Slowdowns Breed Commoditization

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It was interesting today to watch the two sides of the CAT story emerge; the “it’s a cyclical low” versus “there is something more sinister here on pricing” stories.   While we are not in a recession, we are in a period of very slow growth and even the more bullish projections for 2013 call for better but still slow growth.   There is a real risk in this environment that the second school of thought could be more on the mark than the first.

Slow growth brings out a side of creativity in the economy which should be there all the time, but is more pronounced when things are slow or declining.  Cost cutting focus and efficiency.   Twenty five years ago, a college contemporary of mine went to interview with one of the big consulting firms; she was a lawyer at the time but wanted to do something different.  They set her a manufacturing problem: you make rubber hoses; they sell for $100 each and it costs you $110 to make them – you can’t raise prices – what do you do.   They have to be made of rubber, they have to be 10 feet long etc. etc.   The answer they wanted was whether the hoses needed to have the current thickness of rubber or not – the answer was no, you could use 30% less material by understanding the required tolerances of the end use.  The product was overdesigned for its required use in its then design.

The last three years have been the perfect environment to encourage consumer, manufacturers, etc. to determine what they really need and how much they really have to pay.   Another example; in 2003 I was in China visiting chemical companies.  One was about to start up its first plant where the key compressor unit (many millions of dollars in value) was made by a Chinese manufacturer.  At the time I got a quote from the company along the lines “if it works, we will use this machine in every plant we build going forward anywhere in the world”.  It may not have been as fancy as the ones made by manufacturers in the West but it was 30% cheaper and it did what was needed.

In this environment, if you cannot grow your way to better margins, you might be able to save your way to some shorter term improvements.

  • Do you need the same product you bought before if there is an alternate at a lower price?
  • Is the product overdesigned, or if you made a cheaper product would you gain more share lower down in the market than you lose at the top?
  • Can you make your product out of something completely different or source from someone with lower costs?

Products commoditize (or lose pricing power) in downturns – that is when consumers experiment and when lower cost suppliers get their chance.

  • What we now think of as commodity plastics, were a higher priced, higher margin specialty until the economic malaise of the 1970s.
  • Semiconductors commoditized after the tech bubble burst (they had been heading that way for a while)
  • Solar panels have commoditized through this downturn
  • In the chemical space we saw the engineering plastics business commoditize from 2000 to 2002
  • Lycra, as generic substitutes arrived, saw operating margin from 35% in 1998 to 10% in 2001.  These products were not as good as Lycra, but the average apparel manufacturer did not need a fabric that would keep its elasticity through 5000 washes and wears – 1000 was plenty – see chart.

Source: Company Reports and SSR Analysis

As the next twelve months evolve companies are going to find that some businesses they thought would regain pricing as demand recovers, do not.   No one is immune in the manufacturing space – there are cheaper capital goods, electrical components, plastics, paints, paint components, plastic components.  There are metal alternatives and construction material alternatives.

This is a very difficult subject to put much quantitative predictive data around.  The history is easy.  However we will tackle the subject in more detail in forthcoming research.  In the meantime we would be cautious about the expensive sectors where margins are high, such as Electrical Equipment, Specialty Chemicals and Coatings.

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