Battlefield advances in the supermarket price war

If you think the supermarket price war has gone about as far as it can go then think again. Over the holiday break I was yarning with Coles chief executive Ian McLeod who says that there are a lot more price reductions to come in the years ahead. In light of that declaration, the enormous impact of the Coles instigated supermarket price war of the last two years may be merely the starting point for further changes in food industry productivity.

The way these price reductions will be engineered is of great importance to shareholders in Woolworths and Wesfarmers.

Ian McLeod will not talk about Woolworths but if McLeod carries out his intended strategy it will put pressure on Woolworths for a strategic response which in turn will put pressure on its EBIT margins.

McLeod was yarning to me after of the launch of the Coles commissioned Deloitte Access Economics research on the effect of Coles supermarkets on the grocery industry and the Australian economy.

According to Deloitte across the whole Coles product range, excluding cigarettes, prices have fallen 7.9 per cent since 2011 – a benefit to consumers of some $1.1 billion. This represents the majority of the total $1.5 billion benefit to consumers of food and beverages calculated via CPI figures.

These are remarkable Deloitte figures.

The supermarket war has therefore played a key role in reducing Australian inflation.

To understand what is ahead and its effect on each of the players, led by Woolworths and Coles, we need to go back into history. The graph below shows that for the last 30 years food has been a cost-plus business. Suppliers, transport companies and other groups would do sweetheart deals with the unions and suppliers knowing they would simply be passed on ultimately into food prices. So food prices rose every year and were an imbedded part of inflation. Suddenly, as the graph shows, that has stopped and food prices are falling which has transformed the Australian inflation outlook.



But the actual price reductions were started by Woolworths when Roger Corbett was the chief executive. He brought to Australia a series of productivity initiatives started by Wal-Mart and he adapted them to Woolworths in Australia, creating what he called ‘virtuous circles'.

Some of the gains went into prices and others went to shareholders or were invested in the Woolworths business. At that time Coles and other Woolworths rivals simply could not match the Corbett/Woolworths productivity improvements. They found it harder and harder to match Woolworths' prices and as a result lost market share.

But after Corbett, Woolworths management tended to use the productivity gains to fund new stores, upgrade existing stores and/or provide shareholders benefits.

Clearly some benefits went into prices but there was a change in emphasis and the Woolworths EBIT margin advanced into the seven to eight per cent region.

When Wesfarmers acquired Coles in November 2007 the general view in both Woolworths and the industry was that Coles was so badly damaged that it could never make major inroads on Woolworths. At Woolworths there seemed no need to deliver a knockout blow.

Had Woolworths responded by substantial price cutting and reduced its spending in other areas it's unlikely that Coles could have come back.

Woolworths thought a better strategy was to start a hardware chain against the Wesfarmers-owned Bunnings to basically deprive Wesfarmers of oxygen and of having any hope of tackling Woolworths via Coles.

History now tells us that when Wesfarmers appointed Ian McLeod as chief executive of Coles in May 2008 Wesfarmers was changing the Australian food industry. McLeod had been chief executive of UK car parts retailer Halfords but in 2000 and 2001 he was on the executive board of Wal-Mart Germany as chief merchandise officer. Coles at last had access to the Wal-Mart thinking that had transformed Woolworths via Corbett.

McLeod began an accelerated program to improve Coles' productivity. That included better handling of stock and a totally new relationship with suppliers. There would be a greater emphasis on Australian made goods and investment was made in suppliers who were prepared to join with the group. Whereas most of Coles fresh food was bought in the markets, 90 per cent is now bought direct from farms. Woolworths started the farm process but hasn't gone as far as Coles. Both Woolworths and Coles have taken a much tougher attitude to suppliers and the cost of sweetheart deals with unions which were the past norm simply had to been born by the supplier. As a result there has been a very big improvement in the productivity of the food supply sector. Food suppliers say the supermarkets have gone too far and are now at breaking point. The retailers disagree and this is an unresolved question.

But Coles EBIT margin is only four to five per cent – well below Woolworths. The main reason for this is that Coles has still not caught up to the productivity advances of Woolworths. In the theoretical event that prices remained at the current level Coles would look to increase its EBIT margin to be very close to Woolworths once it catches up on productivity improvement.

But McLeod says that is not the plan. Coles believes the threat of Aldi and Costco means that to maintain or increase market share it must pass on, in lower prices, a substantial portion of the productivity increases that it is about to achieve.

It's not easy for consumers to compare prices in supermarkets. And both Coles and Woolworths say they are the cheapest. The Deloitte figures indicate that the Coles reductions have been greater than Woolworths but Woolworths would have been lower when the war started. But if Coles reduces prices even further – as McLeod says he will do – then without a Woolworths response Coles would clearly become the lower priced provider. Accordingly Woolworths will be under great pressure to match.

Woolworths will of course find other productivity improvement opportunities although there are no more "very big steps” on the global horizon. Coles expects to increase its EBIT margin but to nowhere near the level of Woolworths. There is therefore a clear likelihood that Woolworths will have to reduce its EBIT margin closer to the Coles level as the two groups come together on productivity. The Coles expansion program has been devoted to closing small stores and opening larger ones. So its store numbers have not increased although the size of stores has lifted.

Despite the price war Coles has maintained market share which it says is a good achievement because until the last three years its share had been falling and that maintenance of market share at 31 per cent comes in the face of gains by Aldi and Costco. The improvement in productivity in food in Australia has been one of the major factors that have kept inflation in Australia low and enabled the interest rate reductions.