Due Diligence: Mind your p’s and q’s (prices and quantities)

We’ve all heard the idiom “mind your p’s and q’s.”

One theory among many is that p’s and q’s references pubs in England where the bartender tallied all the pints and quarts sold – and, if he liked you, your quarts became pints on the bill.

But in the business world, p’s and q’s speaks to how we drive revenue: price and quantity.

Revenue growth for any company is comprised of growth in the price charged and growth in the number of things sold.

For example, a company with 10% growth could sell 10% more things, charge 10% more per thing, sell 4% more things at a 6% higher price, or even 14% more things at a 4% lower price.

Investors focus a lot on the composition of price versus units because changes in price have a disproportionate impact to margins, and volume increases along with price increases indicate strength in the underlying demand.

Price is 100% margin; quantity is gross margin

Investors cheer price increases and are worried by price declines because price flows through a business at a 100% margin. It is a dollar-for-dollar impact to gross profit, EBITDA, EBIT and PBT.

Quantity usually flows through at the gross margin, given that units usually have at least variable costs associated with them.

Picture two fictitious companies that are the same in 2017: $500 revenue, $300 profit and a 40% margin. Both grow revenue at 20% per year for the next two years.

PricesRUs raises prices by 20% but sells the same number of units, while Sell&Moore sells 20% more. In two years, Sell&Moore still has a 40% margin, while PricesRUs has expanded its margin to 58%, making 46% higher margin percentage on the same sales and more than twice the dollar profit.

2017 2018 2019
PricesRUs
Units 100 100 100
Price/Unit  $      5.00  $      6.00  $      7.20
Total Sales  $       500  $       600  $       720
Cost / Unit  $      3.00  $      3.00  $      3.00
Cost  $       300  $       300  $       300
Profit  $       200  $       300  $       420
Margin 40% 50% 58%
Incremental Margin 100% 100%
Sell&Moore
Units 100 120 144
Price/Unit  $      5.00  $      5.00  $      5.00
Total Sales  $       500  $       600  $       720
Cost / Unit  $      3.00  $      3.00  $      3.00
Cost  $       300  $       360  $       432
Profit  $       200  $       240  $       288
Margin 40% 40% 40%
Incremental Margin 40% 40%

This is pricing power, and investors will pay higher multiples for it because it shows that customers demand the product and that margins are protected by this desire to purchase.

Elasticity and fixed costs

Price versus quantity is also a good indicator of demand.

Elasticity is the tendency for people to buy more units as the price drops and buy fewer units as the price rises. Because lower prices usually result in greater units sold, a company meeting or beating revenue expectations on higher-than-expected volumes and larger-than-expected price declines can be a red flag.

Incremental volume from price elasticity leading to a larger market can be positive. But cutting prices trains the customer to delay purchases for deals and risks a price-cut response from competitors, especially if this extra volume was a gain of market share.

Price wars are a race to the bottom for the entire sector’s margins and multiples.

What usually happens is costs rise, and this cost pressure must be offset by increased prices just to keep margins flat. At the same time, price can be pressured by competitors lowering prices. This combination quickly erodes margins, and investors are always on the lookout to sell or short such situations.

Another fictitious company, Rockin Hard Place, with the same revenue and the fastest unit growth, faces 5% price pressure and 5% higher costs/unit each year. In two years, the company’s units are up 60%, but the margin has compressed from 40% to 27%. Rockin Hard Place is losing money on incremental sales in 2019 and would have been better off selling fewer units at a higher price.

This is the situation investors fear, because such margin pressure quickly turns to losses and proves the business model is not viable longer term.

Rockin Hard Place 2017 2018 2019
Units           100           126           160
Price/Unit  $      5.00  $      4.75  $      4.51
Total Sales  $       500  $       600  $       720
Cost / Unit  $      3.00  $      3.15  $      3.31
Cost  $       300  $       398  $       528
Profit  $       200  $       202  $       192
Margin 40% 34% 27%
Incremental Margin 2% -8%

Communication is the key

The only time when investors cheer lower prices and higher volumes is when a company is explicitly deploying a lowest-cost-provider strategy – in which volume increases to lower unit costs via leverage of fixed costs – to pass the savings on to the customer in the form of lower prices.

This is an excellent strategy as long as the company is indeed a low-cost producer; not all companies will be.

All other companies that are not the low-cost producer will need to find pricing power via stronger branding or better products – or eventually go out of business in the face of constant margin pressure.

Cannabis has generally been a market with explosive unit growth offset by declining prices because of increased supply and declining costs.

When businesses deal with investors, it’s important to communicate the strategy of lower prices ahead of time and articulate why your company will be the low-cost producer or will have pricing power to maintain margins. If neither strategy can be articulated, investors will question the longevity of the business.

As we at Investor Intelligence build out coverage of the cannabis space, we will focus on the business models, potential margin and pricing strategies of the firms involved to help you find a PricesRUs and avoid a Rockin Hard Place.

Mike Regan can be reached at miker@mjbizdaily.com