Who gets trampled in supermarket wars?

The supermarkets control the profits for Australia’s most-loved food and drink brands and the aggressive expansion plans outlined by Coles and Woolworths would have sent a shudder through the industry.

The $2 billion plus expansion plan will see Coles and Woolworths tighten their choke on the market with the former opening 70 new mega-supermarkets and the latter adding 108 new stores across its portfolio of retail brands.

Funnily enough, the news prompted warnings from analysts that profitability for both supermarkets is set to suffer due to cannibalisation of sales as store growth is predicted to outpace population growth of 1.9% by around two-fold.

This, coupled with the fact the supermarkets have rallied ahead of their benchmarks, are prompting analysts to temper their enthusiasm towards Woolworths (WOW) and Wesfarmers (WES), which owns the Coles supermarket chain.

Woolies generated an enviable total return of over 10% in the past 12-months and Wesfarmers gave investors a more than 6% return. In stark contrast, the S&P/ASX 200 Consumer Staples Index is up 3%.

But the debate feels misdirected because the expansion is logical in my opinion, given that it will solidify, if not increase, the market power of the two supermarket gods. While the stocks may be looking somewhat stretched on a relative basis, trading some profitability for market power makes sense as it will justify their stocks having some form of “god premium” built into their valuations.

Such a premium not only reflects the extreme market power the supermarket giants hold, but also their enduring grip on the industry.

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Source: AFGC

Indeed, there is a tinge of near resignation in the voices of everyone I speak to regarding the status quo between supermarkets and their suppliers. Neither the Australian Food and Grocery Council (AFCG) representing suppliers, industry insiders or analysts at major investment houses can tell me how to break the cycle.

So, the stocks are arguably looking fully valued in the near-term, but they are likely to be rewarding investments for the longer-term shareholder given that Coles and Woolies are going to move from strength to strength.

This is why the debate should instead be focused on what the supermarket expansion means for suppliers. More stores should mean more demand for their goods, but I can’t help but think of the African proverb “when elephants fight, the grass gets hurt”.

This could be a case of small cap investors beware given that the vast majority of listed suppliers dwell at the junior end of the market. This includes the likes of pie maker Patties Foods (PFL) and consumer food company Goodman Fielder (GFF).

The fear is that the war could well see the supermarkets extract further special rebates from suppliers, called “trade spend” by the industry, to help fund their campaign – even as a code of conduct to help level the playing field between supermarkets and their suppliers is being finalised.

Trade spend is the biggest bugbear for suppliers. The supermarkets insist suppliers fund discounts and promotions of suppliers’ brands, citing softening sales of these leading brands due to competition from generics or “home brands”.

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Source: AFGC

But suppliers are bitter about trade spend because it is the supermarkets that have introduced the home brands competition as they attempt to bypass suppliers.

Industry sources who wished to remain anonymous told Eureka Report that home brands generate margins of about 25% for the supermarkets, while suppliers would generally achieve twice that margin.

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Source: AFGC

This has probably, in some part at least, fuelled the antagonistic attitude supermarkets have against suppliers. But supermarkets hadn’t quite appreciated the fact that suppliers need higher margins to stay profitable due to their higher cost structure.

This prompted the AFGC to commission KPMG to undertake a research report looking at the declining profitability of food and beverage suppliers in this country.

The report, which was published last year, shaped negotiations over the industry code of conduct and helped suppliers secure fairer deals, according to AFGC’s chief executive Gary Dawson.   

Supermarkets want their suppliers to be profitable, just not too profitable, as the ex-chief executive of Patties Foods (PFL) and former AFGC director, Greg Bourke, said in my article No stomach for food and beverage that was published three weeks ago.

This means there is a “sweet zone” when it comes to picking when to invest in listed supermarket suppliers. The conventional metrics may still apply – I’m referring to price-earnings (P/E) ratios and the like – but other measures worth watching include profit margins and return on capital.

The supermarket gods are said to be willing to help suppliers when their share price comes under intense pressure, but heaven forbid if a supplier were to make superior profits. 

For better or worse, none of the listed suppliers on the table are making profits anywhere near what might be considered "superior", but it may not be a bad idea to buy these stocks when their profit margins and return on capital or equity are hovering close to the bottom end of their historical range, assuming of course that their balance sheet is in a decent enough shape and the outlook is at least relatively stable.

But it’s not only the small player that’s at risk of being trampled on. The problem is the unique structure of the Australian supermarket sector where Coles and Woolworths control 70% to 80% of the market, according to AFGC’s Dawson.

“Even the big guys – the big brands and suppliers – are at a market power disadvantage when it comes to [negotiations with the supermarkets],” says Dawson.

