QUARTERLY REPORT

1st QUARTER 2017 IP-Participações

Illustration: Cecilia Abeid

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“If you’ve got the power to raise prices without losing The emblematic examples of Chanel and Disney help

business to a competitor, you’ve got a very good put this concept into numbers:

business.” – Warren Buffett

• In 1955, Chanel’s Classic Flap Bag cost US$220

Among many virtues that define a company’s (approximately US$2,000 in today’s prices).

profitability, pricing power is by far the most notable. Nowadays, the same bag costs US$4,900, almost

Some factors help explain this phenomenon, but it two and a half times the 1955 price adjusted for

mostly boils down to one word: differentiation. The inflation. In a period of 62 years, Chanel increased

more unique a company’s product or service, the the price 1.4% per year in real terms .1

harder it is to replicate its business. The stronger its

• In 1971, the entry ticket to the Magic Kingdom Park
competitive edge, the greater its capacity to increase
in Orlando cost US$3.50 (about US$21 in today’s
prices and make extraordinary gains. Pricing power
prices). In 2017, the same ticket costs over five times
may also have a broader meaning: a company which
more in real terms: a trifle US$110. In other words,
retains its productivity and efficiency gains rather
Disney ensured an annual real price increase of
than passing them onto customers, is, in practice,
3.7% in its main park during the period. 2
indirectly exercising its pricing power.
Who wouldn’t want to invest in businesses like these?
In addition to differentiation, other factors also The truth, however, is that this is a privilege for few.
contribute to pricing power, such as: Rare are the businesses that possess such enormous

advantages to allow the use of pricing power for so

• A demand structurally greater than supply (e.g. a
long. After all, how do you replicate Disney’s parks
property on Manhattan’s 5th Avenue).
and characters or such an iconic and desired luxury

• An offered benefit disproportionately superior to brand as Chanel?

the price charged (e.g. Amazon Prime).

In the universe of good businesses there are different

• A price representing only a small fraction of the magnitudes of pricing power. In practice, competition,

substitute goods, market potential and other forces

value chain of a product or service (e.g. Visa
ensure a limit always exists. Most businesses enjoy
and Mastercard).
pricing power for only a while - understanding the
• An everyday and essential product or service in company’s trajectory is vital to establish the evolution
people’s lives (e.g. Colgate). of its profitability.
1
Source: https://baghunter.com/pages/chanel-bag-values-research-study
2
Source: http://time.com/3721999/disney-world-magic-kingdom-ticket-price/

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This quarter, we decided to bring this topic to light. investments in research and innovation, segmentation
We have observed several companies – in Brazil or premiumization, etc. This is the only way to exercise
and abroad –exercising pricing power and, in some pricing power in a sustainable way.
cases, recklessly. It is natural for investors to view this
A good example is the case of U.S. railroads,
strategy in a positive light and, therefore, little is said
as discussed in our 3Q14 4 report . The sector’s
about when price increases are misused, undermining
price increases as of 2004 accompanied a strong
the sustainability and continuity of the business.
acceleration in investments. Since the industry’s

Consumers on one side, shareholders on the other deregulation, railroads generated a one-digit return

on capital. After the sector’s consolidation and given

What is the purpose of a business? How does it create
their need to increase capacity, renovate the network
value for shareholders and society? In the excellent
and invest in more efficient locomotives, railroads
book “The Blue Line Imperative” , the authors argue
3
increased freight prices to sufficiently compensate
that companies should pursue two goals:
the major investments made in subsequent years.

• Generate happiness (or utility) for customers.

In the Brazilian education sector, for instance, the

situation has been different. Many institutions took

• Obtain returns above the cost of capital.
advantage of the demand created by the government’s
The price lies in between these two goals. The student funding program (FIES) to increase tuition
company must attain returns greater than its cost of prices without offering an additional benefit to
capital while selling a product or service for a price consumers. In this case, the increase in profits was at
consumers are willing to pay. the expense of not just one, but two stakeholders: the

students and the government.

