Talking to Management, Part 4: Prices and Products

This column was originally published on RealMoney on April 19, 2007 at 9:52 a.m. ET. It's being republished as a bonus for TheStreet.com University readers. For more information about subscribing to RealMoney, please click here.

Editor's note: We're pleased to present David Merkel's five-part series on questions to ask the management of a public company. Each part covers a new set of issues and the reasons to raise them. In Part 1, Merkel explained the philosophy behind his approach and presented the big subjects he likes to get out of the way first. Part 2 addressed top financial concerns. Part 3 covered what you need to find out about the competition. Now, in Part 4, questions on pricing and products.

Pricing and Products

Do you think you can pass through price increases in the next year?

Questions like this can highlight management's competitive strategy and how much excess of demand over supply exists in the current environment. Answers that involve no price increases or price decreases should also explain the reason for that, e.g., technological change.

For example, if you asked this question of a disk-drive manufacturer, he'd probably blink and ask of you, "Where have you been? This business has been so cutthroat competitive that we have been forced to innovate in order to create drives that store more, retrieve faster and at lower cost for more than 20 years! We'll never get price increases! This business is like Alice and the Red Queen. We have to run as hard as we can just to stay in the same place. Our only hope is volume growth, and thankfully, we have gotten that."

Answers that boil down to "demand is eroding" or "competitors are irrational" should contain some idea of what management is doing to combat the problem. Sometimes giving up market share to an irrational competitor can be the brightest move; market share can only be rented, never owned.

I can give examples from many cyclical businesses. All mature businesses are inherently cyclical, and stock price performance follows the pricing cycle. At RealMoney, I have already written about this dynamic in insurance, steel and cement. To give one more example, consider the airlines. As so many of them slipped into bankruptcy early in the 2000s, most of the bankrupt carriers were forced to shed capacity. As they shed capacity, pricing got incrementally better and then a whole lot better, leading to the outperformance of airline shares.

What are your plans for dealing with emerging substitute products?

Sometimes a market comes under threat from a new competitor with a new business model. Usually threats like this begin with simple products with relatively low returns on equity.

For example, when the steel minimills came into existence, they provided only the lowest-quality steel products. Over time they expanded their products to capture more of the value chain in the steel business, and this placed increasing pressure on the integrated steel companies, many of which crumbled under competition from the minimills.

Had the competitive threat been met early, the integrated companies could have minimized the threat by adopting the tactics of the minimills.