The brands testing their customers’ wallets… and patience

The author mentions a number of individual shares and companies in the article. These have been included to illustrate her point only. Please remember reference to specific shares or companies should not be taken as advice or a recommendation to invest in them.

The economic moat, or barrier to entry, is one of the first traits that fund managers look for when analysing a business’s quality. Referring to a type of competitive advantage that prevents new entrants from taking market share, such an attribute will protect profits, often over lengthy periods of time.

Some types of economic moat, such as a strong brand, also give companies ‘pricing power’, which allows them to charge a premium for their products and services. This means they can pass an increase in costs on to their customers without fear they will switch to cheaper alternatives.

But everything has its price, and this includes pricing power itself. It appears the management teams behind many of the world’s most recognisable brands have recently found this out the hard way.

“Value seeking” behaviour

The first-quarter financial reporting season for consumer companies has been a mixed bag: while brands exposed to more resilient, higher-income customers have continued to fare well, mainstream consumer names such as Starbucks, McDonald’s, Mondelēz and Kraft Heinz have issued cautious commentary about the trend for “value seeking” behaviour among their customers.

“Everything has its price, and this includes pricing power itself. It appears the management teams behind many of the world’s most recognisable brands have recently found this out the hard way”

Even Amazon is discussing the amount its customers are saving on deals, while US restaurant chains have reported that diners in lower-income brackets are keeping a closer eye on spending.

In part, this is attributable to the cumulative impact of higher inflation on this segment, as poorer households are disproportionately affected by higher prices.

However, there may be more to this changing pattern, given lower-income consumers also experienced the highest real wage (wage growth after inflation) and employment growth of all segments, to some extent cushioning them from higher prices¹. In addition, card data from Bank of America shows higher year-on-year percentage growth in spending among lower-income customers in the US than their higher-income peers.

Instead, we believe consumers from both higher- and lower-income households have reached a point of price resistance – where absolute price levels have risen to a point where ‘value for money’ alternatives look more compelling, whether they are branded or not.

Above-inflation price increases

A Starbucks Frappuccino now costs $6.55, up from $4.79 in 2019. This is an increase of 37% compared with CPI at 21% – enough to make an occasional customer think twice about ordering a drink that, let’s face it, is predominantly made up of frozen water².

Such behaviour, called out as ‘choiceful’ by several consumer company chief executives, is not exclusive to mass-market fast-food products. Even a quintessential luxury brand such as Chanel, which caters to a high-income consumer, can experience the same backlash if price increases are deemed excessive.

The issue emerged for Chanel when it nearly doubled like-for-like pricing of its iconic medium Flap Bag from $5,800 in 2019 to $10,800 in 2024³, for what many consumers are reporting to be a lower-quality product (gold hardware has been replaced with gold plate, the quality of leather and paint is notably poorer, and some stitching has started to unravel).

The company’s chief executive Leena Nair attempted to defend the price increases during a recent Bloomberg interview, stating: “We use exquisite raw materials and our production is very rigorous, laborious, handmade — so we raise our prices according to the inflation that we see.”

As a private company, Chanel does not report detailed financial reports, but given it reported EBIT (earnings before interest and taxes – a way of measuring a company’s profits) margins of 32.5% in 2023, we would expect to see gross margins (the percentage of a company's sales that it retains after direct expenses, such as wages and material costs are deducted) similar to those of its luxury peers at about 75% in its leather goods division. Therefore, implying that inflation is responsible for most of the price increases doesn’t ring true.

The backlash among its customers has so far been limited to social media and messaging boards, but they could well end up voting with their feet, by limiting their spending at Chanel at these prices. Even this would hardly be a disaster for top-tier luxury brands, which prefer to sell lower volumes at higher prices. Yet our instinct is to look away from companies willing to risk their long-term standing for a short-term boost to profits.

Pricing as a ‘privilege’ more than power

A notable theme to emerge from the consumer brand sector in recent years is the pricing ‘power’ that most of them took for granted in the post-lockdown era is now evolving into pricing ‘privilege’.

“Most listed luxury companies have got the memo in terms of demand elasticity finally reaching its limit and are raising prices more slowly in 2024”

This means that consumers at all income levels are still willing to pay up for brands, but only when they perceive the quality and innovation to justify the ticket. While we regard pricing ‘privilege’ as more enduring, it is the preserve of a much smaller number of brands and segments, further polarising category leaders and laggards.

Most listed luxury companies have got the memo in terms of demand elasticity finally reaching its limit and are raising prices more slowly in 2024⁴, as the industry reverts to its pre-Covid growth rate in the mid-single digits.

Listed luxury players’ yoy price increases, aggregated (2016-2024E) 

What does this mean for investing in leading consumer brands?

We view a highly selective consumer backdrop to be favourable for active fund managers (those who aim to increase the value of investors’ wealth by selecting individual shares rather than aiming to replicate the performance of an index such as the FTSE 100). We are focused on market-share gainers in their respective segments who can drive growth in sales volumes rather than rely on pricing to drive profit margins.

For example, the global rollout of Campari’s Aperol brand gives us confidence in its outlook, despite a tepid spirits market, while Lindt & Sprungli’s focus on value – and positioning as an affordable, occasional indulgence – makes it better able to pass on price increases required by higher cocoa costs than a brand driven by daily consumption such as Hershey.

Companies focused on the wealthiest members of society such as Ferrari and Hermès can continue to deliver pricing-led double-digit sales growth thanks to the lower price elasticity (the extent to which spending on a product changes in relation to an increase in its price) of their richer customer base.

However, such brands need to continuously innovate to offer ‘value’ to their customers, cementing their pricing privilege, and we are monitoring them closely to ensure this remains the case.

And despite our positive view on both these companies’ long-term prospects , we recently reduced our investments in them following recent strong share-price performance. Remember, everything has its price.