No let-up in retail pressure

Anyone involved in supply to the grocery trade who is hoping that the intensity in retail competition will soon relax had their hoped dashed last week. The annual financial results of Wesfarmers and the accompanying statements made by the company's chairman Richard Goyder about the road ahead for its subsidiary Coles give a clear indication that price-based competition with Woolworths has a while to run yet. Why focus on Coles? The resurgence by this retailer is the single biggest driver of the intensity in competition at present.

Some could expect to see the bottom line of Coles hammered by the effects of 6 months of deep-discounts under the "Down Down" campaign, which the company has valued at about $800million of “consumer savings”. But the grocery division profits actually grew more than $200m or more than 21% in the full year.

A couple of months back, the retailer pointed to a number of compensating measures that it said would offset the impact of discounts. These included a reduction in waste and costs of physically moving products through its system, but the biggest boost to the bottom line has been the growth in sales over the full year. The food business grew sales by $1.5billion over the full year. About a quarter of this goes straight to the bottom line helping pull the overall result up.

Coles underlying business is growing faster than its bigger rival Woolworths, and it has turned the tables on its competitor in leading out new initiatives. In terms of an overall grocery retail contest between the big two, the clawback by Coles against its bigger rival has some way to go. Various other measures of retail performance - sales from floor areas, margins on sales, cost of doing business etc – each still have Woolworths well ahead, with a slowly closing gap.

Wesfarmers will be happier with this result, but it knows the contest can’t slow, as any retail chain can’t rest on its laurels when retail spending by consumers is as cautious as we’re seeing in 2011. Chairman Goyder indicated the play will get harder as Coles will only dig deeper. With the hunt for value by shoppers expected to remain intense, any retailer is challenged to refresh its appeal to grow customer numbers, and then win more of their business once they are in the store. Coles updated store format is delivering more added sales than the roll-out being made by its rival.

The rivalry will also remain fierce as regime-change continues as work-in-progress at Woolworths, with a new chief now appointed and management team being assembled. This is a reversal of the state of play before and after Wesfarmers took control.

But while outrunning rivals in food retail is one issue for Wesfarmers, the overriding priority is locking-in better returns on investment. Coles has a relatively low return on capital sunk into the business by its parent compared to other Wesfarmers units. Coles uses more than half of Wesfarmers’ capital, producing only 35% of its profits in 2011.

Extended price-based competition - coupled with a high $A, weak consumer spending and rising operating costs - will continue to force revolutionary change in the supply chains of grocery suppliers.

Food Companies

Ownership of many brands that grace the shelves in stores grocery stores which are foreign-owned may soon change hands with major corporate changes under way. Given the harsh economic reality of a strong $A and rising processing costs in Australia, the reshaping of global food company portfolios is a danger time for food processing jobs.

US-based Kraft Foods, which turns over about $50 billion in revenue, recently stunned the corporate world with plans to split in two. Kraft is still digesting the hotly-contested purchase of Cadbury made in 2009. Kraft will give birth to two companies - a North American grocery products business - which makes up about a third of its overall sales turnover - and a global snacks maker. The timing is interesting, but gives an insight into how the global landscape has forced a redesign of one of the biggest food groups in the world, which itself was spawned from a split several years ago. Those that rallied in defence of the takeover of Cadbury 18 months ago are claiming "told you so".
There has always been a lot of debate about the best way to build large, successful multinational food companies. That question alone – and the deals that been spawned from the issue – have kept planeloads of consultants busy for years.

Some say that it is better to be “diversified” or to operate as a conglomerate with a stake in many food sectors to protect against exposure to specific sectors of the economy or geographic regions. The likes of Kraft, Nestle, Unilever and General Mills follow this model and, between them, dominate supermarket aisles whether in developed or developing economies. The strong presence in most aisles of the supermarket offers strong bargaining power with retailers and, in Australia especially, can resist the expansion of "private label".

Others would say it is better to remain “narrow” and focus on some core strengths and skills. The likes of Kirin Holdings (which owns brewing, juice and milk businesses in Australia) and Coca Cola stick closely to a “drinks” focus yet, when venturing into food which they have each done recently, it hasn’t been so happy.
In recent years these large multinational groups have seen varying success - resisting the tough times in developed western markets, while riding some spectacular growth in emerging economies.

But the varying growth rates in the world's economy and risks of volatility are causing some to rethink of the shape of their vast food conglomerates.