By exercising pricing power, the company puts its

products to the test in search of a new equilibrium The Consumer Dictatorship

between shareholders and consumers. However, to
Even if a price increase makes sense and is well
be well executed – so both goals above are still met
planned, there is no guarantee of success – everything
– the price increase requires a counterpart. Customers
depends on consumer acceptance. This issue is further
must receive something in return if the strategy is not
aggravated once we acknowledge that at no time in
to be a mere value transfer between stakeholders.
history have consumers had as much power as today.
There are numerous alternatives: better quality
Ubiquitous access to information on products and the
products, improved purchasing experience, higher
3
Written by two INSEAD Business School MBA professors: Kevin Kaiser and S. David Young.
https://www.amazon.com/Blue-Line-Imperative-Managing-Really/dp/1118510887/
4
Link: http://www.ip-capitalpartners.com/relatorio/2014_09_RG_Consolidado.pdf

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IP-PARTICIPAÇÕES

frictionless comparison of prices makes it harder for be someone willing to charge less or bring more utility
consumers to accept price increases. to consumers than you.

U.S. media companies, more specifically those that In the previous example, by rising prices, content
own content and cable TV channels, exemplify this companies are in fact helping new market participants.
reality. In this sector, charging more for content has Luckily, many consumers still see TV and online
been the standard for decades – increases which were streaming products as complementary. The price
always duly passed on to final customers. Fueled by difference, however, is increasingly blatant – US$1,200 for
the offer of new channels and more sophisticated - pay TV versus US$120 on Netflix7 and US$99 on Amazon
and expensive - content, more dollars per subscriber Prime – while the quality and content gap among the

were extracted from consumers over time. In 2010, the platforms has narrowed. With such an enormous price

pay TV ecosystem (which includes cable, satellite and gap, exercising pricing power is dangerous.

telecom companies) reached its highest penetration

Netflix currently has nearly 50 million subscribers
in U.S. households – approximately 89%. Since
in the U.S., more than twice the country’s largest
then this strategy became difficult, especially with
cable TV company – Comcast – and over half of the
the rise of Netflix and other over-the-top content
total number of subscribers in the United States. The
distribution platforms, such as Amazon Video and
company is definitely no longer a small nuisance in
Hulu. Letting go of pricing power, however, is not easy
the sector.
and providers have kept increasing prices. As monthly

subscriptions linger at around US$1005, a growing

In the previous quarter, we decided to end our
number of consumers are giving up the service. Pay TV
investment in Oracle due to reasons similar to those
penetration fell from 89% to 84% since 2010, and last
mentioned above. For years, Oracle took advantage of
year the sector lost 795,000 clients (0.8% of the total)6.
its dominant position in the database business to offer

its customers a high performance product but at an

The Dark Side of Pricing Power
increasingly higher price 8. Due to the high switching
Although the power to increase prices is extremely cost of this business, where clients are almost held

valuable, its continued use may make companies hostage by their dependence to the product, it was

vulnerable. Naturally, the higher the margins and easy for the company to exercise its pricing power. The

returns of a business, the more alert competitors will consequence has been Oracle’s outstanding historical

be. This is the essence of capitalism: there will always results (annual growth of 12% in free cash flow per

5
Average amount paid per subscriber in the U.S., including additional connections and packages. Source: http://fortune.com/2016/09/23/average-cable-tv-bill/
6
Source: http://www.broadbandtvnews.com/2017/03/17/us-pay-tv-providers-lost-795000-subs/
7
Some may argue that for a fair comparison the cost of broadband internet– approximately US$600 per year – should be added so that Netflix can be accessed.
Nevertheless, for many consumers, the internet cost will exist anyway (with or without Netflix). Even so, the annual cost of Netflix + Internet would come to around
US$720, 40% lower than cable TV.
8
The database business accounts for 40% to 50% of Oracle’s operating income.

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share over the past 15 years) and enviable profitability Premium = Power?
(it generates around US$33 in free cash flow for every
There is a tendency to believe that exercising pricing
US$100 in revenue).
power is natural in products and services aimed at the
However, the database market is changing, led by the premium market, especially because charging more
massive growth in open source solutions and cloud- is part of the essence of the business. Many believe
based services. Innovative companies with large high-income consumers are less sensitive to price
demands for data analysis such as Uber, Snap, and increases making the strategy even more enticing.
Waze, among others, do not base their operations This can be dangerous. In practice, it does not matter
on Oracle databases, which is concerning. Even if a product costs $10 or $10,000, what matters is that
though Oracle is progressing in the transition of its stakeholders are satisfied with the equilibrium.
App Division (ERP, CRM, SCM, HCM, etc.)9 to cloud
In the U.S. credit card market, American Express
solutions, the continuous use of pricing power in its
has been challenging this balance. During the last
core segment has put the company in a complicated
decade, its competitors have narrowed the gap and
situation. However, reducing prices to adapt to a new
replicated most of the company’s positioning in the
market reality would give up a chunk of its profitability,

