One of the biggest weapons I think a company can have is pricing power.
As Warren Buffett puts it; “the single most important decision in evaluating a business is pricing power”. This is because a company that can raise prices without losing customers can grow at increasing returns and rapidly compound earnings.
Unleashing the weapon
Cloud accounting platform Xero Limited (ASX: XRO) has been building up its pricing power for years by adding new features and linking small businesses to their key customers, bank partners and accountants while at the same time rapidly growing subscribers.
As the platform adds more features Xero can become deeply ingrained into a customer’s operations and over time the risks involved in switching to an alternative product become prohibitive.
Analysts sometimes refer to this as ‘sticky’ revenue. What it means for companies like Xero, as well as others like Altium Limited (ASX: ALU), SEEK Limited (ASX: SEK) or REA Group Limited (ASX: REA), is that pricing can be increased to recoup investment and preserve margins with less risk of customers moving elsewhere.
Of course Xero has successfully adjusted pricing before back in 2015 and 2016. Since then subscribers have continued to grow strongly, while the churn rate of revenue between 2016 and 2017 actually decreased from 1.2% in 2016 to 1.15% in 2017.
And now Xero is about to unleash that weapon again. With 884,000 subscribers across Australia and NZ (at 31 March 2018) Xero has announced tweaks to pricing across it’s Premium plans from the end of September 2018. The increases will help to grow revenue and pay back some of the almost NZ$250 million that Xero has spent on research and development since 2016.
What does this mean for investors?
Any increase in pricing naturally brings a higher risk of churn or slow-down in new subscribers. However given the increasing value Xero adds for its customers and that the increases are in the more mature NZ and Australia markets, I think it is unlikely we will see a material change in subscriber numbers.
For investors I expect this means the increase in revenue will more than offset any increase in churn, giving Xero more ammunition to re-invest and keep growing for years to come.
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You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia owns shares of Altium and Xero. The Motley Fool Australia has recommended REA Group Limited and SEEK Limited. 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. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.