Counting the cost as the dust settles in supermarket wars

After two years of heavy discounting of milk, the tide seems to be turning against private brands, writes Colin Kruger.

The photo ops don't get much friendlier than the cow sheds at Sydney's Royal Easter Show, and Woolworths was playing it for all it was worth this week, when it announced plans to buy direct from a group of NSW dairy farmers in order to give them a "better deal for their milk".

For the first time, milk processors such as Parmalat will not be the intermediary between supermarkets and dairy farmers when it comes to fresh milk supply, with the implicit promise that it will benefit the industry.

Never mind that Woolworths, Australia's largest supermarket operator, sells the $1-a-litre milk many have said imperils Australia's dairy folk.

Woolworths, which has portrayed itself as a reluctant participant in this particular battle with its arch-rival Coles, appears to concede it is part of the problem.

"There is no doubt there are a variety of significant issues affecting different parts of Australia's dairy industry," Woolworths fresh food chief Pat McEntee says. "No one factor - whether it be the impact of $1 milk, or a tough export market exacerbated by a high Australian dollar - is solely responsible for the state of the industry."

The announcement is being interpreted as an attempt to finally put some daylight between Woolworths and Coles over the price wars its smaller rival ignited more than two years ago.

It is no surprise Woolworths has attempted to break ranks with Coles. While its image has received an equal tarnishing from concerns over what the cheap milk is doing to Australian dairy farmers, cheap milk has not been as beneficial for Woolies as it has been for Coles.

At the peak of the price wars in 2011, more than 72 per cent of the milk sold in Coles supermarkets was its $1-a-litre private label offering.

Coles increased its private label sales by 64 million litres in the two years following its price cuts, which means it captured most of the growth in white milk sales.

Data from industry sales tracker Aztec shows sales of fresh milk across all supermarkets, corner shops and convenience stores only grew by 100 million litres over that same period.

Woolworths still holds a sizeable lead for overall milk sales, selling 498 million litres last year compared to Coles 424 million litres. These figures include sales of milk brands such as the Lion-owned Pura, Dairy Farmers and Parmalat's brand, Pauls.

But despite matching the Coles price cuts, Woolworths - the market leader - paid the price of being the follower, adding just 10 million litres of private label sales over the period.

This means Woolworths did not get the volume increase needed to offset the price cuts to its private label milk - but it is not alone in that regard.

Aztec data shows that in 2011, the first year of the price war, Coles' overall milk sales - including sales of milk brands such as Pauls and Pura - were up 11 per cent by volume but down 2 per cent by value.

Woolworths' overall volumes increased 3.7 per cent and its value of sales declined 3 per cent.

Despite volume share peaking at more than 72 per cent, Coles' private label share of the milk sales dollar peaked at just above 56 per cent in late 2011 and fell to 50.7 per cent in the three months to February 17 this year - almost where it was before the milk wars began, although its volumes would have been much higher.

Woolworths private label share by value of sales barely increased from the 50.3 per cent it had before the price war and the paltry volume gains meant it fell to 44.6 per cent late last year as brands such as Dairy Farmers, Pauls and Pura regained market share and super brands such as A2 powered ahead.

Regaining lost ground at Coles has been a lot harder, with the Wesfarmers-owned supermarket operator holding the volume gains made by its private label offering.

The fresh milk retail sector as a whole has not fully recovered, revenue-wise, from the price war either.

"The price drop inevitably had a downward effect on value sales," Nielsen's retail head Kosta Conomos says. "It has taken two years for the milk category to almost get back to similar value sales seen in 2010."

The volume gains came from somewhere, and not much of it was people buying more fresh white milk. As a product, fresh milk is relatively inelastic: people don't buy more just because it is cheap, and sales growth tends to reflect population growth.

For the most part, consumers have changed channels, buying more of their milk from the major supermarkets and less from independent supermarkets, convenience stores and the corner shop.

Aside from the sledgehammer impact of Coles wanting to embed its message of low-priced groceries, this was the intended effect.

Conomos says Nielsen data showed Coles, as the catalyst for the $1 milk price point, "captured significant incremental share within the category as shoppers intentionally moved away from non-major supermarket chains when purchasing milk".

By deeply discounting perishable items such as milk, which people need to shop for more regularly, Coles and Woolies have attracted a pool of shoppers that would normally have gone to convenience stores and ensured they spend more time at the supermarkets.