a hard decision for any CEO. premium card market. Amex cards’ differential in

terms of status, rewards and services has decreased

Meanwhile, its competitive edge continues to in that period. Of all competitors, the market leader
deteriorate. In 2010, AWS’s revenue was negligible – Chase – is the most bothersome. Last year, Chase
¬– just under US$500 million – and many competitors launched the Sapphire Reserve card to compete on
(including Oracle) did not pay much attention. What
equal terms with Amex Platinum. The success of the
were only ripples became a tsunami: last year AWS’s
card was so resounding that the bank’s fourth-quarter
revenue totaled more than US$12 billion, a US$4.3
profit was hit by a US$200 million charge due to the
billion (or 55%) increase from 2015. Aurora – AWS’s
massive adoption of Sapphire Reserve (by purchasing
database service – is considered its fastest growing
the card, Chase customers won 100,000 miles, a cost
product in history. Microsoft and Google have also
booked as marketing expenses by the bank)11.
strongly advanced in the cloud segment, creating

close relationships with corporate customers, in an To make matters worse, earlier this year, Chase, Visa
architecture which may allow them to gradually leave and Amazon launched the Amazon Prime Rewards
their Oracle legacy behind.10 card with 5% cash-back (the highest cash back

9
ERP: Enterprise Resource Planning. CRM: Customer Relationship Management. SCM: Supply Chain Management. HRM: Human Capital Management.
10
Until today, Oracle has only made shy attempts in the Infrastructure as a Service (IaaS) segment. Investing in this area poses yet another dilemma for the company,
since it would require massive CAPEX to obtain uncertain success faced with three well-established players.
11
Chase recently decided to reduce the initial 100,000 bonus to 50,000 miles, due to the strong adherence of new customers.

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IP-PARTICIPAÇÕES

value among branded cards) on purchases made on generics, overall drug prices rose 29%, twice as much

Amazon.com12. as the period’s inflation15.

To defend itself, American Express increased the Apart from the obvious harm to patients, the sector’s

benefits of its Platinum card by, for example, offering price increases created an unnecessary conflict with

a monthly credit of US$15 on Uber13 and five times its paying sources, particularly the government.
more miles for airline tickets purchased through Amex Considering that U.S. drug expenditure per capita
Travel. However, along with the benefits came an is twice the average of that of OECD countries16,
unwelcome surprise: the card annual fee jumped from it is not surprising that the U.S. government has

US$450 to US$550, while Chase Sapphire Reserve’s fee been unsatisfied with pharmaceutical companies’

costs US$450. aggressive price policy. The problem for the

pharmaceutical companies is that the government’s

We find it difficult to understand why a company
retaliation arsenal is vast. President Donald Trump’s
would increase prices in such a fierce competitive
recent declaration sets the tone of what may be
environment. Only time will tell if they’re doing the
to come:
right thing.

“We’re the largest buyer of drugs in the world, and yet

Don’t provoke the big bad stakeholder
we don’t bid properly. We’re going to save billions over

It is hard to imagine an industry which has increased a period of time. And we’re going to do that with a lot

prices more than the pharmaceutical sector in the of industries”.

United States. There are several factors that encourage

Trump refers primarily to Medicare Part D, Medicare’s
the exercise of pricing power, such as patents, market
prescription-drug benefit program for senior citizens,
consolidation, mounting regulatory barriers, distorted
regulated by the George W. Bush administration
incentives and low price transparency along the value
in 2003, currently benefiting around 41 million
chain. Recently, companies seem to have taken it
Americans. Although it represents 29% of prescription
too far, attracting the attention of the press and the
drug revenue in the United States17, the US Government
public’s rage.
does not take advantage of its huge bargaining power,

According to a survey by Express Scripts, price since the responsibility of getting the best prices with
increases of brand-name drugs in the United States drug manufacturers lies with the private insurance
averaged 208% from 2008 to 201614. Including companies who manage the program.
12
Exclusive for Prime members.
13
In December, the credit rides with Uber will increase to US$35.
14
Source: Express Scripts Drug Trend Report 2016. Link to the report: http://lab.express-scripts.com/lab/drug-trend-report.
15
Source: Bureau of Labor Statistics.
16
Source: OECD Health Statistics (2014).
17
Source: Overview of Medicare Spending (http://kff.org/medicare/issue-brief/the-facts-on-medicare-spending-and-financing/).

