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More Muscle for Lifting Prices

By Matthew Morrow In the minutes of the Federal Reserve's last meeting, which were released May 25, Fed members mentioned that some companies are seeing pricing power. The Fed indicated that this is one of many reasons to continue to raise interest rates at a measured pace this year.

Naturally, investors must wonder exactly which companies or industries have pricing power. Analysts at Standard & Poor's have found many outfits in the materials and industrials sector have successfully put through price increases in the past few months.

CHEMICAL REACTIONS. "The economic recovery of the past three plus years has greatly boosted demand for a large variety of products, including commodities and industrial products," says Michael Jaffe, group head of the industrials and materials sectors for S&P's equity research unit. "With industrials and materials companies also doing a good job, in our view, of keeping capacity at reasonable levels, it has brought a large upturn in prices in many areas of these sectors." Transportation companies also have been raising prices by significant amounts, Jaffe says, thanks to the overall purchase of goods and the resulting increase in shipping activity.

In particular, the chemicals industry is showing pricing power. In April, chemical prices were 11.6% higher than those of a year ago, says Richard O'Reilly, S&P's chemicals industry analyst. He notes that there are a number of key product lines operating at more than 90% of capacity, allowing those producers to hike prices. These lines include ethylene, polyethylene, chlor-alkalies, and soda ash, according to O'Reilly.

Soda ash, which is used to make certain kinds of glass, among other things, has been a very strong product for FMC Corp. (FMC

; ranked 5 STARS, or strong buy; recent price: $55) of late. O'Reilly notes that 40% of soda ash is traditionally exported, with that percentage gaining yearly. He adds that FMC announced total increases of $45 a ton for soda ash since last May, considered a substantial increase for a business that has typically experienced price increases of a few dollars here or there. FMC has seen an increase in demand for soda ash due to growing exports, while there have been plant shutdowns in the past several years affecting capacity.

BRIGHTER ALUMINUM. S&P analyst Leo Larkin is generally positive on steel, aluminum, gold, and diversified metals companies. Assuming 3.3% gross domestic product (GDP) growth in the U.S. in 2005, Larkin believes industry conditions for steel will not be as robust as in 2004, and spot steel prices will drop from what he views as unusually high levels last year.

Still, Larkin believes that the steel industry will benefit from greater pricing power resulting from recent consolidation, a lower cost structure, and a cyclical decline he foresees for the U.S. dollar. Among the companies he follows, Larkin has a strong buy recommendation on steelmaker Allegheny Technologies (ATI

; $21).

Larkin believes the aluminum industry still suffers from excess capacity, but thinks consolidation will mitigate the structural glut. He notes that following the acquisition of Pechiney by Alcan (AL

; ranked 4 STARS, or buy; $30) in February, 2004, three companies account for slightly more than 50% of primary global aluminum output.

FLOW-ON IMPACT. As for gold, Larkin believes that an apparent bear-market rally in the U.S. dollar has temporarily limited the appeal of gold stocks. However, he thinks that the long-term bullish fundamentals for gold remain intact and that the group will likely outperform the S&P 1500 index when the dollar likely resumes its cyclical decline.

S&P analyst John Hingher, who follows well-known industrials such as Ingersoll-Rand (IR

; ranked 5 STARS; $78) and Rockwell Automation (ROK

; ranked 3 STARS, or hold; $51), believes that the magnitude of raw material price increases has made it easier for companies to implement price increases and have them stick. "The rise in commodity costs has been so pronounced and well publicized that most customers readily accepted higher prices for finished goods," explains Hingher.

Given the lag in fully implementing price increases (due to fixed price contracts and high inventory levels at some customers who buy ahead of their needs), Hingher sees price increases continuing for at least the first half of this year. "Most companies noted on their quarterly calls that this is the case and that, assuming relatively benign commodity cost pressures from here, they should have fully recovered the cost/price gap in the back half of 2005," he says.

PACKAGE PRICING. Air freight companies have similarly experienced pricing power this year, as have the airlines. "In general, pricing power for the logistics and air freight companies I cover has been very strong," says S&P analyst Jim Corridore.

United Parcel Service (UPS

; 3 STARS; $75) and FedEx (FDX

; 5 STARS; $88) dominate the package shipping business and have been instituting annual hikes for years, he says. Since customers perceive that they have no other alternative, they pay the higher rates, Corridore explains.

The airline industry seems to be experiencing a bit of a resurgence in pricing power, Corridore says. Average airfares had been declining every year since 2000. In the past two months, however, major airlines -- including Delta (DAL

; 2 STARS, or sell; $3), Northwest (NWAC

; 3 STARS; $5), Continental (CAL

; 5 STARS; $12), and American, which is owned by AMR Corp. (AMR

; 3 STARS; $12) -- have raised airfares about seven times. In many markets, according to Corridore, leisure travelers are paying as much as $70 more for a one-way domestic ticket than was the case a couple of months ago.

FLYING IN FORMATION. Corridore believes there are three reasons why airlines have successfully increased fares. First is less competition on pricing from the discount airlines, he says. It appears some of the discount carriers have been slightly less aggressive with their promotions and have also put through small fare increases, due to the high cost of oil, he says.

Second, customer traffic has returned. Corridore estimates that passenger air traffic this year may surpass levels set in 2000. And perhaps the most important reason why the recent fare increases have been successful is that all the airlines are instituting them. In the past, one carrier would try to put through an increase, but the others wouldn't match it.

In terms of sector recommendations, S&P currently has a market weighting for industrials, which make up about 12% of the S&P 1500. S&P advises an underweight allocation to materials, which make up about 3% of the index. Morrow is a reporter for Standard & Poor's MarketScope

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