While the major supermarkets do benefit from cheap milk, the same cannot be said for Australia's milk processors, which have their own brands to protect, yet have cut their own throats providing low-margin private-label milk for Coles and Woolworths.

On the day Woolworths announced its farmer-direct initiative, New Zealand dairy co-op Fonterra announced plans to slash its consumer brands and jobs in Australia to restore profitability as competition intensifies for milk supply and retail sales.

Fonterra says earnings from its Australian consumer brands fell 31 per cent for the first half of its financial year.

"There's a new reality in Australia," says chief executive Theo Spierings, with Fonterra facing "aggressive competition" in milk supply and a retail price war in Australia.

It has no option other than to strip out costs.

"That's why we have to rationalise brands, rationalise our organisation," he says.

Fonterra has 21 brands in Australia, which has room for a maximum four or five, he says.

The woes of Australia's milk processor Lion have been well documented.

Lion's total white milk volume across branded and private label was down 14.5 per cent for the year to September last year.

Before his departure, Lion's then chief Rob Murray said the milk portion of its dairy business was in a terrible state and not too dissimilar to the profitability profile of a charity, thanks to Coles and Woolworths and private label milk.

"We don't make any money [on milk]," Murray said. "The simple truth of that is nobody is making money and you can't make money if [consumers] buy milk at $1 a litre."

The problem for Lion was not just the loss of sales from its higher margin brands such as Pura and Dairy Farmers to the cheap private label products it sold to Coles and Woolworths. It was also hit by the migration of milk sales from other channels, where margins are higher, to the major supermarkets.

But Woolworths' latest manoeuvre may also reflect the fact the tide has started to turn on cheap private label milk.

Woolworths' private label milk sales went from 307 million litres for the 2010 calendar year to 324.6 million in 2011 and declined to 316 million last year.

Milk brands such as Pauls and Dairy Farmers have started to claw back market share with their permeate-free milk at both major supermarkets, according to the industry body for dairy farmers, Dairy Australia.

"Aztec supermarket scan data to December shows branded milk has recovered supermarket sales share, to close to pre $1-per-litre milk campaign levels," Dairy Australia says in a recent market update.

"This has coincided with the introduction of branded permeate-free product lines and increased promotional activity."

But a clearer picture of where things are headed might be provided by market darling A2, which has doubled the value of its sales over the past two years to 6.9 per cent of the grocery sector.

At the opening of A2's NSW plant last year, Michael Perich, who runs the dairy at one of its main suppliers in Australia, the Leppington Pastoral Company, says the milk discounting wars may have had an unexpected effect in focusing public attention on those brands offering a point of difference.

He says this is why A2 is thriving - "the price wars have actually helped that because consumers have seen the point of difference".

Dairy Australia names provenance as another issue, which appears to be reflected in this week's initiative by Woolworths.

"Interest in greater provenance is also likely to have some bearing on new supply and marketing arrangements for fresh drinking milk," the industry body says in its report.

Coles says it is ahead of the game on this front as well. It already partners directly with farmer-owned groups across Australia with offerings such as the Great Ocean Road brand of milk and cheese by Warrnambool Cheese & Butter. In NSW, it works closely with Bega Cheese and Norco; in Western Australia, it has Harvey Fresh, and it has Tamar Valley Dairy in Tasmania.

"Coles is continuing to look at opportunities to grow our milk, cheese and yoghurt business direct with farmer-owned groups," the supermarket says.

This may not be of much help for Parmalat and Lion, which are still struggling with increased costs from going permeate-free, higher spending on marketing to get on the front foot with consumers, and lower sales of fresh milk.

Permeate - a watery, greenish waste product from the production of cheese - was added to milk to cut costs until Fairfax Media revealed the practice last year.

Internal documents from Lion's subsidiary National Foods - which makes Pura, Big M, Dairy Farmers and supplies Woolworths and Coles brand milk - revealed $23,000 could be saved by adding 16 per cent permeate to the production of 350,000 litres of whole milk.

This shaves almost 16 per cent of the cost off the price of production, and does not have to be disclosed on the label.

This cost saving is now gone for Lion, Parmalat and the supermarket giants, which have also ensured all private label offerings are permeate free.

"Increased sales volumes have not offset the decline in the average fresh white milk supermarket retail price," Dairy Australia says, adding the impact of the supermarket home brands going permeate free has yet to be felt.