Pricing Power in Disruptive Companies
Can you easily define a good business? What characteristics would you look for? What operating metrics would matter most?
Probably one of the first answers most investors would give would have to do with pricing power. Of course, there is the famous Warren Buffett quote on pricing:
"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 a tenth of a cent, then you've got a terrible business.”
- Warren Buffett
Buffett is, of course, correct. Classically "good" businesses raise prices every year and suffer minimal price elasticity of demand from their customers. We see this from makers of luxury goods (Hermes, Ferrari, Chanel, etc.), as well as monopoly-like businesses like Visa and Mastercard, cable companies in the 2010s, and others. Some of our portfolio companies are easy to classify as "classically" good businesses - Armstrong World Industries, Brunello Cucinelli, etc. They always raise prices above inflation and capture widening economic margins over time. In fact, the last few years of inflation have been beneficial to them because, as good businesses, they rarely give back price increases, but their costs benefit from disinflation, allowing them to pull forward the spreads they should have gained over a longer period of time.
There is another category of "good" businesses that we get pretty excited about, but they don't necessarily look like agreed-upon, classically good businesses. These are companies that expand their economic margins over time, but do so in ways that increase value (and/or decrease price) to customers. Many classically "great" businesses tend to exploit their market power over consumers, such that their customers' purchasing power is the source of the widening economic spreads. These other great businesses sometimes are well-recognized (like Amazon), but often get confused for bad businesses because they pass significant cost savings onto customers and generate expanding economic margins at the expense of their competitors, not customers. They tend to do this when there is significant market share yet to be gained. Typically, customers love these companies because they add tremendous and increasing value over time. In contrast, some “classically” good companies can exploit their monopoly-like advantages to squeeze value out of their customers via higher prices, lower service levels, etc. Cable companies are notorious for this.
In this post, we will discuss this concept in more detail and talk about some of our companies that fit in this category.
Cost Curves vs. Price Curves
At the heart of a good business is a pricing curve that is more positive than a cost curve, hopefully driving a significant economic spread that widens over time. In many “classically good” businesses, price per unit curves trend upward, while costs have a flatter or possibly negative slope. Perhaps costs per unit rise with inflation, but price per unit rises above inflation. Good businesses create a widening gap between price per unit and cost per unit over time such that margins expand and revenue grows through both volume and price. Some of the world's best businesses have rising price per unit and falling cost per unit - like Google and Meta in their core ad markets, Visa and Mastercard now that their networks are built out, etc. Below is an illustrative example of a “classically” good business’ price/cost curves, and profit margin %.
As mentioned above, there is another subset of high-quality businesses that sometimes stay hidden from view for longer. We call them “Disruptive Good” companies. Their price per unit to customers doesn't grow (or declines), but their cost per unit declines on a steeper curve. These companies tend to have highly profitable marginal units because their marginal costs per unit are significantly lower than their current average cost per unit.
This dynamic is easy to understand for airlines, even though airlines are not a “good” business to us. Airlines have high fixed costs to operate an aircraft on a route - fuel, crew, airport fees, overhead, technology expenses, etc. If they sell one ticket or 150 tickets on that route, their costs are very similar, which makes the marginal passenger highly profitable. There can be large swings in profitability based on relatively small changes in load factors.
We own a handful of businesses whose investment into verticalizing important parts of the value chain generates steeply declining marginal costs per unit, which typically feeds back into the business by offering more value to consumers. When competing against non-vertically integrated competitors, this is the type of virtuous cycle that should compound and lead to sustained market share gains over time. Companies that develop leadership in price-cost spreads can make choices to optimize their businesses for free cash flow generation. For example:
· They could let those profits flow through to the bottom line.
· They could reinvest a portion of those profits to capture more growth.
· They could reinvest profits to ensure that they offer the highest level of product quality and/or customer service.
How they reinvest that widening spread is at the discretion of the managers, but as long as they have a leadership position that strengthens with more scale, they have ample opportunities to optimize. See below for a conceptual, illustrative example of the price/cost curve dynamic.
We have found this dynamic in a number of our portfolio companies, like Cogent (NASDAQ: CCOI), Amazon (NASDAQ: AMZN), Carvana (NYSE: CVNA), and Wayfair (NYSE: W). Substantial investments in the infrastructure required to enable faster/better/cheaper service levels differentiates them in their ability to achieve superior cost curves (i.e. cost curves declining more steeply than competitors') and service levels than their competitors. Cogent, Amazon, and Carvana operate predominantly in commodity-like industries where pricing dynamics are mostly set by the market's supply/demand. Wayfair's items are somewhat less commodity-like because other dimensions of value matter to its customers (selection, design, quality, delivery experience, etc.).
As the low-cost operators in each of their markets, we believe the economic advantages they have built over time support their ability to invest a portion of their growing surplus into delivering more value to customers in the form of superior service levels, better prices, and/or higher product or service quality. This should allow these and other such companies to consolidate market share over time.
