Tech Firms Doing the Pivot
First, let’s look at two companies that have proactively managed expenses: Microsoft and Amazon. Microsoft’s expansion of its cloud business over the past few years was accompanied by high expense growth. As revenue growth slowed in fiscal 2023, expenses didn’t come down as quickly, and the company experienced a couple of quarters of margin compression. But Microsoft pivoted by prioritizing its spending and putting a lid on expenses—just as revenue growth began to accelerate again. This combination drove operating margins higher over the last couple of quarters.
Amazon has experienced lower margins in both its core retail business and Amazon Web Services unit as capacity expansions ran into slowing revenue growth. Like Microsoft, Amazon eventually clamped down on spending, which helped it expand its operating margins from 2% to 7.8% in the third quarter.
This isn’t to say that cost cutting is easy or that all forms of spending are misguided. Companies must spend and invest to foster growth, but there occasionally needs to be some garden-weeding. Active equity investors must determine which companies do this most effectively.
New Labor Contracts Could Drive Wage Growth
Striking the right balance between expenses and growth is already challenging in an inflationary environment and tight labor market. It will now be further complicated by the resolution of high-profile labor contracts across a number of industries.
In August, delivery giant UPS ratified a five-year contract that boosted the pay of 340,000 full- and part-time Teamsters just days after American Airlines approved a four-year deal with the Allied Pilots Union that bumped pay and benefits by nearly $10 billion. Since then, pilots have secured wage concessions from United Airlines that would increase pay by up to 40%, while Southwest Airlines flight attendants are close to locking down a generous deal of their own.
And now, with the United Auto Workers union extracting significantly improved contracts from the three major US automakers, investors are left to wonder what the financial impact on these companies could be—and how far the aftershocks will spread.
The case of Ford Motor Company is illustrative. The firm estimates that its new contract with autoworkers could add $850–$900 to the cost of each new vehicle. With an average price of around $48,000 per vehicle, this increase represents just under 2% of the vehicle cost, on average. In our view, this means automakers could be in the uncomfortable position of having to raise prices just as consumers are pressured by the high cost of auto loans. Other options include seeking efficiencies elsewhere or simply absorbing a hit to profit margins.
Pricing Power Is Key
Each firm will respond differently, but one of the big takeaways is that the strong pricing power companies enjoyed in 2021 and 2022 has become more challenging in 2023—and could worsen in 2024. This is because supply chains have normalized, consumers are becoming more discerning with their spending, and interest rates remain elevated. If economic growth levels off, companies could see margins and earnings pressured further.
The bottom line: as firms experience differing labor cost, pricing power and growth outlooks, investors will need to be increasingly selective in their hunt for companies that can produce desired levels of earnings growth.
Firms with unique business propositions, recurring revenue streams and dominant market positions are among the best positioned to raise prices. Companies that sell products with defensible, competitive moats and have a clear innovative edge will also be more capable of maintaining pricing power. Finding them requires active management based on disciplined, fundamental research that drills deep into a company’s business model and industry dynamics, with an eye toward the broader macro forces at play.
Pricing power and expense management have always been important. But if recent labor agreements are any indication, they’ll be more critical than ever for US equity investors seeking to capture consistent growth and return potential.
