Inflation is great if you have pricing power — just ask Mercedes

For years Mercedes-Benz's profits failed to match the desirability of its luxury vehicles. Now, semiconductor shortages have given it the perfect cover to hike prices and prioritise production of its most expensive high-performance models.  

The impact on earnings has been stunning. Mercedes reported a 15% operating profit margin during the final three months of 2021 — about double the car unit’s average return during the past decade. With inflationary pressures building across the supply chain, there could be no better demonstration of the benefits of the German giant’s pricing power.

Warren Buffett once described pricing power — the ability to raise prices without curtailing demand or losing share to a competitor — as the most important decision in evaluating a business. Considering the frequency with which the subject is debated on quarterly earnings calls, plenty of investors agree.

If companies are unable to fully pass on soaring raw material, energy and logistics costs to customers their profit margins will suffer or they’ll have to find cost savings via more onerous productivity improvements.

With a value chain spanning component suppliers, tires, steel and semiconductors, as well as auto dealerships and rental firms, the automotive world reveals plenty about who has pricing power, who doesn’t and why.

Due to a lack of inventory much of the industry has an unusual ability to boost prices and thereby reinforce profitability. Dealerships are selling new vehicles above the manufacturer’s recommended sticker price, for example, while rental car firms can charge whatever they like to desperate holidaymakers. Even laggard Renault is making decent money again.

Some of this pricing power will fade once supply chains normalise and vehicle inventories are rebuilt. But just as luxury fashion houses have had no trouble raising prices lately, luxury car brands such as Mercedes look best positioned, thanks to customers willing to spend. Even wait times of more than a year for some premium models haven’t deterred wealthy clients.

Similarly, premium tyre manufacturers such as French group Michelin have announced big price hikes for replacement tyres without spurring a shift to budget brands, which also face raw material and shipping cost pressures.

Winning in an inflationary environment depends on how indispensable your product is and where you are in the value chain. Manufacturers of hot-ticket items are well placed, whereas it’s harder for suppliers to negotiate price hikes. If the latter pushes too hard clients might shift business to a rival or bring the work in-house.

For example, Continental's loss-making automotive technologies division was forced to shoulder higher costs last year related to automakers cutting production. Meanwhile, logistics, energy and the price of semiconductors for its advanced electronics have also become more expensive. Its management has made no secret of how it’s getting the raw end of the deal, saying in November there were “strong discussions” with automakers about recouping costs.

Suppliers are finding ways to avoid being squeezed. German peer Schaeffler has a big after-market division that has had less difficulty hiking catalogue prices for essential replacement car parts. Schaeffler has also highlighted how cost-escalation clauses in North American auto client contracts allow it to automatically pass on soaring steel prices.

These cost pass-through agreements are a vital lifeline for industrial companies. The trouble is there can be a time lag before they realise the full benefit and they don’t always cover all the cost pressures businesses face.

At Goodyear Tyre & Rubber, higher selling prices have more than offset commodity price increases. However, passing on transport, wage and energy inflation is more challenging, management said this month.  

In the past, automakers have sabotaged themselves by producing too many vehicles, which encouraged steep discounting and undercut margins. Similarly, the rental-car industry failed to capitalise on its oligopolistic advantages due to perennial price wars.   

Now, Ford Motor, Renault and Mercedes are among carmakers saying they won’t go back to the days of loading dealers with excess inventory once supply-chain issues ease. High values, not high volumes, are the new priority. 

Given the industry’s track record, I don’t blame investors for fearing a return to bad habits, which explains why auto stock valuations remain meagre compared to earnings (Tesla is the exception). If inflation persists, rising wages could become the next big burden auto companies must deal with on top of the added costs of electrification. Pricing power is hard won and easily spurned. 

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