Inflation is a hot topic at the moment. And it should be. Prices for almost everything are climbing in the UK. Wage growth has not kept pace. As a result people are poorer. But, apparently corporations are not. They are apparently enjoying bumper profits from passing on the inflationary costs they are experiencing onto consumers and then some in an orgy of corporate greed.
Inflating profits
The claim that wages are not keeping pace with inflation is accurate. According to the Office for National Statistics real total and regular pay fell on the year up to April 2023. However, a corporate profit bonanza is not occurring across the board. There are 590 companies listed on the London Stock Exchange for which I could screen for earnings-per-share (EPS) growth on a training 12-month basis. Some companies did extraordinary well like Virgin Wines UK with its 11,000% EPS growth. 888 Holdings, however, saw its EPS fall 100%.
How about at the level of the index. Well, the median EPS growth for companies in the FTSE 100 was 12.9% over the last 12 months, compared to a forecast of 8.8% going forward. For the more domestically focused FTSE 250 its 13.8% compared to 6.7%.
The median FTSE Smallcap company saw its EPS shrink by 0.6% over the last 12 months. It was even worse for the typical FTSE Fledgling company for which EPS dropped 10.8%. The forecasts of a 6.6% and 14.9% rise over the next year might offer some reassurance for investors in smaller UK companies that are found in these indices.
The fact that EPS has been high over the last 12 months, and is forecasted to fall with inflation for the larger UK listed companies has it seems raised eyebrows. The newspaper reports of corporate greed and mega profits, and the calls for windfall taxes do tend to focus on well known oil & gas majors, utility companies, and supermarkets. These tend to be bigger, and find themselves in the FTSE 100 and 250 indexes. And they sell food and energy, which everyone has little to no choice but to purchase, and have had to pay a lot more for them over the last year or two.
Passing on costs to the consumer
A fairly comprehensive revenue model has just two variables: price and volume. If you can raise prices without losing much business (volume) then you have pricing power. Pricing power is generally cited as being a competitive advantage for a company, and something that investors should be looking out for.
Now, companies do face inflationary pressures themselves. Unless the expectation is for all companies to face terminal decline they will have to increase prices if their costs increase. For example, if a company prices a product at £100 and has costs per unit of £80, then it makes £20 and a margin of 20% on sales. If costs increase by £10 and it adds these on to its selling price then it ends up making £20, but its margin drops to 18%.
| Base | 1 | 2 | 3 | 4 | Change | |
| Price | £100 | £110 | £120 | £130 | £140 | 40% |
| Costs | £80 | £90 | £100 | £110 | £120 | 50% |
| Profit | £20 | £20 | £20 | £20 | £20 | 0% |
| Margin | 20% | 18% | 17% | 15% | 14% | -29% |
Continue this trend of £10 cost increases added to the selling price and the margin declines further as seen in the table below. A company passing on costs pound for pound (or dollar for dollar) maintains its profit per unit sold, but sees its margins fall. Should this be regarded as a power? Well, perhaps if volumes are maintained then yes, it should be. After all, some firms might end up selling fewer units if they add the increase in costs to their selling price, and see aggregate profits fall.
Let’s look at the cost increase differently. If costs rise from £80 to £90, that’s a 13% rise. So, what if prices also rise by 13%. Well, the company used to make a profit of £20 before the increases. After it makes a profit of £23, which is a 13% increase. But, it has maintained its margin at 20%.
| Base | 1 | 2 | 3 | 4 | Change | |
| Price | £100 | £113 | £125 | £138 | £150 | 50% |
| Costs | £80 | £90 | £100 | £110 | £120 | 50% |
| Profit | £20 | £23 | £25 | £28 | £30 | 50% |
| Margin | 20% | 20% | 20% | 20% | 20% | 0% |
A company that can raise prices in line with inflation does see its profits increase, but its profitability, as measured by margins, remains unchanged. If this is pricing power it’s nominal. In contrast, firms with real pricing power can increase prices at rates higher than inflation.
Real pricing power means that a firm can raise its prices faster than its costs. If costs go up by 50%, prices can rise 60%. This will result in profits increasing but also profitability, as margins will also expand.
| Base | 1 | 2 | 3 | 4 | Change | |
| Price | £100 | £112 | £126 | £142 | £160 | 60% |
| Costs | £80 | £90 | £100 | £110 | £120 | 50% |
| Profit | £20 | £22 | £26 | £32 | £40 | 100% |
| Margin | 20% | 20% | 21% | 23% | 25% | 25% |
So, depending on how you look at it, pricing power, could result in level profits, but worsening profitability, increasing profits but stable profitability (nominal pricing power) or increasing profits and improving profitability (real pricing power).
Windfall taxes
The likes of supermarkets like Tesco, oil & gas companies like BP, and multiline utility company’s like Centrica have been accused of profiteering through exercising their real pricing power. Banks like NatWest have come under fire.
The UK government’s response has been to introduce a windfall tax, called the energy profits levy, on energy suppliers. This was justified by citing that energy companies have done nothing to justify the increase in their profits, save being exposed to higher market prices of energy This obviously leads to counter claims about what happens when the market price of energy falls. I guess you could say that in that case, should losses result, they get to carry them forward to reduce taxes on profits made later: unless of course that benefit is not eroded by another windfall tax.
In a survey run by the Financial Times back in 2020, the public appeared to be in favour of a windfall tax on supermarkets if they benefited from increased spending during the coronavirus pandemic. I see no reason why this opinion would change over post-pandemic inflation. And I think its easy to understand a consumers frustration at watching food and energy prices rise, and their wallets squeezed as corporations bottom lines swell, especially when the price increases of everyday items have been large and rapid.
Equally it is easy to point to the share price charts of these companies stock, which have pretty much all gone up since mid to late 2022—although some are heading lower this year—and any dividends that were paid (ignoring the cuts that happened during the pandemic) and accuse shareholders of profiting from misery as well. Yes, it is true that shareholders are not a distinct class of people. If you have a pension you have equity exposure and could very well be a greedy shareholder yourself. However, it is also true that the wealthier you are the more likely you are to own stocks, and thus benefit disproportionately from capital and income gains.
UK stocks with real pricing power
A windfall tax should crimp share price rises and dividend payments, because they slash earnings, which deals with the greedy shareholders although not so much the packets of the bosses of these firms. They also raise taxes which can be deployed to support the most vulnerable in society who are genuinely struggling. But, leaving that to one side, and acting like someone who is only interested in finding great investment ideas, we still have the question of whether it is worth hunting for UK stocks that have pricing power.
Well, yes, obviously so long as we are talking about real pricing power. That is a genuine competitive advantage. And let’s remember, the economic environment right now is (hopefully) not the norm. Inflation is typically not as headline grabbing nor destructive as it is right now. And when firms with real pricing power exercise it, they don’t typically face calls for windfall taxes or otherwise with anything near the volume as we hear right now.
DISCLAIMER: James J. McCombie owns shares in London Stock Exchange. The Storied Investor has no beneficial ownership position in any of the stocks or securities mentioned. No comment in this article should be construed as a recommendation of, or opinion regarding the future performance of, any stock or security or collection of them mentioned herein. Opinions expressed are the author’s and do not represent the views of The Storied Investor.
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