To illustrate this point, let's look at some examples.
Cogent's pricing dynamics in its IP Transit business might initially scare away investors seeking a “classically” good business because its price per MB declines 20-25% per year. However, its cost per MB declines more than 60% per year, and it gets to ride the tailwinds of internet traffic growth in perpetuity (it tends to grow traffic about 2x faster than the broader internet due to share gains). In this business, in which Cogent sells internet connectivity to other networks and content companies out of 1,500+ global data centers, the company has a standing offer to undercut its competitors’ prices by 50%. With steeper negative cost curves and lower marginal cost than its competitors, any additional market share Cogent gains comes at 95% incremental margins. It uses price to win market share in this commoditized end market.
In Cogent's direct internet access (DIA) buildings, it uses its vertical infrastructure and highly efficient operations to offer a superior broadband service at the same price as competitors’ inferior services. The quote below from Dave Schaeffer highlights its value proposition.
"So Cogent's corporate product is priced at parity with our competitors, which are typically the incumbent and one other competitive carrier. We differentiate ourselves by offering an installed time that's 9x faster on average than our competitors, a service once delivered, that is 3x more reliable. And then finally, 30x to 60x the actual throughput."
- Dave Schaeffer, Founder & CEO of Cogent Communications
2. Until recently, Carvana has posted years of negative EBITDA, pushing many analysts to believe that it "loses money on every car it sells" and other variations of the same argument. However, used car retail economics are fairly well defined. Carvana was building its vertically-integrated apparatus comprised of vehicle acquisition, reconditioning, transportation, financing, delivery, and retail operations, while scaling volumes simultaneously. We analogize this to building a 50-floor skyscraper while only leasing out the bottom 5 floors. Should we evaluate the economics on cash flow from those 5 floors, or on what it should earn when fully leased?
Looking at consolidated results can be misleading when a company is building significant fixed infrastructure, especially in an operationally intensive business. We assess companies’ unit economics to understand the underlying dynamics that should play out in the future as the company increases its scale. As mentioned in our prior post, we believe Carvana's vertical integration enables today over $1,000 per car of economic advantage when compared to the tens of thousands of small independent dealers in the used car market. Its advantage will grow as Carvana fills up its capacity and leverages its significant fixed cost footprint.
3. Amazon has invested hundreds of billions of dollars into core transportation, logistics, and delivery infrastructure to (a) not rely as heavily on third-parties which could have impacted its ability to grow and (b) unlock vastly superior service levels at low (or no) costs to customers (same day, next day, 2-day delivery). This was partially defensive (to control their own fate instead of relying on UPS, Fedex, and USPS), but their faster/better/cheaper e-commerce value proposition to customers has made Amazon the go-to destination for general merchandise, and it also has opened up other revenue-generating opportunities via third-party seller services (FBA, Buy With Prime, Amazon Logistics, etc.).
Amazon has a diverse and powerful marketplace lubricated and differentiated by its incredible core infrastructure, and its competitive advantages built through vertical integration created numerous opportunities to monetize that core infrastructure across its marketplace.
4. Wayfair has invested significant sums into building the largest scaled e-commerce marketplace for home goods. It has built a platform that enables global suppliers to sell their products, and for customers to discover and purchase those products based on their budget, stylistic taste, and other preferences. Home goods, especially large parcels like furniture, can be notoriously difficult to merchandise because suppliers' selection often is significantly larger than retail showrooms, resulting in significant catalog browsing across the category. Wayfair has developed a superior customer front-end experience supported by high-quality photos, detailed and accurate descriptions, and technology solutions like virtually placing furniture in your room while using the Wayfair app. Additionally, Wayfair has invested in consolidation points, ocean freight capacity, and local infrastructure in distribution, logistics and delivery to improve delivery times, reduce damage rates, and ensure a high-quality transportation and delivery experience for both suppliers and customers.
Wayfair's capabilities allow for differentiation across a multitude of factors which tend to be reinvested into gaining market share from the many thousands of small furniture retailers across its markets. The power of its model has been on display now that the Covid-era supply chain disruptions are in the past: Wayfair's US business is growing mid-single digit while the industry is declining in the double digits y/y, representing significant >1,500 bps of market share gains in a weak market.
Hopefully these examples shed some light into how we think about some of the dynamics around competitive differences in cost curves and how those differences translate into better value and better quality/service for customers, which in turn should translate into open field for gaining market share.
Closing
Companies with steeper cost curves than their competitors present some interesting opportunities for them to sustainably gain market share. By constantly lowering costs and/or improving service levels, they are more likely to develop healthy relationships with customers that significantly reduce customer acquisition and re-acquisition costs, which in turn translates into healthy customer lifetime value metrics as they grow and mature. While most “classically” good businesses have been recognized and picked over by the market, there remains a robust market for differing opinions on many “disruptive” good companies that are still relatively early in their journeys which distorts historical and near-term consolidated financial results. These are fertile ground for our idea generation and for building our research pipeline.