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Nothing a legislative stroke of pen can’t solve to as follows: “I will pass on virtually all productivity and
return part of the price increase to the government efficiency gains to my customers, but my increase in
and the population18. According to a study by inventory turnover will more than offset this, ensuring a
Carleton University19, the Medicare program entitles high return on capital.” Within the sector, Costco has
its beneficiaries to an average discount of 17% on best incorporated this concept. A seemingly anecdotal
list prices of prescription drugs sold in the U.S., while example can help us better understand the company
other government programs, such as Medicaid and and the philosophy of its founder, James Sinegal: at
Veterans Health Administration, grant discounts of Costco, the hot dog and soda combo has cost US$1.50
52% and 54%, respectively. since 1985. Sinegal says the following:

One day this party will end… “A typical retailer might look at this hot dog and say

‘Gee, I’m charging five bucks for this. I wonder if I can

The opposite is also true: shareholder value is also
get five and a quarter for it’. We look at it and say: it’s
created by lowering prices!
US$ 1.50 and is there any way we can reduce the price?”
The retail sector has numerous business models and
This is one of the beauties of Costco’s model: it forfeits
various forms of differentiation and positioning. In
its pricing power, creates great value for customers
an extremely competitive sector, many competitive
and shareholders and drives the competition crazy.
advantages are apparent and replicable – but not
It may sound easy, but temptation is hard to resist,
all of them. In a universe with many losers, there are
especially in a low-margin business, where a slight
few winners with such extraordinary advantages that
price increase can significantly impact profits.
serve as a lesson for companies in all sectors.

The numbers speak for themselves. Costco’s operating

In this context, the cash & carry segment deserves
margin is 3.1% lower than that of its main competitor –
attention. This market gained prominence over
Sam’s Club – but its revenue per square meter is 77%
the past decades, both in the United States and
higher. Its gross margin is 13%20 (Brazilian cash & carry
Brazil, for indulging consumers in an effective way:
companies operate with a gross margin of around
differentiation through low prices, limited assortment,
15%) and the company’s return on invested capital
scale, simple store formats and exclusivity via an
is around 13%. This is the “Lollapalooza Effect” which
annual fee.
motivated Charlie Munger to become a shareholder:
A businessman in the cash & carry segment thinks persistently lower prices attract more consumers; the
18
Not all drugs are 100% subsidized.
19
Link to the study: https://carleton.ca/sppa/wp-content/uploads/Mirror-Mirror-Medicare-Part-D-Released.pdf.
20
Including annual membership fees.

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more consumers, the greater the company’s scale and allowed the company to pressure competitors in the

bargaining power; with more scale, even lower prices shoe segment, acquire market share. The decision

are possible and thus, the cycle continues. proved further successful given the severe crisis Brazil

has been facing in recent years: while competitors were

Today, an average Costco store posts an impressive
passing on cost increases, Arezzo protected itself and
US$166 million in revenue. In the last 10 years, the
maintained a close relationship with its consumers,
company’s shares have appreciated by 286% (14.5%
offering shoes at an even more accessible range.
p.a.), versus 103% of the S&P 500 (7.3% p.a.) – including

reinvested dividends. In 2016, revenue from the Brazilian footwear

industry contracted by 16%22. In the same period,

The similarities between Costco’s and Amazon’s
Arezzo brand’s revenue rose 9%, while the group’s
models are noteworthy. In our 3Q16 report, we
consolidated revenue grew 8%.
mentioned a few reasons why we have invested in

Amazon. One of the most curious aspects of the At the end of the day, enjoy in moderation

company’s strategy has been to pass on to customers

Lastly, let’s take a look at Gillette: a company that
most of its operating gains of scale – through lower
became inebriated by its pricing power, selling
prices and greater benefits. While the vast majority of
razors at an exorbitant cost. Between 2007 and 2016,
CEOs would not have resisted the temptation to seek
the company’s volumes contracted 1.4%, while its
heftier short-term margins, Bezos continues to bet on
average price rose 34% (excluding the effect from
accelerated growth and “total domination” – with the
product mix)23. During the same period, Gillette’s
option to indirectly exercise some pricing power in
market share in the U.S. razor segment fell from 70%
the long run.
to 54%. In addition to the Dollar Shave Club (acquired

In Brazil, Arezzo&Co’s strategy is worthy of mention. by Unilever), there is another new market participant

In its main brand (Arezzo), the company kept making a lot of noise – like Harry’s and its 5 million

prices virtually unchanged for its basic category customers24 25. These two players already hold 12%

(approximately 20% of sales volume) between 2012 of the U.S. razor market 26. Even in a business with

and 201521. In the last few years, they launched a such strong competitive advantages, Gillette’s price

handbag line that currently represents 18% of Arezzo’s increases paved the way for the barbarians to reach

total revenue. The entry into the handbag category the gate.