Kraft isn’t the only food group to question its future structure. A spate of "unbundlings" will possibly create new companies and keep the advisory houses feasting in huge fees. Sara Lee (with frozen food units under a cloud in Australia), Pepsico and possibly others are working on plans for either a breakup or the sale of major units. There are common intentions behind these changes. The aim is to ensure things are made simpler for investors to understand and to ensure managers are able to gain better focus. Time will tell if that theory holds before we see the next fad emerge.
Food processing units involved in several food categories in this country will be examined as part of those changes, at a time when the variables in play (consumer spending, the strong currency, labour costs, and rising ingredient prices) don’t make this a happy hunting ground for food processors.

We are going to need China now

While the world’s financial markets teeter on the abyss created by falling credit-worthiness of several major countries, the situation has the populous cowering and expecting the worst. Now more than ever, this country needs the relatively new and narrow trading dependence on China to stay strong.

A China fact sheet sitting on the DFAT website shows just how large but narrow that relationship is - and where it has quickly come from. China is now Australia’s largest export customer, responsible for a quarter of all merchandise exports in 2010, while they are our also biggest supplier of imports, with nearly 20% of that share. The usual suspects of clothing, computers and phones (and their associated bits) and toys head that list. Imports are growing as the hunger for cheaper goods driven by bargain-hunting consumers and a strong $A pulled in more products.

It’s the exposure to minerals, iron ore in particular which alone speaks for 60% of the value of exports that stands out in the numbers. We’ve got here very quickly. We didn’t have a trade surplus with China until sometime in 2008/09 when the value of exports first passed imports. A few short years later, exports are now 50% greater in value than imports, and in 2010 grew at almost 40% in value due to the surge in shipments of iron ore.

The Western Australian iron ore quarry shipped more than 400 million tonnes of iron ore offshore last year. China took a staggering 70% of that volume. The base of natural resource exports won’t change too quickly but it will broaden in future years. China would probably like to have more of our coal, which went from a little more than nothing to 4 million tonnes in the short space of a couple of years. The two countries have signed up a $50billion natural gas project that sees a lot of capital being plowed into north-west Australia, but actual export dollars won’t flow on that and other big gas export projects for several years.

Are there risks? The economic power base of the world has firmly shifted to China, not only due to its massively expanding consumer demand, but also given that it is now the effective banker to many, albeit now with added risk due to sliding credit ratings. China has a few internal challenges of its own to digest – inflation is a key one of those.

It is fantastic that we get to ride that coattail – it is probably the best option we have compared to that if we’d staked all our belief in the “special relationship” with the broken and battered United States.

In the meantime the ill wind of recession that endangers stable recovery in the US and many parts of Europe may threaten China’s own growth train. A large part of China’s growth miracle has been due to its role as a low-cost factory for the western world – steel (consuming iron ore and coal) being one of the key products in question, but consumer goods exports are generally at risk.

We’d like more out of the relationship. Australian negotiators have been grinding away for more than 6 years in negotiations over a free trade agreement, while others (such as New Zealand) brokered one seemingly in a flash. Maybe we keep mentioning “human rights” too often in official talks and websites for a broader deal to be a higher priority for our most important customer.

Inflation numbers defy reality

The fears of further pressure on a fragile Australian economy were raised again last week when the Australian Bureau of Statistics released its latest guesswork on inflation.

Thin analysis that appeared in many news reports set the hares running that inflationary pressure had built and that this would be putting pressure on the Reserve Bank to crank up interest rates. The last thing the delicate situation needs right now is a more downward pressure on consumer spending, which has stalled in 2011 much to the alarm of retailers of all forms. Consumer sentiment plunged in the latest assessment by Westpac and the Institute of Melbourne to the lowest since May 2009, when the flow-on effects of the global financial crisis were rippling through the economy. Blame it on any of the factors getting plenty of media play at present – debt crises, carbon tax, house prices, interest rate fears and the pressure to restore household savings.

According to the inflation numbers, the key movers in the list of goods and services shows that the hot spots for upwardly mobile prices are food (booking a 6% rise), energy, fuel and water charges. Just about anything else that consumers buy continued to fall in price according to the ABS. If a lift in interest rates is warranted in response to inflationary pressures, it should address overheating demand that is driving up costs of living. That isn’t apparent in any sector except the supply of labour to mines.

