Filter #1 BUSINESS: Cost pass-through demystified


Filter #1: Business

When it comes to examining our understanding of a business, the average investors unfortunately look at the firm's products and services more than their value adding process. This is an overestimation of what they know through surface observation instead of the deep dive that business-like investors would endorse.

Warren Buffett did not mean that we should go and buy all the poultry stocks just because we consume chicken products nearly everyday.

We are able to make better call than the average investors if we know the entire value chain (from inputs to the final products), have familiarity with market demand, and grasp the economics of the industry.

While such in-depth investigation is time consuming and rewarding, the average investors and analysts simply prefer quick conclusion and investing calls.

In response to a hike in the prices of a main (raw) input, they often conclude that the profitability of a firm hinges upon its cost pass-through power. Their conclusion is not wrong, but is less helpful to generate a fruitful investing idea if the issue is not deliberated.

For this reason, the objective of this letter is to discuss the economics of cost-pass-through framework and seek financial evidence for identifying cost pass-through power company(ies). Paper and corrugated industry is employed for these purposes since it falls within our circle of competence.

Cost-pass-through framework

Cost pass-through describes what happens when a firm changes the price of its products or services following a change in the production (mainly raw materials and labour) costs.

A cost change in a common raw material affects all firms in an industry.

Upstream firms normally set lower absolute mark-ups relative to downstream firms, who then set the greater extent of downstream pass-through. The greater downstream pass-through will effectively reduce the bargaining power of the upstream firms, amplifying by the availability of cheaper imports and (in)direct substitutes.

Pass-through power of the industry-wide escalated cost is strong if the product is a necessity, of little local and imported substitute, of little differentiation (product or service quality and value), of high demand, and the market structure is highly concentrated (with a few players).

In particular, it is essential to consider how cost pass-through may interact with other dimensions of competition. Pass-through power may be sensitive to the interactions arising between the choice of price and product & service quality or value in entirety.

As a result, there may be significant differences between firms in the extent of cost pass-through, even in response to industry-wide cost changes.
Cost pass-through can be measured using (1) absolute pass-through is the degree to which a given absolute change in cost causes a given absolute change in price, and (2) pass-through elasticity gives the percentage increase in price arising from a 1% increase in cost.

These are two inter-related measures:
  • absolute pass-through equals the pass-through elasticity multiplied by the ratio of price to production cost. Suppose that an increment of $1 to a production cost of $100 causes selling price to increase from $200 to $202. In this case, both production cost and selling price increase by 1%, so the pass-through elasticity is 1. However, the absolute pass-through is 2.
  • Where a firm maintains a constant gross profit margin over time, this means that it has a pass-through elasticity of 1. In the example above, the original percentage gross margin was 50% (200-100/200). After the cost shock, the gross margin is unchanged at 50% (202-101/202).
Cost-absorbing happens where the absolute pass-through rate is less than the $1 in view of a $1 increase in production cost.

Cost-amplifying occurs when the relevant absolute pass-through rate is greater than the change in production cost. Firms exhibiting pass-through elasticity greater than 1 are most desired.

Paper & corrugated packaging industry

According to this recent press release of Malaysian Corrugated Carton Manufacturers' Association,  local paper & corrugated packaging manufacturers have been increasing their selling prices since the early of 2017.

The hike in selling prices is a direct result of increasing raw materials costs, which affected by both limited supply and increasing demand.

In retrospect, key production costs of the paper & corrugated packaging have been on the rise.

For example, minimum wage RM800/month that implemented in 2012 was upped to RM900/month in 2014, and later revised to RM1000/month in 2016.

Similarly, prices of the raw materials of the paper & corrugated packaging have been increasing in tandem with the global and national industrial and e-commerce growth as well as sourcing competition posed by China (prior to the recent importation halt).

These historical cost changes render us a base to examine cost pass-through power of paper & corrugated packaging firms. In this sense, our examination is robust since key production-related costs are considered.

Before doing so, let's us consider the main characteristics of the industry.

Characteristics of the industry

Generally, paper & corrugated packaging is a commodity that is necessary for protecting goods regardless of economic cycles. Their demand has continued to escalate.

The enlarging economic pie is enjoyed by all local paper & corrugated packaging manufacturers.  All of them have consistently demonstrated healthy growth in revenue year after year. Such shared economy is likely related to the fairly concentrated market structure of the industry.

Competition, however, still exists in the industry. Winning formulas of a paper & corrugated packaging company are likely to depend on its value preposition that is better than its local competitors.

This is the case since dumping is unlikely to happen in Malaysia. China's carton manufacturers are already experiencing sold out phenomenon since the import halt of waste materials.

Pass-through elasticity of paper & corrugated packaging companies

From the above, it is clear that competition among local carton manufacturers and value preposition are key determinants of a firm's ability to pass through the increased production costs.

Although two measures are offered in the earlier framework, pass-through elasticity is deemed most relevant since information on production/unit and selling price/unit are not published in annual reports.

A firm can be labeled as possessing:
  • Elastic pass-through power if it exhibits a pass-through elasticity of more than 1 as measured by the expanding gross profit margin;
  • Unit elastic pass-through power if it exhibits a pass-through elasticity of 1 as measured by the constant gross profit margin; or
  • Inelastic pass-through power if it exhibits a pass-through elasticity of less than 1 as measured by the shrinking gross profit margin.  

Based on the estimated gross profit margins below:
  • Master demonstrates fickle gross pass-through elasticities;
  • Muda exhibits inelastic pass-through power. Increased production costs are largely absorbed by Muda;
  • Orna displays somewhat unit elastic pass-through power. The same change rate in production costs is passed through to Orna's customers; and
  • Pphb presents elastic pass-through power. The relevant absolute pass-through rate is greater than the change in production cost, suggesting that Pphb has a strong pass-through power.

Understanding the economics of cost pass-through is essential. While that sounds like a difficult issue, through this letter, we have demonstrated that a firm's ability to pass through the increased production costs can be glimpsed through gross profit margin.

Companies demonstrating constant gross profit margins are able to increase their product or service prices at the same rate of the change in production costs.

Companies showing expanding gross profit margins are able to charge their customers at a greater rate than the change in production costs. This kind of companies is most preferred at ValueVeins.

In our case study, Pphb appears as possessing the strongest cost pass-through power. Although the company did not report gross profit in its quarterly reports, Pphb's latest operating profit margin has again expanded (click here for recap). The expanded profit margins are also attributed to improved efficiency.

Importantly, any evidence of strong pass-through power bags a critical related question:  "how did the firm win over competitors and do that?"

Insights into Pphb are available here. Its strong cost pass-through power validates the quality of Pphb's business model, competitive advantages, and the management's business skills.