WHEB Commentary

Ted Franks

Sharing the wealth: pricing power and impact


“The single most important decision in evaluating a business is pricing power”. Not our own words, but those of Warren Buffett. He’s a man with a long history of making astute observations about investing and he has a strong point here.

Pricing power is the ability to raise prices without suffering a fall in sales volumes. If a business can do that, it can instantly increase margins and improve cash flow. Pricing power gives flexibility to defend against cost pressure, and confirms the company’s position in the value chain: its customers need it more than it needs them.

Pricing power and sustainability

So as equity investors we definitely value pricing power. But as impact investors, we can see a problem. We invest in companies with a positive impact: the goods and services they sell provide solutions to sustainability challenges. But if those solutions are priced out of reach, then the impact is lessened. The equity investor wins but sustainability loses.

Here’s an example from the world of healthcare. Specialty drugs are drugs used to treat rare and complex conditions such as cancer and haemophilia. The relatively small numbers of sufferers from these diseases are usually entirely dependant on their specialty therapies.   But in the US especially, the makers of these drugs have followed a strategy of exploiting the pricing power this dependence gives them.

The drugs are introduced at a reasonable price, until they become the standard of care. As soon as this is established, the pricing power is in place and then….wham! Double-digit price increases every year. So the drugs themselves are a solution, but the positive impact is undermined.

Figure 1: Specialty Pharmaceuticals price increases 2012 – 2015[1]

2012 2013 2014 2015 F9M
Drugmaker
Valeant 21% 36% 50% 66%
Akorn 10% 34%
Impax Labs 10% 42% 14% 15%
Allergan 14% 15% 15% 13%
Mylan 24% 30% 22% 13%
Teva 14% 14% 8% 13%
Jazz Pharma 23% 23% 14% 8%
AMAG 7% 16% 14% 6%
Average 16% 29% 22% 19%

 

This played out between 2012 and 2015 for a group of specialty drug companies, and while they were following this path the equity market paid a premium for the pricing power they displayed. The Bloomberg Specialty Pharmaceuticals Index rose more than 270% from the start of 2012 to July 2015. We’ll come back later to how this story ended.

Figure 2: Specialty Pharmaceuticals Share Price 2012 – 2015[2]

Four ways to reconcile pricing and impact

So how does WHEB find genuinely positively impactful companies, and avoid those that reduce their impact with unsustainable pricing policies? There are four ways in which we think this relationship can actually be a positive one.

The first way is to look for innovation. If a company is working hard and innovating, and improving its products then it deserves its pricing power. Each new iteration of their products enables their customers to achieve more, so they are happy to pay for it.   We have a lot of companies in our portfolio which fit this description, from Dassault Systemes in our Resource Efficiency theme to Wabco in our Safety theme.

The second means to balance impact and pricing power is benefit sharing. Our investee company HMS Holdings helps to eliminate fraud and waste in the US Healthcare system, and it works on a contingent fee basis: the more its clients save, the more HMS earns. And at the same time, the more wasted spending is reduced, the more the cost of health care is reduced and the easier it is to provide it to more people. So pricing, investment returns and impact are all aligned.

The third approach is through price discrimination. Some companies provide the same product at different prices to different customer groups. Almost always this is because they have identified different abilities to pay. And this certainly works for us! By definition, price discrimination increases the availability of the impactful product to customers that need it.

The fourth way in which we reconcile price increases to impact is through intentionality. When a company intentionally passes its pricing power down the value chain, and such pricing power is actually coming from the sustainable qualities of its product, then there is no pricing power issue.   Our recent investee company Lenzing does exactly this. Its wood-based textile fibres replace environmentally damaging cotton in the fashion industry. They also make clothes more comfortable to wear. This gives Lenzing pricing power, but it works with its end customers (such as Inditex, owners of fashion retailer Zara) to make the most of these advantages.

So between these four models there is plenty of scope to reconcile raising prices with having a positive impact. What they all have in common is a thoughtful and collaborative approach to working with customers. Building long-term, sustainable relationships like this is another feature of the kind of quality companies we like to invest in.

A longer term perspective

Which just leaves the question of what has happened to those specialty drug companies who exploited their pricing power to maximise short term profitability? Well, perhaps unsurprisingly, stakeholders all around the value chain have started to spot what is going on, and the business model is now under real pressure. A symbolic inflection point came on 21 September 2015 when Hillary Clinton, then strong favourite for the US Presidency, tweeted that “Price gouging…in the specialty drug market is outrageous”. This pressure has continued even under the current US administration, and the equity investors have themselves paid the price. Like Icarus flying too close to the sun, maximising short term returns can undermine long term value creation.

Figure 3: Specialty Pharmaceuticals Share Price 2012 – 2017[3]

 

[1] Source: Deutsche Bank

[2] Source: Bloomberg BI Global Generic-Specialty Pharma Peers

[3] Source: Bloomberg BI Global Generic-Specialty Pharma Peers