Pricing Power a Key Concern for Smaller U.S. Companies

The difficulty of passing rising costs on to customers is a primary concern for the leaders of smaller U.S. companies, according to the latest Merrill Lynch Smaller Firms Survey(SM) (MLSFS), conducted by Satya Pradhuman, chief small cap strategist, Merrill Lynch Global Securities Research & Economics Group. This finding suggests inflation worries in the economy as a whole may be exaggerated.

Roughly 21% of respondents identify pricing pressures as a major issue for their businesses over the next 12 months, which is nearly double the reading for the first quarter of 2005. The survey also found that labor costs, rather than commodities, pose the greatest threat to margins in 2006. Increasing market share remains a key aim for respondents, either by growing organically or through M&A. Around 40% of these leaders believe credit terms are improving.

Launched in March 2005, the MLSFS focuses on micro and small cap public companies. The only survey of its kind, it is based on the responses of CEOs, CFOs or COOs at 168 companies. These companies are often under-followed and poorly understood. As a whole, smaller cap public companies employ about 10 million people and boast combined revenues of almost $2 trillion, which represents about 17% of US GDP.

Pricing Pressures Mount
A remarkable 40% of respondents cite pricing as their primary tool for addressing competition in 2006, up from 35% in the first quarter of last year. Financial and Technology companies appear especially sensitive to pricing concerns. This data, combined with the finding that around 36% of the sample describes competitive pressures as fierce, suggests that inflationary fears in the wider economy may be overblown.

Labor, Not Commodities, Pose Greatest Risk to Margins
Labor-related costs are shaping up to be a greater risk to operating margins than commodity prices. More than 29% of respondents cite labor as a major threat to operating margins over the next 12 months, a 7% increase compared to the first quarter of 2005. Commodity prices remain a concern, but the number of managers flagging it as a major worry is only slightly up on the first quarter of 2005.

Business Services is the sector most threatened by Labor costs, with 55% of these managers naming labor costs as their number one concern. In addition to rising wage bills, survey participants fret over rises in benefit and health insurance costs.

Higher Market Share is Key
A focus on growth by expanding into existing markets is a consistent theme in this month’s survey. A total of 59% of the panel say higher market share is their primary goal, up from 50% who put it at number one in the first quarter of last year.

A majority of survey participants expect to achieve this growth organically. However, a solid 38% claim that M&A will be the biggest driver of their financing needs in 2006, with the Capital Goods and Financial sectors the most likely candidates for M&A activity.

Credit Terms Improve for Most
Roughly 40% of firms polled feel that credit terms have improved, despite a year-and-a-half of rising interest rates. Only 7% of firms cite funding availability as a primary challenge for growth in the next 12 months. However, a small but rising number of companies report deteriorating access to credit.

Regional Breakdown Echoes National Findings
Findings from the MLSFS at the regional level are generally consistent with the findings at the aggregate level. In the Midwest and Southeast, the two actions most often cited to meet challenges are pricing and economies of scale. In these regions, an additional 15% of respondents highlight pricing, and an additional 13% seek greater economies of scale.

The focus on organic growth is strongest in the West, where 87% of the panel says it is a key initiative. Regions with the least interest in organic growth are the Midwest (66%) and the Southeast (50%). Plans to grow organically in the Midwest are becoming slightly less of a priority, as companies in the region become more interested in growing through M&A.

Overall, interest in the use of M&A appears to have moderated. The exceptions are the Southeast (34%) and the Midwest (24%), with both reporting an increase.

Financing terms continue to be healthy across regions, with around 88% of Southeastern respondents characterizing access to credit as improving or unchanged. At the same time, there appears to be some deterioration in access to capital, especially in the South, where 23% of respondents report lower access to capital, up from 5% in the first survey.

Merrill Lynch Smaller Firms Survey (MLSFS) was conducted among 168 micro and small cap firms across the U.S. in November and December 2005. “Merrill Lynch Smaller Firms Survey” and “MLSFS” are service marks of Merrill Lynch & Co., Inc.