<May 5, 2023>
While working as a small cap analyst in the mid-1990s, I followed a company called Pactiv Corporation. Pactiv was best known as the manufacturer of Hefty trash bags. After a strong earnings report in 1997, I jumped on Pactiv’s conference call to learn more. During the call, management revealed the secret to their success—shrinkflation! Specifically, the company disclosed that they reduced the number of trash bags in each box.
Analysts seemed impressed. “Congratulations on the great quarter!” they said before asking their questions. One analyst, however, was a bit more skeptical and asked management about the sustainability of their strategy. The analyst surmised that if Pactiv continued on its current path, at some point they wouldn’t be selling trash bags—they'd just be selling an empty box! Management acknowledged the analyst’s reasoning and responded, “You’re quite right.” As analyst humor goes, this is about as good as it gets!
With Wall Street anticipating rate cuts later this year, we’ve been documenting an emerging trend that may impair the Fed’s ability to return to its easy money ways. Similar to Pactiv, a growing number of companies are offering fewer products or services to enhance profits. These actions are being taken even if it means a decline in business activity. In our post Jabba the Mutt, we provided several examples of companies that increased prices, generated revenue growth, but experienced lower volumes and transactions. Based on our review of recent earnings reports, this trend is continuing in 2023.
Throughout 2021 and early 2022, the inflation fire burned red-hot while the Federal Reserve sat on its hands. After twelve months of exceeding its 2% target, the Fed finally acknowledged inflation could no longer be dismissed and raised the fed funds rate by 25 basis points on March 16, 2022. In hindsight, it was much too little and much too late as a significant amount of inflation had already accumulated, destroying considerable purchasing power in a short period.
As the Fed dragged its feet, companies were left on their own to manage sharply rising costs, overstimulated demand, and stretched capacity. For many businesses, keeping up with demand simply wasn’t possible. Instead of ramping up supply, companies began to learn working harder may not be the best path to maximizing profits. Just the opposite. With labor and capacity stretched, businesses discovered declining production, and even productivity, may not necessarily be a bad thing. In effect, they learned by making less they could make more (profits).
One of the few things I remember from business school was a professor’s advice on how to determine the best price for a product or service. He said, “Raise prices until you lose business.” Such simple advice made sense and it is exactly what many businesses have done over the past two years. However, based on our analysis, a growing number of companies have taken it a step further and have raised prices to intentionally lose business. In addition to receiving more for their goods and services, the strategy has reduced stress on their employees, infrastructure, and balance sheets. Further, the revenues lost due to price increases have often been targeted, and in some cases, unprofitable. In effect, these are sales companies are happy to lose. We believe the strategy of making less to make more has been an underappreciated contributor to inflation and the 2021-2022 profit boom.
Restaurants are one of the many industries that have been aggressively increasing prices to combat rising costs, labor shortages, and unprofitable revenues. During its Q2 fiscal 2023 conference call, Brinker Corp., owner of the Chili’s chain, noted they were implementing price increases (up 10% year-over-year) and encouraging customers to “trade up to more premium and margin-accretive offerings.” Their strategy also includes a move away from discounting. As a result, same-store sales increased 8% at its Chili’s restaurants even as traffic declined 7.6%.
The strategy to raise prices and intentionally lose business has had a disproportionate impact on lower-end consumers. As inflation has accumulated over the past two years, it is becoming increasingly difficult for lower-end consumers to afford modest luxuries such as occasionally dining out. In fact, Brinker noted their lower-end customers are coming in less frequently. And for the customers that are coming in, they are “willing to spend considerably more.” Brinker’s strategy has resulted in having fewer but more profitable customers that they are better able to serve.
Brinker isn’t alone in shedding lower-end customers and less profitable revenues. Conagra, the producer of a wide range of food products and services, recently reported a similar strategy of pruning low-margin volume. The company used the term “premiumization” to describe their strategy of maximizing returns through pricing and discarding less profitable revenues. In its most recent quarterly call, management noted that it didn’t make sense to stick with dated promotional practices in an “inflationary supercycle.” Management explained, “While these inflation cycles are painful…sometimes they're actually quite good because they become a catalyst for getting pricing right and getting off of legacy promotions…that have low profitability.” During the quarter, Conagra’s strategy resulted in 6.1% organic sales growth, a 321 basis point improvement in operating margins, and a 9% decline in volume.
The trend towards “premiumization” and targeting wealthier customers has spread during the later stages of the current market cycle. With asset prices remaining inflated and wealth inequality increasing, businesses are discovering the advantages of cuddling up to the beneficiaries of asset inflation. Wealthier consumers are much less price sensitive and are less likely to balk at aggressive price hikes. Paying $5 or $10 more for a product or service is a lot easier when the value of your home and stock portfolio has doubled over the past 5 or 10 years!
As the strategy of targeting wealthier consumers spreads, we believe the risk of asset inflation spilling over into consumer inflation is accelerating. The spillover of asset inflation could lead to interest rates remaining higher for longer, threatening the asset prices supporting high-income spending. However, to date, asset prices and higher-end demand remain resilient, helping companies offset weakness in lower income segments.
For example, Tempur Sealy International, recently reported sales of their higher-end mattresses were resilient while sales to their “value-focused customers were a bit more subdued.” Management commented, “So focusing on the U.S. consumer…we're seeing the high-end consumer continuing to hang in there. Low-end consumers have been where a lot of the deterioration has been.”
Ralph Lauren had similar comments about its apparel sales, noting, “The increase [in sales] was driven by product mix elevation with AUR [average unit revenue] up 10% on top of 19% growth last year.” The company’s average unit revenue at its outlets was up high single-digits, “reflecting ongoing brand and product elevation” while experiencing “softness in value-oriented consumers.”
The providers of larger ticket items are seeing similar trends. Pool Corporation, a leading distributor of pool supplies and equipment, noted the uncertain lending environment has worsened “an already pronounced issue with entry-level pools” while mid and upper-end pools have not been impacted. Management noted that wealthier buyers of high-end pools are less affected by rising borrowing and construction costs.
After reporting 7% sales growth and a 3% decline in volume, Procter and Gamble’s CFO recently said, “The U.S. consumer is holding up well.” We must ask, which consumer? The consumer that doesn’t flinch at paying $32 for a box of Tide Pods, or the consumer that is being priced out of the market and is increasingly becoming a less important source of revenue.
Like many of the drivers of the current market and profit cycle, we believe the strategy of making less to make more is unsustainable. The willingness and ability of certain customers to pay higher prices should not be confused with a healthy economy. It’s not. As prices increase and volumes decline, economic activity is shrinking. Further, as more companies crowd into the higher-end segment, the risk of becoming overly dependent on volatile and inflated asset prices is growing. While revenue growth from price increases and serving the wealthy may camouflage the decline in economic activity in the near-term, ultimately, to grow organically, the economy must make more, not less. If it doesn’t, we’ll eventually just be buying and selling empty boxes.
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