Feeling the Pain
Implications of Increasing Commodity Prices
by Michael Collins

At a time when gasoline prices persist in rising above four dollars per gallon, it is easy to think of this country as existing in a permanent environment of inflation in the prices of commodities. However, a recent analysis by investment manager Jeremy Grantham revealed that, over the past century, prices of key commodities have drifted slightly downward when measured on an inflation-adjusted real dollar basis. (Grantham’s analysis appeared in an article called “Time to Wake Up” from the GMO Quarterly Letter’s April 2011 issue.)

Consider the Research
An equal weighted index of the prices of 33 key commodities was used to measure the average inflation in commodity prices over the 100-year period from 1900 to 2000. Commodities of relevance to the door and window industry included aluminum, silver and iron ore, as well as energy sources such as coal, oil and natural gas. There wasn’t a pure lumber price included, but the inclusion of plywood added a wood products element to the index. It was determined that the average price of these 33 strategic commodities declined by roughly 1.2 percent annually during the period studied. As a group the prices decreased over time. Much of this price decline was driven by improvements in production machinery, minerals extraction and other technologies.

"The game very likely has changed permanently, meaning that climbing commodity prices will be a permanent part of the landscape going forward."

Starting in 2000, an interesting shift in commodity prices occurred. The enormous increase in consumption among emerging economies, particularly China and India, has led to a commodities price surge. In just ten years, this accelerated consumption has wiped out 100 years of general price declines. Normally, we might take comfort in the fact that deviations from long-term averages tend to correct themselves by returning to that long-term average. However, that principle only applies if the conditions being measured remain fundamentally unchanged. In this case, the last ten years have seen roughly 2.5 billion people living in China and India undertaking an unprecedented push to achieve middle-class living standards. The game very likely has changed permanently, meaning that climbing commodity prices will be a permanent part of the landscape.

Turning a Profit
The question becomes determining how door and window manufacturers should respond in order to maintain profitability. In every segment of the industry, there are companies that are able to pass along price increases more quickly than others. Often, they also benefit from allowing their prices to drift downward more slowly if the price of the underlying commodity decreases. Other companies are only willing to follow the leader with price increases and they typically must lower their prices more quickly than the leader if the prices of materials subside again.

There are a number of ingredients that are required in order to become a price leader and be largely insulated from commodity price increases. Among these is an emphasis on the perception of your brand among customers. Strong brands are best supported by extremely high product quality. Another key element is an unwavering level of extremely high customer service. When a dealer has a customer in their location and they have a question, they want a live, knowledgeable person to pick up the line when they call the manufacturer. Simply having a very broad product offering also can aid in price leadership. If customers are aware that they would need to seek out two or three additional vendors if they were to leave a manufacturer, it increases switching costs and, therefore, customer longevity.

Another way to achieve price leadership is to be able to offer high customization with a short lead time. If your customer has engineered its business to rely on such swift delivery, it is unlikely to take a chance on a new supplier.

If it is true that we are headed into a future where prices rise more quickly and persistently, it is incumbent on manufacturers to use these and other methods to increase the value they add to customers and enhance their abilities to be price leaders.

Michael Collins is a Chicago-based investment banker with a specialized merger and acquisition practice in the door and window industry.

DWM
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