From the advent of electricity to the adoption of the internet, technology has often been a catalyst for cost reduction. Yet today, investors may find that some technology companies can raise prices amid inflationary pressures, adding to their fundamental appeal in a challenging economic environment.
For decades, technology companies accelerated progress, galvanized efficiencies, lowered costs and slashed their own margins as new innovations infiltrated modern life. But today, supply-chain snarls and inflation have shifted the balance of power from customers to select tech companies, and many now have the opportunity to raise prices and expand margins.
Tech stocks have sold off heavily this year as the market reprices expensive, high-growth stocks. When the volatility subsides, we think technology companies that benefit from inflation and have pricing power should be well positioned for the long term.
Here are five ways technology companies can flex their pricing power muscles in the current environment.
1. Time for Your Price Adjustment, Again
Imagine companies that have positioned themselves such that consumers are delighted to pay annual price increases for the right to continue the same service. These companies often control property or information that is a necessity in the business of others.
Cell phone tower companies fall into this category. They rent space on their towers to cell phone carriers. Tower placement is regulated, so maintaining coverage areas requires cell phone carriers to ensure their equipment makes it onto specific towers—and stays there. That’s worth an annual price increase of about 3% on the network already in place. Additional growth comes from the on-going build-out of the global cell tower network. The industry has many participants, but we believe investors should focus on pure cell tower plays, avoiding companies that have exposure to other, less profitable communication infrastructure.
2. Raising Prices—Because We Can
Companies that can raise prices because they want to, and know the market will bear it, are in the ultimate power position. These companies have products or services so ubiquitous that they’re an irreplaceable must-have. And they aren’t propping up inflation-ravaged margins.
Microsoft and its Office 365 web-based software rules this category. The company has added more than 200 functions over the past decade, but prices have remained static while usage has soared. Its first-ever price increases this March are only a dollar or two per month above current levels—but that’s an increase of between 8.5% and 25% depending on the subscription type.
3. Higher Prices—Pass Them On
The companies in this group benefit from inflation their suppliers flow through. These product resellers pass-on price increases (and sometimes a little more), boosting revenue growth while protecting margins. For example, CDW, an IT solution provider, has combined these higher prices with a favorable mix shift—its customers are upgrading employees’ digital work environments. That’s a recipe for earnings success.
Even financial technology firms can benefit from this phenomenon. The cost of goods and services purchased on a Mastercard increase during inflation, increasing its fees based on the dollar volume of transactions.
4. Outsourcing with an Additional Hidden Benefit
Companies seek efficiencies as inflation rises, which may include automating payroll and outsourcing human resources. The price for those services is based on wages. A tight labor market leads to increasing labor costs, and higher paydays for the payroll providers such as ADP—without any cost increases. Additionally, since customers transfer payroll funds to the servicer before payday, there’s the opportunity to earn interest on that cash until its dispersed. Interest rates are increasing, and this income stream is 100% gross margin, further boosting earnings.
5. Pay What You Must to Keep Business Moving
Indispensable goods or services have enjoyed unprecedented pricing power as inflation has inflated costs. For Amphenol, a global supplier of high-tech electronics throughout many industries, not only have input commodity costs increased, but shipping and freight costs have soared. However, management has noted that customers have become conditioned to accept extraordinary pricing increases to keep manufacturing at some level, often lower than average production levels.
Recent supply-chain snarls have reminded us that virtually everything manufactured needs a semiconductor, from self-driving electric vehicles to toasters. A lack of semiconductors has created cascading effects.
Semiconductor equipment maker ASML sells to the three largest semiconductor makers. Under normal circumstances, its limited customers dictate pricing. But semiconductor manufacturers are under pressure and desperate for higher production capacity. ASML is selling them its existing technology at premium prices while also building a backlog for its newest, and more expensive, solutions.
In turn, semiconductor manufacturers that can produce are receiving enhanced prices for their goods. Automakers, for example, unable to obtain enough semiconductors through traditional means, are now working directly with semiconductor vendors—and paying those premium prices.
Based on the Federal Reserves’ most recent statement, the inflation battle will be ongoing for some time. And the technology industry sell-off has prompted investors to rethink how they are exposed in the sector. Savvy investors have the opportunity to leverage inflation protection embedded in technology firms until inflation is tamed, and perhaps beyond.
© AllianceBernstein
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