21
Given the period’s 32% inflation, in fact, shoe prices significantly fell in real terms.
22
Source: Brazilian Shoe Manufacturers Association (Ablac).
23
The volume and average price mentioned include all Gillette products, such as shaving creams, deodorants, etc.
24
We recommend that readers watch Harry’s excellent commercial, available on YouTube:
https://www.youtube.com/watch?v=eYWCUGmGuss.
25
According to the company’s latest corporate presentation.
26
Source: Euromonitor.

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 Miscellaneous

“Gillette Slashing Razor Blade Prices by as Much as 20%”

— Wall Street Journal, April 4, 2017

“Invert. Always invert.”

— Charlie Munger

“I only hope that we never lose sight of one thing – that it

was all started by a mouse.”
— Walt Disney

“You know you’re priced right when your customers

complain—but buy anyway.”
— John Harrison (Is that really true??)

“The moment you make a mistake in pricing, you’re eating

into your reputation or your profits.”
— Katharine Paine

“Pricing has covered up a multitude of other

disappointments over the past 15 years (in the
pharmaceutical industry).”
— Geoffrey Porges, biotechnology analyst at Leerink Partners LLC

“On the face of it, shareholder value is the dumbest idea in

the world. Shareholder value is a result, not a strategy.”
— Jack Welch

“Pricing is the exchange rate you put on all the tangible

and intangible aspects of your business. Value for cash.”
— Patrick Campbell

“Pricing is the moment of truth – all of marketing strategy

comes to focus on the pricing decision.”
— Raymond Corey

Miscellaneous

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“So everything we do is from the lens of the brand. We
are building the brand. We have to invest in the brand,
because the brand is the most important thing (…) when
you think about stores that have brands, whether it’s
Starbucks or Nike or maybe Louis Vuitton, those brands
have real equity. People will go that extra mile, walk the
extra 200 or 500 yards to go to Starbucks and go past
a Dunkin’ Donut or a McDonald’s or drink some other
flavored hot water because they value the brand and the
brand experience.”
— Leslie Wexner, founder and CEO of L Brands

“We should not abuse our pricing power. Some people

are not stupid. They first look on the Internet to see the
pricing and the differences of pricing more than ever. And
as you know, and it doesn’t please to everybody, but we
are committed to our so-called fair pricing, meaning that
excluding tax we are managing to try to have a pricing
equivalent around the world, to create confidence and
trust with our consumer for prices”.
— Gary Saage, CFO of Richemont

“The accounting is fiction. One of the fictions here is the

marketing cost. The marketing cost gets booked over 12
months. The benefit of the card gets booked over 7 years.
The (Sapphire Reserve) card was so successful it cost us
$200 million, but we expect that to have a good return on
it. I wish it was a $400 million loss.”
— Jamie Dimon, CEO of JP Morgan Chase

“For builders, the same yearning for freedom exists.

Freedom to build fast. Freedom to understand your data
better. And the freedom to unshackle yourselves from
customer hostile database vendors.”
— Andy Jassy, CEO of Amazon Web Services (AWS)

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11
 “Our profitability is not our customer’s problem. We don’t
take the point of view that we’re going to price products
at a particular margin. We price products competitively
and if that means on that product that we lose money
that’s ok. We need to take care of the customer and earn
trust and we’ll figure out over time if we can or if we can’t
ever make money with that product. If we can’t we’ll stop
selling it, but we’re not going to make customers pay for
any of our inefficiencies.”
— Jeff Bezos

“Our policy is to reduce price, extend the operations, and

improve the article. You will notice that the reduction of
price comes first. We never consider any costs as fixed.
Therefore we first reduce the price to the point where
we believe more sales will result. Then we go ahead and
try to make the prices. We do not bother about the costs.
The new prices forces the costs down. The more usual
way is to take the costs and then determine the price; and
although that method may be scientific in the narrow
sense, it is not scientific in the broad sense, because what
earthly use is it to know the cost if it tells you cannot
manufacture at a price at which the article can be sold?”
— Henry Ford (just to illustrate it, the price of Ford’s first Model T car cost
US$950 in the year it was launched, in 1908. Price fell 72% to US$269 in
1923 - approximately US$3,832 in today’s value) 27

27
Information from the book ‘The Rise and Fall Of American Growth’, by Robert J. Gordon.

Miscellaneous

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