There are two major problems with the food CPI numbers that we’ve seen before. Firstly, the ABS seems to have made the same “Larry mistake” it made the previous time a cyclone bowled over the North Queensland banana crop, by failing to take account of the fact that only a small volume of bananas were available as a result. While unit prices have been very high, the cost of living impact across the board has been limited. The distorted gains in fruit prices have dragged up the entire food CPI result. The concept of “weighted average” isn’t endorsed in crunching inflation calculations.

The second issue is that just as the ABS put out its numbers with food CPI at 6% for the June quarter, two major grocers, with 60% of the spending on food, put out their own numbers on the weighted average of price changes in their businesses. They collectively showed price deflation that probably averaged out at 2.5% over the same period, with the effect of discounts and promotions continuing to drag down prices. Both have mounted major discounting campaigns that kicked off at the start of 2011, pulling prices on fast moving lines below what they were this time last year. The retailers’ numbers make more sense on this basis, leaving us to believe that prices for goods outside the supermarkets have bolted so sharply that the ABS is truly capturing the net effect.

I don’t think so. Sales non-retail channels are depressed according to my firm’s own tracking of household spending, and any price gains in those areas would be hard to achieve.

So, if we’ve got these sorts of issues in one sector, how reliable are the rest of the numbers?

Tackling volatility?

We’ve never seen global food commodity markets in such tight and complex states, with the complexity and interrelationships of influences on the values of grains, milk, meat and horticulture. We’ve also rarely seen as much investor interest in food production assets.

Agriculture ministers of the G20 group of nations agreed last week at a two-day talkfest in idyllic springtime Paris to a set of measures to tackle volatility in food commodity prices. But the deal reached contained few elements that might inflame disagreement between key players in that club and claimed to “pave the way to greater international cooperation on sensitive agricultural issues”. We’ll see.

The parts of the actual agreement reached play it safe by dealing mostly with humanitarian issues. The G20 nations agreed to exclude humanitarian aid from ongoing export restrictions, and explore use of humanitarian food aid stocks.

Many harder issues have been deferred. The French President Nicolas Sarkozy – who star has faded badly at home - has used this platform as a hope to build his position as a statesman with a French election less than a year away. He’s been beating the food security drum for most of 2011, but has been most vocal about the influence of commodity trading speculators on food prices. Sarkozy blames speculators for causing the surging food prices - especially wheat, corn and soy - that have increased the exposure to the world’s population to poverty and driven unrest in many countries.

His government took a hard stance in the negotiations, claiming it wouldn’t sign a deal that didn’t take a tough line on speculators, by placing “position limits” on trading in food derivatives.

The G20 didn’t go near that. It has merely called finance ministers and Central Banks of G20 countries to better regulate and supervise agricultural financial markets. Proposals on these actions are due later this year, but bitter differences between countries exist here – just as they have surfaced within Europe when trying to agree an exit from Common Agricultural Policy.

The agreement swerved any forceful effort to reduce the distortions from biofuels policies, only going as far as to support further analysis on its influence on food production. Hardly breaking any new ground there!

Information and transparency is another theme of EU reforms that the G20 has also grabbed. The meeting wish list provides for the creation of a global agricultural markets information system (“AMIS”), which would “keep track of stocks and provide supply forecasts”. AMIS will initially cover wheat, corn, rice and soybeans, with others to be added later. There isn’t much urgency about this measure – appropriate given the challenge in making any such approach commercially relevant. AMIS managers will hold their first meeting in September 2011, and publish their first outlook in June 2012.

It’s a bit ironic now that the French want to be the driving force for liberating trade to take the world out of the current tight food supply situation. French agricultural and trade policies have for many years been at the heart of traditional European values that have kept trade walls high and helped protect its homeland farmers. Now it suits the French to free-up trade – quickly.

Don’t hold your breath waiting for any rapid change in the landscape driven by outcomes of this meeting. “No change” is a more realistic bet.

Milk discounting

A lot of profile is given to the allegations that the milk price war has claimed many casualties since it commenced on Australia Day. Dairy farmer organisations have invested considerable managerial efforts and expense to highlight the risks for their members associated with deep-discounting of mainstream dairy products.

With retailers absorbing the price discount on private label lines, the key reality of any impact on farmers depends on how much volume migrates to private label products. This has varied state to state – in Victoria for instance, branded fresh milk sales volumes are now higher than they were a year ago.

Milk producers in Queensland are at greatest risk from cuts in farmgate prices, where most milk ends up in milk cartons. Processor competition ensures branded milk prices are typically much lower than in Victoria and NSW, while farmgate prices are higher to ensure year-round milk production. Milk producers in Queensland feared the added slug from discounting would result in a slashing of farmgate prices to restore profit to processing in the northern state.

