In the business world, pricing power is absolutely critical. This term describes the ability of a company to raise prices without experiencing a subsequent drop in demand, and it might just be the only measuring stick worth bothering with, according to Warren Buffett. Here's how Buffett categorically described the significance of pricing power back in 2011:
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.
But the industries in which I so frequently fish for new investments -- notably manufacturing and transportation -- are often lacking in this category. Typical "industrial companies" aren't known for their market power or hefty margins like, say, a consumer product company like Coca-Cola or a near-monopolistic Internet company like Google.
Now, there are a couple of reasons for this right off the bat. One is that pricing power without some sort of regulatory advantage is primarily about differentiation, a rare characteristic of traditional industrial products. Further, a powerful consumer brand is able to achieve a premium price due to intangibles like "brand association" or "top of mind awareness." For end users of industrial products, which are often other businesses and not consumers, this is less often the case.
Unlike an average consumer, the purchasing departments of companies are typically armed with information about competing products and are incredibly price-sensitive when making buying decisions. Both of these facets of the highly competitive manufacturing industry tend to squeeze profit margins into the single digits.
Source: Wikipedia
Nevertheless, I've stumbled upon a few manufacturers from time to time that do exhibit incredible pricing power, a feat that truly separates these players from the rest of the pack. One of those companies is the diversified industrial company 3M (MMM 0.73%).
To illustrate 3M's clout in the market, the first place you would want look at is profit margins. By placing 3M's profit margins next to several of its closest peers (all of which, by the way, possess highly recognizable brands), its clearly evident that 3M has a greater ability to flex its pricing muscle than its counterparts. Note the discrepancy between when it comes to two important profitability metrics, gross margin and EBITDA margin:
Based on the financial results posted by these six companies, which includes world-class brands ABB, United Technologies, GE, Siemens, and Honeywell, 3M is head-and-shoulders above the pack. At 47.8%, 3M's gross margin is approximately 62% greater than the average of the other five. Its EBITDA margin is an even more impressive 67% larger relative to its competition.
Of course, one of the reasons 3M towers over the competition is that its a stretch to describe these companies as true competitors. To be frank, there's not another company I can think of that competes head-to-head with 3M across a wide variety of products at the same international scale. You can't say the same for GE, for example, which goes toe-to-toe with Siemens in nearly every major product category.
To be sure, 3M vies with GE in transportation manufacturing and has some overlap with the health care focused Johnson & Johnson medical technology, but for the most part the Minnesota-based industrial outfit has carved out a unique niche, especially in materials technology. That high level of differentiation translates to outsized margins and the ability to raise prices without fear of deterring customers.
What's more is 3M's international operations are more profitable than those in its home market, also a rare trait in manufacturing. In Latin America and Canada, operating profit margins before tax are 25% versus 20% in the United States. In the Asia Pacific region, they're even higher at 26%. For perspective, Coca-Cola's global operating margin before tax in 2013 was 22%. Google's was 23%.
One of 3M's classic brands, Scotch tape. Photo: The Motley Fool
Foolish takeaway
Operating in a manufacturing industry widely known for razor-thin margins, 3M's profitability and pricing flexibility dwarfs the competition, if you can call it that. By sticking to the businesses it knows best, whether it's highly visible consumer products like Scotch tape or more specialized natural gas fuel tanks, 3M's sliced out a niche all its own. And it's done so on a global scale with a savvy management team. If this isn't a stock Warren Buffett could love, I'm not sure what is.
