Many US companies have enjoyed an earnings boost from premium products in recent years. But a strong sales mix may leave a company’s profitability vulnerable in the late stages of an economic cycle, when spending trends begin to weaken.
Buoyant consumer demand has fueled the US economy over the past decade. During good economic times, consumers are more capable of embracing premiumization and tend to trade up from good products to better or best products. Investors often don’t pay much attention to this process, but it can make a big difference to a company’s sales mix, profitability and financial performance.
A stronger sales mix—or a greater share of higher-end and higher-priced products—feels great for companies. It typically boosts sales and profits, with limited incremental investment. So profit margins and return on invested capital (ROIC), a key profitability measure, tend to be higher when the mix is rich.
Mix It Up: Large Coffees Unlock Profitability
Coffee sales are a great example of how premiumization can dramatically affect a company’s bottom line. Go to any coffee chain, and you’ll find that a medium-sized coffee costs a bit more than a small cup. But for the company, there’s little added expense, and probably no incremental capital investment, to deliver it. Selling more medium coffees is a winning strategy.
Adding large coffees to the mix is even better. As the analysis in the illustrative example below shows (Display), a large coffee is more than twice as profitable as a small cup. And shifting just 10% of sales to large cups would push the ROIC to 18.2%. That’s a 20% improvement in profitability from selling only small cups. So when coffee consumers regularly upgrade to larger cups, they trigger a change in the sales mix that’s arguably as powerful to the company’s financial results as pure price increases. These financial dynamics occur across industries.
Investors can’t usually see the sales mix effect. Few companies provide enough detail on how sales are generated to evaluate the mix. For instance, even when Apple reported smartphone unit volumes in the past, it did not disclose sales volumes by phone model. With good (or bad) mix trends potentially lasting for years, both investors and companies may lose perspective on what a normal sales mix is. It’s also difficult to disaggregate productivity gains (which theoretically are structural) from mix improvements (which can have limited life-spans).
Since the Great Recession, the sales mix of many companies has benefited from monetary policy, in our view. Central banks’ low interest rates have driven a consumer-lending boom. This has enabled consumers to buy products and services that they might not be able to afford without financing. As a result, we think excessive monetary liquidity has likely inflated demand volumes across many industries. This possibility implies that if conditions normalize the risk to many companies’ financial performance is greater than many realize.
Will Car Buyers Downshift from CUVs?
For example, look at the automotive sector. Cheap financing has helped US automakers persistently increase the combined share of trucks, crossover utility vehicles (CUVs) and sport utility vehicles (SUVs) (Display, right). Driven by surging CUV demand, the share of cars has never been lower.
It’s easy to understand why automakers prefer to sell larger vehicles. In 2018, US consumers paid more than $32,000 on average for vehicles (Display, left). For large pickup trucks, the average was $44,000—about 75% of the median annual household income. Midsized SUVs sold for an average of about $35,000, while midsized cars and compact cars sold for $23,300 and $19,000, respectively. As a result, some automakers are significantly scaling back their exposure to the lower-margin compact car/sedan segments of the passenger vehicle market. This shift implies returns are better on larger vehicles and that companies believe the current vehicle production mix is sustainable. If it isn’t sustainable, they’ll need to scramble to adjust their product mix and production footprint to produce more lower-return vehicles.
Sales Mix Matters for Earnings and Stock Returns
Companies with higher margins and returns tend to trade at higher price-to-book ratios, all else equal. Clearly, the sales mix has an important impact on financial returns. And conversely, return levels often serve as a proxy for mix, in our view. When stock prices rise to levels that assume good times will continue to roll, the failure to identify a company or industry benefiting from an unusually good sales mix can be risky. If business trends revert toward or even below normalized demand levels, disappointing investment returns may follow. The risk may be greater for companies heavily weighted to high-end product lines since they may not have medium or lower-end products to support a change in consumer preferences. A sustained premium mix also makes an industry more attractive for new entrants.
In today’s market conditions, with slowing macroeconomic growth and earnings, we think investors should pay close attention to the sales mix. Look for companies that are either largely unaffected by a sales mix (such as in the early adoption phase of a key product cycle) or those with a mix that is below normalized levels and credibly able to improve. While not an easy task, focusing on the sales mix can help reduce stock-specific risk and improve investment returns by ensuring that a company is well positioned for a more challenging business environment.
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of all AB portfolio-management teams, and are subject to revision over time.