Part 1: Industry Price Outlook
Type of Industry and Its Profitability
Capsule: If future demand exceeds capacity, prices should rise. Prices should fall if future capacity exceeds demand. This rule holds most readily in industries with low marketing and sales expenses as a percentage of sales. If you are in a low marketing and sales expense industry, one with commodity-like characteristics, spend the time to develop detailed forecasts of demand and supply. Otherwise, don't bother. In high marketing and sales industries, expect prices to come under pressure if industry returns are high or if the industry has had several years of price increases at a rate greater than inflation.
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Symptoms and Implications:
The amount of effort the Company may wish to commit to specific price forecasts depends on the kind of industry in which it competes. Companies in low marketing and sales expense industries, especially those producing cyclical commodities, benefit from detailed projections of future prices. Companies in higher marketing and sales expense industries do not. In these industries, companies should consider more generalized pressures on industry prices, especially incentives for the expansion of capacity.
The key driver of an industry's expansion of capacity is the industry's return on investment. Low returns discourage capacity expansion for all but the lowest cost competitors and for the marginal expansions requiring the least capital investment. High returns invite rapid capacity expansion. Whether the Company is in a low or high marketing and sales industry, it should look at its industry's returns to anticipate the direction of future prices.
Low Marketing and Sales Expense Industries
Skip this section if your gross margins are above 10%
Companies in low marketing and sales industries should begin with an analysis of the basic price outlook for the market in the coming few years. Done in detail, this diagnosis entails the Company's developing forecasts of future prices from estimates of demand and capacity in the future.
The detailed forecasts of demand and capacity prove particularly helpful in these cyclical, commodity industries. These industries are usually low in marketing and sales value-added and are capital intensive. The production costs for the product at the plant door will usually exceed 90% of revenues. Examples of these industries include mineral and natural resource-based industries, process-based industries and other industries where the finished product appears little different from one supplier to the next. The high capital intensity often demands that the operations of these industries run continuously. Companies in these industries drop their prices when demand slackens in order to keep operations running continuously. Their prices rise or fall dramatically as the balance between demand and capacity tips one way or the other. When capacity outstrips demand, prices fall to low levels. When the opposite condition prevails, prices rise to high levels.
In these cyclical industries, if future demand equals or exceeds the industry capacity, prices are likely to remain strong or to rise. Prices should rise far enough to attract new capacity to the industry. On occasion, even higher prices cannot attract capacity fast enough to meet demand. In these instances, prices must rise far enough to depress demand until it finally matches available capacity.
In the same cyclical industries, if future demand falls short of capacity, industry prices should be weak. Industry prices would then have to fall far enough to prevent some of the industry's current capacity from producing its product.
How far is far enough? The market sets the Price just below the cash costs of the next increment of product availability, or capacity. The practical effect of a Price is to regulate the amount of product available in the market. A rising price and margin environment brings more capacity and product availability. A falling price and margin environment contracts industry capacity and product availability.
Competitors produce all they can at the price level prevailing in the market. A competitor would find it worthwhile to produce product as long as that competitor can sell the product for more cash than the cash cost to produce it. At the same time, the competitor would set his price at the highest level that he can obtain from the customer without that customer defecting to another, lower priced, competitor. This price would be just low enough to keep more capacity from producing than the current demand needs. When capacity exceeds demand, the price for the product falls just below cash costs of the last unit of capacity removed from the marketplace.
The task of projecting future prices in a low marketing and sales industry calls for the estimate of the cash costs of operating current and planned increments of industry capacity. These increments may be plants, production lines or even production shifts. The calculations are detailed and onerous but the results are highly predictive of industry prices as demand rises and falls around the industry's capacity.
Normal to High Marketing and Sales Industries
If we wish to predict future prices, we need to have some understanding of the cash costs of the next increment of capacity. What will it take for competition to increase or decrease the capacity or product available to the market?
Here, we encounter a problem. There are many industries that appear to have plenty of excess capacity to produce a product but have no apparent excess of product availability, at least as witnessed by a dearth of effective price discounting in the market.
