April 15, 2006

Companies/ industry with falling pricing

There are industries with stable pricing power like FMCG companies (to a certain extent), cylical pricing power like cement, steel and other commodity companies which depends on the demand and supply conditions and then there are companies which have a business model where the price is always dropping. A few industries, which come to mind are the computer industry (Dell, HP etc), semiconductor industry, memory (moser baer) and even electronics.

These industries are not even like airlines where there is a certain cyclicality of pricing. In the above industries, there is a relentless race to the bottom. Its almost a given. A PC now is around half the price of a PC in 2000 (maybe lesser), but it is 5 times or more powerful. So you have a scenario where the product keeps getting better and the price keeps falling.

So even when the revenue is increasing, the margins and profits may be shrinking. So what does it mean for an investor?

  1. To be competitive all participants in the industry must constantly spend huge sums on new technologoies, equipments and other cost reduction options. So effectively the earnings are overstated for these companies, as depreciation is way to lower than the obsolence in the industry.

  2. Due to poor pricing power, any drop in the demand has a severe impact in margins (see samsung results here). Companies like Intel which have a monopoly in the processor business have also taken huge hits when the demand has dropped.

  3. Sudden shifts in technology can destory the exisiting product lines and put the company at risk. Even small shifts can hurt these companies badly (nokia got hurt and lost market share when the preference moved to clamshell phones in 2004/2005.)

In the end I would value these companies at low multiples if I can forsee the future of the company and figure out that the company would do well for quite some time.

As an example, look at Moser baer. This company has grown a lot, but at the same time operates in a falling price environment and needs constant investment into capital equipment. As result the company has had to add capital to the business. I am not sure if this business would really have any free cash flow.


Prem Sagar said...

True, as Peter Lynch puts it, its better to be a user of technology than a manufacturer of technology..

amit said...

Very correct analysis,what??? are you working in some semiconductor company,looks so,or how did this attracted your attention.

There is cut throat competition in the semiconductor industry and i think the condition will improve only if there are only few players that is a series of acquisitions and mergers have to be there for the survival of semiconductor industries.Intel,Infineon,ST Microelectronics,Philips all have witnessed a steep fall in their share prices in the past 3-4 years, and i hope it to continue.From investors point of view this is not the right space to be in.

Nice point raised friend.

Rohit said...

moser baer comes up if you run screens based on pe ratios. So it always looks statistically cheap.

as a result i have analysed this company in the past, but given it a pass

Deepak Shenoy said...

I had picked this up a few months back at about 179 or so - the recent news that it's patented technology is in the DVD "Blu-ray" format has picked it up to about 240. Slightly overawing but the company's a solid player in this market; plus there was an institutional placement at Rs. 300+ about two years ago, awaiting the DVD sale growth. WIth the blu-ray becoming dominant in the HD-DVD space (and I believe it will be) Moser stands to gain from the patent licensing and of course, the media manufacturing itself.

Surely, there's something more to be said of a company that has invested, apart from manufacturing, into R&D?