Raising Prices Won't Fly

So almost everyone must keep slashing them--and that's hurting profits

While it may not have matched the vintage years of the late '90s, 2002 should have been a good one for California winemakers. With more and more wine drinkers impressed with the quality of California labels, vintners had succeeded in pushing retail prices up by roughly a third in recent years. Instead, prices for many domestic wines are being squeezed by a worldwide grape glut, the soft U.S. economy, and a strong dollar that has allowed rivals from the likes of Chile and Argentina to undercut them. That has forced California producers such as Sutter Home Winery to match the competition by slashing prices on $7.99 bottles to $4.99 since January. "We have put ourselves in a box," says Debra Eagle, senior brand manager for Sutter Home.

Winemakers aren't the only ones in a pricing vise these days. Even as the economy shakes off the recession, many companies face a daunting problem: They have virtually no pricing power. It's impossible to raise prices, and often, the pressure to slash them continues unabated. The pricing pinch is affecting business across the spectrum of manufacturing and services--everything from chemicals and autos to hoteliers and phone service. "We're seeing pricing pressures of a severity that we have never seen before," says John Lonski, chief economist at Moody's Investors Service. "I don't know of too many companies that are factoring price increases into their budget with any certainty."

You'd think that might be cause for celebration--proof that inflation is dead in its tracks. But for all of the U.S. Federal Reserve's success at getting inflation under control, the pricing pressures befalling many companies suggest that the pendulum may have swung too far the other way. While price cuts are a boon for consumers, the lack of pricing power is a key reason corporate profits remain anemic. "I don't think we'll be back to 2000 earnings until 2004 or 2005, largely because of the the pricing environment," says David A. Wyss, chief economist at Standard & Poor's.

That's bad news for the broader economy. Without a surge in corporate profits, companies may defer the heavy capital investment that's so essential for restoring robust growth to the economy. Wyss says that he expects capital spending, which fell 4% in 2001, to dip another 0.2% this year, before rising 10.5% in 2003. Even that will be less than the pace of the late 1990s. Says Wyss: "It'll kick in later than usual and not be as strong as usual."

The pain is most pronounced in manufacturing, where the makers of telecom equipment and autos, as well as commodities such as fertilizer and wood pulp, are battling overcapacity. Total finished-goods prices have fallen 2% over the past year, while prices for core consumer goods have dropped 1%. That's the sharpest decline since the early 1960s--and it's in stark contrast to the last time the economy emerged from a recession, in 1991. Then, consumer-goods prices rose 3.9%.

Even where companies are starting to see a little lift, it's hardly much to write home about. In such industries as airlines and wireless-phone service, companies have been able to eke out moderate price gains in recent weeks and months. But those increases haven't been able to compensate for the sharp price cuts that have accrued over the past few years. While the average domestic airfare, for instance, has risen 2.9% so far in 2002, to about $125, that's still significantly less than the $150 or so the airlines were able to charge as recently as February, 2001.

Although prices in services have have risen more than 3% over the past year, there may be less there than meets the eye. Economists say the gains were confined largely to the red-hot housing market and a few sectors, such as health care and education, that have been historically immune to price competition. Some other industries in unique positions--tobacco and insurance--have also succeeded in pushing through considerable price hikes. But the vast majority of service firms, from restaurant chains to retailers, are having just as much trouble as manufacturers in getting price increases to stick.

That's especially true of advertising, marketing, and other creative services, since many companies have cut such "discretionary" spending heavily. Steve Addis, president of Addis Group, a $6 million branding firm in San Francisco, notes that as clients have pressured him for concessions, he has had to cut his fees by as much as 30% to retain accounts. "It has been across the board," says Addis. "Clients are under tremendous pressure to reduce their costs." While he works hard to maintain quality, Addis has nonetheless had to trim the number of staffers on each project. "If a client wants to pay less, they get fewer people on the project and lower-paid people," he says.

To be sure, it is not uncommon for companies to struggle to raise prices coming out of recessions. But the situation is exacerbated this time around by a stronger-than-usual dollar, which is keeping the pressure on.

Consider CP Kelco, a Wilmington (Del.) maker of chemicals used in everything from drilling fluid to food products such as jelly and mayonnaise. Thanks largely to a sharp rise in Chinese imports, the prices for CP Kelco's xanthan gum fell as much as 25% over the past four years. "The procurement directors at the Krafts and Unilevers of the world have been very good at negotiating," says Senior Vice-President John Falcetta. When CP Kelco announced an 8%-to-12% price hike in January, most customers balked. But about a third of the company's food clients relented after the company convinced them that its product was more reliable. "As we talk to people, our pricing is gaining a stronger foothold," says Falcetta.

Many industries also suffer from years of overinvestment. For all industries, capacity utilization is down to 75.5%, and the rate is much lower in such troubled sectors as aerospace, machinery, semiconductors, and paper products. That's not only well under the 81% average of the past decade but also lower than the 78% level coming out of the 1990-91 recession. Given the slow improvement that many sectors face, Moody's Lonski believes that it could take until early 2004 to break the 80% barrier--the historical threshold, say economists, where manufacturers' price hikes stick.

For now, many producers of goods are just doing their best to weather the pricing drought--often by making cuts that put their suppliers in the same bind. At Ryerson Tull, a Chicago steel processor, executives have responded to the 7% drop in prices since early 2001 by slashing the annual capital-spending budget, from $30 million to just $13.5 million. And back in Napa Valley, Sutter Home has begun looking for cheaper bottles and cardboard packaging.

Then there are those stealth price hikes. Sure, auto makers are dangling rebates of as much as $3,000 in lieu of the earlier 0% financing offers. But since December, General Motors Corp. has been charging up to $600 for safety features such as antilock brakes and side-impact air bags on some models that previously included them as standard features. Even that maneuver hasn't been enough to reverse the ongoing slide in car prices, though. They fell 0.2% in April, after a 0.3% dip in March. "Pricing continues to be negative," says GM Chief Financial Officer John M. Devine. "That's true for almost any product you can name." As long as that remains the case, companies--and the economy--will struggle to regain flight.

By Dean Foust in Atlanta, with Michael Arndt and Robert Berner in Chicago, Amy Barrett in Philadelphia, and bureau reports

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