As examples, we see many consumer products with current prices seemingly high enough to support more product availability. Further, many consumer product firms could easily use current capacity to offer more product availability at prices below the current price. Yet, they do not reduce their current prices in an attempt to use their excess capacity to create more revenues and profits.
A simple explanation for this phenomenon is that the cash costs of producing the next increment of product availability must include all the costs of marketing and selling the additional product availability as well. These are industries where the costs of production are less than 80% of the total cash costs of servicing new customer sales. New production in these industries requires additional advertising, sales and marketing support costs beyond the cost of the product at the plant door. This makes for a very complex mathematical challenge in industries where there is more than a few percent added to the cost of producing the physical product. Of course, this includes most industries. The precise forecast of prices in most industries is too costly and time consuming to be worth the effort.
Companies in normal and high marketing and sales industries should spend little time on the projection of specific future prices. Instead they should concentrate on the competitive expansion questions in the Industry Price Outlook/Future Prices section. These questions focus on profit margins in the industry and the likelihood of new competitor entrants into the market or fast expansion by current competitors.
Projecting specific future prices is difficult in these average to high marketing and sales expense industries because of the hefty costs of gaining new customer volume. Prices are more stable in these markets. Competition has a difficult and costly job to enter an industry with substantial marketing and sales costs. High value-added industries often stay healthy for long periods of time. They tend to become less healthy when the industry leaders raise prices by more than inflation, or than their cost increases, for long periods of time. These price increases raise margins and industry returns. High returns invite new low-priced competition into the market.
Whether or not the industry prices move in concert with short-term changes to capacity and demand, the Company should develop some sense of the price and margin environment it faces in the coming few years.
Prices determine margins. In turn, margins produce returns on investment. And low return-on-investment industries operate with different rules than do high return industries. An average Company in a low return industry would have a return on equity below 8%. These markets are "Hostle markets" that clearly fail to earn their cost of capital. In contrast, the average Company in a high return industry has a ROE in excess of 14%. Medium return industries have industry average ROEs between 8% and 14%. (For more on these measures, see the Benchmarks/Quartile Ranking Reports section of the web site).
If the company finds itself in a high return industry, it faces the risk that its industry's capacity growth will outstrip demand growth. In some markets, especially consumer markets, these high returns result from price increases above cost inflation over the previous few years. An industry with high returns encourages expansion of current competitors and invites new entrants to the market. These markets are forgiving of many competitive mistakes and allow even weak companies to prosper.
The high return industry might avoid the problem of overly aggressive capacity expansion if there is some constraint on the ability of current competitors or new entrants to expand at will. These constraints could include a limited access to critical raw materials or components or difficulties in gaining effective distribution. (See Pricing: Industry Price Outlook/Future Capacity for more explanation.)
Medium and low return industries pose less of a threat of excess competitor expansion. Returns are often not at a level to attract the most expensive, and largest, incremental expansions, such as a new facility. Capacity expansions in these industries are more moderate, though they can still threaten current industry profit margins and returns if they yield an industry with excess capacity.
Without constraints on competitive expansion, industries with high returns should anticipate intensifying price and margin pressure in the future. The sources of this pressure will be those competitors expanding faster than the industry's demand or those just entering the market.
The price environment has a powerful effect on the plans for the business because of the pricing tactics that succeed in low, compared to high, return environments. As a general rule, companies in markets with falling prices operate more often with defensive pricing tactics, which seek to arrest or minimize declining average prices in the industry. Those companies in industries with rising prices operate more often with offensive pricing tactics. Offensive pricing uses price to raise margins or to increase sales. The Company increases margins by raising average industry prices from their current levels. In some industries with falling prices, the Company may have an opportunity to use a unique low price to win more sales volume. Medium return industries operate with both offensive and defensive characteristics in their pricing tactics.
The Company begins its evaluation of its future price and margin outlook by examining its industry's past in order to understand its returns compared to the average industry and the reasons those returns were high, medium, or low. (For comparisons of returns with other industries, see the Benchmarks/Quartile Ranking Reports section of the web site.)
Type of Industry and Its Profitability Questions
Whether the industry is high or low value added, the Company should have a sense of medium and long term price and margin directions. We begin this analysis with a forecast of demand growth.
|Summary Points||Next: Demand Growth|