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Published: October 26, 2010
Deflation has
become a central concern these days. The Federal Reserve sweats
the notion of falling prices across the economy, as it tends
shrink asset values even as debts against those assets remain
constant. And companies hate
deflation, because it usually signals weakening revenue,
margins and profits. For many firms, it's simply impossible to
even think about raising prices. But in a few industries,
pricing power has come back, and investors may be
underestimating the future earnings power that can result.
Fewer planes means more pricing power
When the airlines experienced the turbulence of 2008, they took
a lot of planes out of commission. And as soon as the economy
rebounded and demand for air travel started to build, many
assumed that the airlines would simply bring all those
mothballed planes back on line. It hasn't happened. Instead,
airlines saw this as an opportunity to not shoot themselves in
the foot, which they had done every time before.
A quick glance at Delta's (NYSE: DAL) recent quarterly
results spells out the benefits of restrained capacity. The
nation's largest carrier boosted the number of planes in service
by 2%, but demand was more robust than last summer, helping
Delta to boost revenue per passenger from $12.22 per mile flown
to $14.22 -- a +16% jump.
The payoff: Analysts at Bank of America note that the
publicly-traded U.S.-based airlines likely earned a record $2.4
billion in the third quarter, up from a $260 million loss last
year. Industry laggard AMR (NYSE: AMR) even managed to
post its first quarterly profit in two years thanks to surging
yields and slower-to-rise costs.
Industry watchers expect airline carriers to only slowly add
more planes back into the service, below the rate that would
lead to price wars. American Express just issued a report
predicting that tight supply will enable airfares to rise
another +2% to +6% in the United States next year, and +5% to
+10% in the rest of the world. That's a real positive for Delta,
AMR and United Continental (NYSE: UAL), as these carriers
are most heavily exposed to international travel. The weak
dollar may impede some Americans from traveling abroad, but
could trigger a fresh surge of foreign tourism to the U.S.
Fewer discounts mean higher prices
Auto makers are also benefiting from restrained supply to help
firm prices. Advertised prices for new cars and trucks are
rising only modestly, but auto makers are finally able to stop
the rebate game, which often took $1,000 to $2,000 off of the
listed price. They can afford to do that since many auto plants
were shuttered during the downturn, and few will be re-opened.
Domestic auto plants are now producing two million fewer cars
than a few years ago, and similar cutbacks have been made in
Europe.
Even as industry sales still
remain in a funk, pricing power is already in evidence. Goldman
Sachs expects U.S. auto and truck sales to be around 11.5
million this year, well below the 17 million unit levels seen
back in 2006 and 2007. Yet they expect that figure to rebound to
13 million next year, 14 million in 2012 and 15 million in 2013.
As long as the auto makers expand output at levels in line or
below industry sales, they should see continued improvements in
pricing power.
As an example, Ford Motor (NYSE: F) has produced about
-10% fewer vehicles in the third quarter than the second
quarter. That means fewer cars will pile up on dealers' lots,
and Ford will not need to resort to profit-sapping rebates to
move the metal. We're typically bombarded with year-end closeout
specials from car dealers in September and October, but that's
not happening as much this time around, as inventories remain
quite lean.
Reversing the freight pricing trend
When economic activity slowed, major publicly-traded trucking
firms such as Arkansas Best, Con-Way, J.B. Hunt, Knight
Transportation, and Heartland Express had to take a number of
trucks out of service. Nowadays, demand for freight carriers is
increasing, and thanks to better control of supply, these firms
are finally able to push through some badly-needed price
increases. As Dahlman Rose's Jason Seidl recently wrote, "the
industry, whose recovery has lagged that of other modes of
transportation, is experiencing a gradual return of pricing
power, resulting from dwindling capacity and improved demand."
As this is a business with high fixed costs, moderate revenue
growth can lead to much faster profit growth. For example,
J.B. Hunt (Nasdaq: JBHT) is expected to boost sales +12%
next year (half from volume increases, half from price
increases), though per share profits are expected to rise +28%.
Arkansas Best (Nasdaq: ABFS) is expected to swing from a
$1.31 a share loss in 2010 to a $0.67 per share profit next
year.
Alcoa's upturn
Sometimes, an industry giant can set the tone for a whole
industry. Alcoa (NYSE: AA), one of the world's largest
aluminum producers, has severely reduced output, and management
insists that the company will be slow to rebuild output when the
industry rebounds. It helps that Chinese aluminum producers are
cutting output.
Alcoa's management discussed the improving industry dynamics in
great detail on its recent conference call. Other industry
players such as Century Aluminum (Nasdaq: CENX) stand to
benefit from Alcoa's leadership on the supply front. Then again,
that's bad news for companies like Noranda Aluminum (NYSE:
NOR) and Kaiser Aluminum (Nasdaq: KASU), which count
on cheap prices to boost their profit margins on manufactured
aluminum goods.
Action to Take --> Many
of these supply-induced pricing gains are impressive enough in a
weak economy. They'll look even more impressive when the economy
rebounds, as long as supply growth lags demand growth. These
sectors have already posted decent gains, but investors are
likely under-estimating their impressive earnings power when the
economy is back in growth mode.
Of the companies mentioned here, Ford Motor, Aloca, AMR (because
it's much cheaper than the other airline stocks) and Arkansas
Best are my favorite names to consider.
-- David Sterman
Staff Writer
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