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?