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How These Companies Profit From Varying Customer Price-Sensitivity

By Mark Lin – Feb 10, 2014 at 12:07PM

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Many investors invest in companies with little pricing power and find that their companies’ share prices fall in tandem with profit margins. They need to understand that pricing power is a function of customer price-sensitivity, which is in turn influenced by the price of the product and how much it is as a part the customer’s budget.

Every company likes customers who don't care about price when they buy stuff. Price-sensitive customers do a lot of price comparison, drive hard bargains, and impact the profitability of retailers negatively. Companies like Libbey (LBY), Conn's (CONN 4.62%), and SodaStream (SODA) have leveraged customers' varying degrees of price sensitivity for greater profitability.

Small-ticket items
Libbey is the second-largest glass tableware manufacturer in the world and sells more than 1 billion glasses every year. It sells to a wide variety of customers including houseware stores, groceries, breweries, hotels, and restaurants.

Taking restaurants as an example, glasses make up a relatively insignificant proportion of food-service operators' total costs, especially compared with store rental expenses and wages. Restaurant owners will rather spend their time negotiating with their landlords and top chefs than waste their energies getting a discount of a few dollars on each piece of glassware.

Interestingly, food-service operators work in the same way themselves, offering their specialty dishes at affordable prices while making most of their margins on beverages. Therefore, restaurant owners are also more forgiving of price increases on beverage-ware because these are partially offset by the high margins on beverages.

The results speak for themselves. Libbey has expanded its gross margin by more than 1,000 basis points from 13.5% in 2008 to 23.6% in 2012. Also, it has maintained a gross margin in excess of 20% for the past three fiscal years from 2010 to 2012. Furthermore, 90% of its U.S. food-service glassware sales are connected with replacement for damaged ones, so food-service operators can't save a few bucks to have non-matching beverage-ware.

Big-ticket items
It is obvious that customers don't have the same price sensitivity with big-ticket items such as electronics and furniture that they have with small-ticket items like glasses or coffee. Consumers don't mind going around to different retailers to do price comparisons and get the best bargains because the price disparity and resulting savings can easily be a few hundred dollars.

This is made worse by the fact that more than one in four households are either unbanked or underbanked, based on the results from the Federal Deposit Insurance Corporation's annual survey.  

Conn's, a specialty retailer of branded consumer home durables, offers a variety of in-house and third-party credit financing options to its customers. In particular, its in-house financing scheme has been in place for close to half a century.

The results are very impressive, as its customers indeed had their price sensitivity lowered because of credit availability. While a typical consumer buys a television set that costs below $500, the average selling price of a television for a Conn's customer is way higher, at above $1,000. By providing accessible credit at lower rates than non-bank lenders, Conn's has managed to 'encourage' its lower-income customers to buy more expensive quality, branded products.  

Similar to Libbey, Conn's has expanded its gross margin over the past few years. Its current trailing-12 months gross margin of 49.5% represents a 1,570 basis points improvement over its 33.5% gross margin in 2009.

High- and low-ticket items as part of a single product package
Since the average ticket item of a product is proportional to customer price sensitivity, is there a business model that exploits this relationship? Yes, this is what people commonly refer to as the razor and razor-blade model, where the initial product is a low-margin, big-ticket item, while follow-on products are high-margin, small-ticket items.

One example of a company that follows this model is SodaStream, a manufacturer and distributor of homemade soda makers. It makes most of its profits by selling consumables such as carbon dioxide refills and flavors to customers who have already bought its soda makers. Its operating margin is as high as 25% in countries like Switzerland, where a high sales mix of consumables contributes to superior profitability.

One key success factor for the razor and razor-blade model is to make the initial product purchase as affordable as possible. Once the customer buys SodaStream's soda maker, his price sensitivity drops dramatically for the follow-on consumables because he is already locked-in. SodaStream does a good job here, keeping its entry level soda maker as cheap as $100 and below.

SodaStream has maintained a consistent level of high profitability historically with a gross margin of more than 50%. Going forward, as it increases penetration in less developed home-soda markets, it should see a further uptick in margins from a larger installed base and increased consumables sales.

Foolish final thoughts
Customer price sensitivity isn't an obstacle to profitability, as along as companies know how to take advantage of that. Libbey has the ability to raise prices because its customers are less price sensitive; Conn's has used credit to reduce consumers' high price sensitivity toward big-ticket items. SodaStream incorporates both higher price sensitivity on initial purchase and lower price sensitivity on follow-on purchases into its razor and razor-blade model.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends SodaStream. The Motley Fool owns shares of SodaStream. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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