Nicholas Hyett, Equity Analyst 14 June 2019
All businesses aim to charge customers a higher price for a product than it costs to deliver. How big that gap is depends on a business’ pricing power.
Unfortunately the attractive margins that come with high prices also attracts unwanted attention from rivals looking for a slice of the action. Increased competition will usually end up driving prices down.
However, some companies are able to sustain their high prices, and the healthy margins and profits that come with it. All being well, such businesses should be able to deliver consistent and attractive returns for investors over the long term. When it comes to protecting your pricing though, there’s more than one way to skin a cat.
This article isn’t advice and all investments can fall as well as rise in value, so you could get back less than you invest. Yields are variable and aren’t a guarantee of what you’ll get in the future.
In a monopoly you’re the only provider of a good or service, and that means you can set the price.
Monopolies tend to be pretty unpopular with regulators – who don’t like companies fleecing customers. But some industries are natural monopolies (or at least oligopolies – where a few players divide the market between them) and digital marketplaces, like Rightmove, are a prime example.
Gravitating towards the largest source of house listings works for both buyers and sellers. And while there are competitors, most notably Zoopla and Onthemarket.com, Rightmove’s 76% market share means it’s the go to place. Estate agents have little choice but to list properties on Rightmove, and they pay handsomely for the privilege.
Time spent on Rightmove (billions of minutes)
Source: Rightmove annual report, 2018.
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On average Rightmove charges estate agents a shade over £1,000 per office, per month and that’s been steadily creeping up for years. Since Rightmove's just managing a website, higher prices drop straight through to profit. Operating margins of 75.9%, and low capital requirements make for an attractive and cash generative business model.
Of course there’s always a danger that Rightmove squeezes a little too hard, killing the goose that lays the golden egg.
A flagging property market is hurting estate agents. Add in online challengers like Purplebricks, and Rightmove’s customers are really struggling, with some major chains closing branches. The number of agents signed up has flat-lined as a result.
Rightmove’s plugging the hole by working directly with housebuilders and broadening the range of services on offer. New analytics and data-based tools are proving popular, with lots of customers tacking extra products on to existing subscriptions.
Rightmove’s dominant position means we’re confident it can sustain its pricing power for some time to come, even if markets get tougher. If that’s the case, its hefty cash flow should continue to make its way back to investors as either buybacks or dividends.
Luxury goods companies sell aspirational products, and often the right image is more important than the price tag. A standard polo shirt just doesn’t cut it for the rich and famous the same way a designer label does.
That means luxury lends itself to pricing power in a way few other industries do, which explains why a Gucci polo-shirt will set you back around £500.
There are a number of reasons we think LVMH is particularly well placed.
For starters, it’s the biggest player in luxury. As the name might suggest, Louis Vuitton, Moet and Hennessy, are in the portfolio, but the stable of thoroughbred stretches well beyond these names to the likes of Dior and Bulgari. LVMH has a presence everywhere from watches to perfumes.
Variety helps LVMH roll with the fashion trends better than names who have all their eggs in one brand basket. A global reach adds geographic diversity too. That could be important if souring relations between the US and China dampens demand in the Far East, although weakness in such an important growth market would still be bad news for the group.
For now, sales are ticking up nicely across the board. Operating margins in the low twenties and relatively low capital requirements mean about 1 euro in every 8 converts straight through to free cash flow. That’s helped fund a string of bolt-on acquisitions such as recently acquired Belmond Hotels, and a run of dividend increases stretching back over 20 years – though not guaranteed to continue.
LVMH share price and impact of acquisitions
Past performance isn't a guide to future returns. Source: Thomson Reuters to 23/04/2019
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The group currently offers investors a prospective yield of 2%, and we’re hopeful of further hikes in the future.
Rentokil may seem an odd candidate for an article on pricing power. After all, pest control and corporate hygiene is hardly a hi-tech monopoly or luxury fashion house.
However, like Rightmove and LVMH, Rentokil’s pest control customers aren’t all that bothered about price. When an infestation strikes, customers simply ‘must’ have the group’s services – price is a secondary consideration.
It’s a position strengthened by being the world’s largest pest control business, with by far the most recognisable brand in the sector. As a result, the Pest Control business is able to deliver an operating margin of 17.6%.
A bolt-on acquisition programme in a fragmented market should help it make the most of an attractive position. The group bought 42 pest control businesses last year, rapidly scaling up already sizeable positions. New acquisitions mean potential costs savings, further boosting margins, and allow Rentokil to make the most of its scale.
Leadership positions in developed markets are the largest contributor to profits. With 90% of the US population covered by Rentokil’s footprint, the North American region has delivered annual growth of 21.2% over the last five years.
Global pest control spend by region ($bn)
Source: Rentokil annual report, 2018
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Emerging market exposure has long term potential. The combination of increasingly wealthy and hygiene-conscious populations with tropical climates is likely to see demand increase in the coming years, and Rentokil has dominant position from India to Brazil.
We find it difficult to get as excited about the prospects of the hygiene business – which provides services for corporate restrooms. But the division has been of diminishing importance over time, despite continuing to deliver a reasonable growth rate and very respectable margins.
To date the rewards for investors have been substantial, with dividends rising by an average of 18.9% a year since 2011. However, a strong share price performance means the 1.3% prospective dividend yield is hardly generous, and the group’s PE ratio of 26 times is 67% ahead of its longer term average.
Renotkil’s customers may not be price sensitive, but investors always should be.
Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
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