The timing of the discount campaigns heightened protests, as water had barely receded from the January floods which immediately cut milk flows by 20%. Production challenges coupled with fears of farmgate price cuts has deflated regional sentiment in an anxious recovery period.

Discounting has two effects – volume shift and price response. A volume effect has been greatest in Queensland. After 5 months, it seems the annual equivalent of about 14 million litres, or 6% of sales, has moved from processor brands. A seminar in Brisbane last week heard (with some disbelief that it wasn’t worse than this) the annual volume effect adds up to about 1.3 cents a litre when applied to differences in product prices. A price impact appears to have been less than this – retail data suggests branded prices have held ground, and the regional wholesale price index (tracked by Dairy Australia) is also steady. The volume impact in NSW is about the same despite the gaps in milk product prices being larger in that state.

In hindsight, this won’t be industry-threatening by itself. Putting it into perspective, a 2-cent shift in the $A (seen frequently in the past year) is worth about 1.2 cents a litre to a Victorian producer in the current season. A $20/tonne lift in grain prices has a larger impact to costs for most farmers. National Foods suppliers have been hit with far greater adjustments due to the change in private label supply arrangements to Woolworths in the northern states. But demonising grocery chains is a favourite agripolitical pastime.

Such a low impact to date across industry can mean several things. The vocal political and industry protest persuaded consumers to pause before choosing the cheaper product. The entrenched value of milk as a convenience product, accessible from in a vast array of places outside the supermarket, protected brand sales. The result will be a combination of these effects and others.

For the farm sector, there might be bigger fish to fry, but now confidence is the biggest casualty. Where this issue goes from here matters most, as the story may be far from over. If milk processors are forced to sacrifice branded prices to claw back market share in an extended price war, the harm to margins – and the threat to milk suppliers – may grow.

A tragic salad

Big lessons can be taken out of Europe’s food safety nightmare. The story about the e.coli crisis in a salad vegetable is far from over – people were still dying over last weekend in Germany where the death toll went into the 30s, with thousands ill across several countries. The episode sprang from people eating affected food about a month ago in a number of outlets in German and Eastern Europe.

Consumers across Europe are shunning fruit and vegetables, and German warnings against eating cucumbers, tomatoes, lettuce and sprouts are still in place.

There will be many that use the benefit of hindsight to lay out the unholy mess in the EU’s food safety alert system and how the issue was handled from the time people started checking into hospitals. That might be a tad unfair, as the outbreak was detected over a large area over several days, as the unsafe products were had been distributed to a number of food service outlets in several countries.

As the drama rolled on it has been conclusive proof that has evaded scientists and regulators. Several strains of the bacteria have been found – not all have been killers.

The European Commission quickly laid the blame on Spanish cucumbers which tested positive for the bacteria – but unfortunately it wasn’t likely to be the strain causing death and illness. Growers that suddenly lost their livelihood sought compensation. As the Germans and EU authorities fumble for a definitive trail and source, the mounting compensation bill is approaching $A1bn.

After initially blaming cucumbers, then tomatoes and lettuce, investigators narrowed their search for the source of the killer bacteria to bean sprouts from an organic farm in northern Germany.

The issue quickly escalated with some predictable and exaggerated trade responses. Russia, which is always quick to use trade barriers to make a point, claimed the need to protect its citizens in the confusion as to the actual cause of death and placed a ban the importation of any fruit and vegetables from Europe. The EU has since negotiated a back-down from the Russians.

The two big takeaways from the tragedy have been about regulatory ownership and communication.

The greatest difficulty faced by consumers and producers as authorities raced to identify the relevant strain of the bacteria and its likely source, was the lack of coordination across regional and national governments.

Germany has 16 states, each with broad powers over health and safety may have slowed response to the E. coli outbreak, with no single federal agency responsible for tracking the bug and assigning the blame. Each of the 16 states – which apply varying levels of resources - is responsible for tracking cases inside their borders. Confusion was escalated as different states were issuing parallel alerts for different vegetables.

Expect a complete overhaul of European food safety management and even a reactionary stiffening of approaches in a host of other countries.

The other problem might be harder to fix – it about keeping pace with how people are now communicating with each other. Health authorities struggle when working with conventional media communications, which compete with the lightning speed at which news and opinions spread through the community through social media networks. Luring consumers back to complete trust of fresh food will need some mastery of these channels.