“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” - Warren Buffett
European companies have underperformed their US brethren in the last several years whether you look at profits or share prices. How much can this be attributed to an undeniably tougher domestic economic backdrop in Europe over this time frame, if at all?
Why the underperformance?
Revenue growth in the two regions has actually been more or less the same, perhaps highlighting that large companies, for the most part, enjoy a similar global opportunity set. Working down the income statement, this gap in profits doesn’t seem to be down to differences in tax rates, interest costs and depreciation charges, with the same poor relative trends even adjusting for the above. Sector differences don’t seem to explain it either as, when you weight the sectors equally, profit inferiority remains – European firms have a lower return on equity in almost every sector.
The real culprit
Here, we think the problem has to do with pricing. At its simplest level, profitability is determined by the gap between the prices charged by businesses and the marginal costs that they face – the profit mark-up. Since the Great Recession, European firms have been struggling to increase product prices at a faster rate than unit labour costs, thus contributing to weak profitability. US firms, on the other hand, were able to increase prices faster than unit labour costs throughout the same period.
This inability of European firms to keep up with rising unit labour costs may be evidence of a lack of pricing power. Economic theory tells us that profit mark-up developments depend on the relative speed of the adjustment of selling prices relative to marginal costs. If European firms are generally price-takers, the speed of the adjustment of prices is predominantly determined by demand conditions, which can be proxied by the capacity utilisation rate. In fact, past experience shows that a rise in Europe’s capacity utilisation rate is associated with an increase in the profit mark-up and vice versa.
Still high, albeit falling, European unemployment tells us that plenty of slack remains, suggesting that unit labour cost growth isn’t likely to pick up anytime soon. Therefore, corporate pricing growth should be the main determinant of European profit margins for the time being. Here, the broadening and strengthening economic recovery in Europe should lead to better demand conditions for European firms. Assuming that past relationships hold, this should provide European firms with a little more breathing space to raise their profit mark-up and help start to narrow the profitability gap between US and European firms – a process that is already underway on the evidence of the latest earnings season.
Things are more complicated in the US, where wage growth is picking up at a faster pace. Interestingly however, we find that the US profit mark-up isn’t correlated to demand conditions. This may suggest that US companies have stronger pricing power, and are thus better able to set prices independent of demand conditions. If that were indeed the case, it may mean that US profit margins are less vulnerable to rising labour costs, since firms have more flexibility to raise prices in response to higher wages.
It is possible that structural factors such as weaker management practices, differences in regulation, and lower economies of scale have contributed to the Europe – US profitability gap, pointing to a structural as well as cyclical element. However, if history is any guide, the current improvement in demand conditions should help alleviate some of that pressure. It may be time for Europe to pay back all that accumulated investor faith of the last few years, ironically at just the moment when many of those previous champions of the region have become too focused on the political backdrop to notice. We would urge investors to trust the carefully constructed constitutional restraints in Europe and focus instead on those improving fundamentals.
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