Lockheed, Nvidia, and Others Have Pricing Power. Their Profit Margins Prove It.
Corporate profit margins are a hot topic on third-quarter earnings calls, with inflation impacting consumers and businesses alike.
Corporate profit margins are a hot topic on third-quarter earnings calls, with inflation impacting consumers and businesses alike. It’s also an issue for the coming year, should an economic slowdown force companies to offer discounts to move inventory.
Firms with the ability to keep their profit margins intact or growing through the uncertainty should see their stocks outperform.
Companies can achieve pricing power in several different ways. A business can sell a good or service that is vital to customers or limited in supply, giving them no option but to pay up. To put it in economic terms, the product has low price elasticity. That could be gasoline at the only station for miles, toilet paper at the grocery store, or accounting services during tax season.
The fewer direct competitors a company has, the greater its ability to set prices. A strong brand that has particular affinity or loyalty from customers can also lead to greater pricing power. Think of the typically higher price per unit for Procter & Gamble’s (ticker: PG) Tide laundry detergent compared with a store brand.
A company can also innovate and improve its products, increasing prices as it rolls out the upgraded offerings. If the price hikes exceed the cost of the improvements, that’s pricing power. It’s common in new versions of software, pharmaceuticals and medical devices, semiconductors, and other high tech goods and services.
Finally, companies can expand their profit margins by becoming more efficient and productive, or by leveraging economies of scale. That brings down the cost of goods sold per unit produced, and increases profits without raising prices.
Barron’s screened the S&P 500 for companies that grew their gross margin (revenue minus the cost of goods sold, divided by revenue) from 2020 to 2021 as the economy rebounded, but also had rising, positive gross margins in at least the three years before the Covid-19 pandemic.
Those that were best able to demonstrate pricing power in a 2% annual inflation environment should be better set up to do it when inflation is running in the high single digits, too. The companies must also have been free cash flow positive in 2020 and 2021, demonstrating their businesses’ resilience through an economic downturn.
The screen yielded 23 names. As with any screen, it’s a blunt instrument that serves as a starting point for further analysis. Here is the list:
Several healthcare firms make the list, including Merck (MRK), Zoetis (ZTS), Mettler-Toledo International (MTD), and PerkinElmer (PKI). Their pharmaceutical, medical device, or related products and services tend to be differentiated from the competition and nondiscretionary for most customers. That gives the companies pricing power and the ability to maintain profit margins even in an inflationary or decelerating-growth environment.
Semiconductor firms Nvidia (NVDA) and Broadcom (AVGO) also pass the screen, thanks to their steady margin growth over the past few years. But the outlook isn’t as bright. The chip industry is highly cyclical, with periods of shortage and high pricing typically followed by inventory gluts and forced discounting.
Nvidia and Broadcom have long-term secular tailwinds, but they’re on the wrong side of the inventory cycle today. The stocks are down 55% and 31%, respectively, so far this year.
Altria Group (MO) sells cigarettes and other tobacco products, including Marlboros. Addictive products give the firm pricing power.
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The screen yields several industrials, including Rockwell Automation (ROK), Roper Technologies (ROP), Lockheed Martin (LMT), and Eaton (ETN).
“We operate a portfolio of market-leading businesses in defensible niches,” said Roper CEO Neil Hunn on the company’s third-quarter earnings call on Wednesday morning. “Each of our businesses has high levels of recurring revenue, strong margin, and competes based on customer intimacy, which yields highly resilient organic growth rates.”
Roper is a sprawling conglomerate with hands in dozens of areas across engineered products and software services.
Rockwell, which makes factory equipment, is increasing prices alongside its input costs. “We have very strong pricing power in the market, thanks to our highly differentiated offerings,” said CEO Blake Moret earlier this year. “We’re seeing good price realization as annual customer agreements renew, and we are taking action to get quicker realization of future price increases.”
Other companies to pass the screen include McDonald’s (MCD), Fiserv (FISV), Gartner (IT), and Hilton Worldwide Holdings (HLT).
Write to Nicholas Jasinski at nicholas.jasinski@barrons.com