“They basically have to be on the shelves in both supermarkets [and] if you combine that with the fairly intense competition between Coles and Woolworths and their drive to improve their margin and profitability, what we’ve seen is a pretty significant transfer of profitability from suppliers to retailers.”

The KPMG report found that gross profit for Australian food and beverage manufacturers have fallen to under 5.7% in 2011-12 from 6.9% in 2008-09.

In contrast, data from Bloomberg shows that Woolworths’ gross margin has doubled over the period to nearly 27%. This has been achieved even as sales growth has slowed to 4.5% on average over the past five-years from the 11.8% average before 2007, when Wesfarmers (WES) bought Coles for $22 billion.

While the slowdown in sales is probably in large part due to the maturity of the market, the takeover was a bleak turning point for suppliers. Indeed, Coles and Woolworths enjoyed a comfortable duopoly pre-2007, to a point where they have been called “complacent”.

But the change in Coles’ management under Wesfarmers broke the peace. Wesfarmers paid a lot for Coles and it was compelled to lift profitability of the supermarket, which resulted in a head-to-head confrontation between Coles and Woolworths.

Both are relatively unscathed in the battle – a point picked up by Goldman Sachs last week when it reviewed the reporting season. The broker noted that the major supermarkets are “winning at the expense of wholesalers and consumer goods companies”.

Sales growth and profit margins for supermarkets were described as solid or expanding, which is the total opposite to suppliers.

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Source: Goldman Sachs

But it is not only the food and beverage companies that are likely feeling the heat. Non-food suppliers Pental (PTL), McPherson’s (MCP) and Pacific Brands (PBG) are also probably made to bend backwards for their supermarket masters.

Suppliers move to diversify

Simon Dumaresq has written about Pental, which supplies detergents like White King and Jiffy. Management is trying to expand its product base to appeal to other customers outside Coles and Woolies, such as Aldi and Costco.

While Pental will struggle to wean itself off its dependency on Coles and Woolies, there is upside to the current share price as the risks is more than reflected in the current share price. We have an “outperform” recommendation on the stock.

McPherson’s is also trying to diversify its customer base through acquisitions, such as its recent move into the home appliances market. The group also distributes foil and cling wrap products to supermarkets, as well as personal beauty products to department stores.

Competition from private label products, rising costs and difficulty in passing on these costs to customers have dragged on its interim profits and management is forecasting its third year of earnings decline for 2013-14 with a 15% decline in earnings per share to around 16 cents.

Management hinted it had to give additional “support” for its products sold in supermarkets during the February reporting season. I suspect the company is referring to trade spend, and the fact that it declined an interview request underscores how sensitive the relationship between supplier and retailer is.

Pacific Brands makes intimate apparel and hosiery that are sold at department stores. While the department store sector is less concentrated than the supermarket sector, Woolworths and Wesfarmers (the owner of Coles) dominate the budget retail category through their Kmart, Target and Big W outlets.

These department stores would account for a significant proportion of sales and the market power imbalance is forcing Pacific Brands to change its thinking away from being a wholesaler to a consumer-focused business through expanding its own network of shops and selling online to the public.

The direct to public strategy is working, with the group reporting its first increase in sales in five years with revenue inching up 2.7% to $656.3 million. However, challenging market conditions, strong competitive pressure and the lower Australian dollar will impact on margins and management is warning of a 14% decline in group EBIT for 2013-14 to around $105 million. We do not have recommendations on McPherson’s and Pacific Brands.

While the management teams of these suppliers should be commended for working hard to claw back some market power, it may be a case of too-little-too late for many. Nurturing exports and developing a direct-to-pubic sales channel are an obvious opportunities for some, but they will probably prove to be a Band-Aid solution that is unlikely to offset their dependency on the supermarkets enough.

Further, there are better ways for investors to gain exposure to the export/offshore stocks – such as through nuts grower Select Harvests (SHV) and nutritional supplement maker Clover Corporation (CLV) because of their relatively limited dealings with local supermarket giants.

Bega Cheese an exception

And then there is Bega Cheese (BGA) which marches to its own beat and enjoys a better relationship with the supermarkets than most for a number of reasons. The main one is probably because it supplies home brand cheese to the likes of Coles and Aldi, so it never gets asked for trade spend. Further, around 30% of Bega sales go to international markets.

Perhaps struggling suppliers have themselves to blame too.

“If you looked around manufacturing at large in Australia, all the ones that are in precarious situations generally have under-invested,” says Bega’s chief executive Aidan Coleman.

“You’ve always got to reinvest [to boost] your productivity to ensure you remain competitive, which is something we have continued to do over the years.”

Unfortunately, Bega is more the exception than the rule when it comes to listed suppliers. Get comfortable folks, the dominance of the supermarkets is here to stay.