following to say about the importance of pricing power when evaluating a business:

"...the single most important decision in evaluating a business is pricing power."

He added that when you can "raise prices without losing business to a'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 (laughs), then you got a terrible business. And I've been in both and I know the difference."

Pricing power might result from structural changes to the competitive landscape of an industry**, or by having well-known brands (fast-moving consumer goods: FMCG) with wide distribution like Pepsi (PEP), Coca-Cola (KO), Procter & Gamble (PG), and Kraft (KFT).

During the interview, Buffett talks about the reason for Berkshire Hathaway's (BRKa) investment in Moody's (MCO). Once again, the attractiveness of Moody's as an investment comes down to pricing power that stems from the company's large percentage market share.

In contrast, consider the U.S. airline industry:
  • Intense rivalry among many competitors
  • No significant barriers resulting in ease of entry into the industry by new competitors
  • Frequent industry overcapacity
  • Cheap substitutes to air travel (especially over short distances)
It all adds up to lots of buying power for airline customers and little to no pricing power for the airlines.

Intense price competition among too many players.

There's some additional reasons why most airlines (if not all) are very unattractive businesses beyond the aforementioned lack of pricing power. Airlines are capital intensive businesses that have to deal with significant supplier power (i.e. just two major manufacturers - Boeing and Airbus), large yet unpredictable fuel costs (with little control over those expenses), and high fixed operating costs (operating leverage).

Add in some financial leverage and you've got one of the toughest businesses to manage. The combination of excessive financial and operating leverage makes the earning power of any business very sensitive to even small changes in revenue.

So airlines would seem to have just about everything you don't want in a business. The possibility does exist for an airline with the lowest cost structure to do relatively well against competitors, but that doesn't make it a good business. The lowest cost airline is usually just the best house in a bad neighborhood at any given point in time. It might be a good business for an airline but it's not a good business more generally.

The risk/reward for investors is much more favorable with the best companies in other industries.


Long positions in NSC, PEP, KO, PG, KFT, and BRKb

* A bunch of expert interviews (including Buffett's) can be found on the FCIC website. Collectively, these interviews are a useful way to better understand the financial crisis.
** The current consolidated structure of U.S. railroad industry (Norfolk Southern: NSC, Union Pacific: UNP, CSX: CSX, and Berkshire's BNSF Railway) comes to mind. Until more recently, the industry had too many competitors for there to be attractive business economics.
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