Price war draining life out of suppliers

ADELE FERGUSON
March 26, 2012
The Age

‘Suppliers are asked to stand at the edge of a cliff and agree to discounts and if they don’t, they are told to look over the cliff …’

IF THERE is one message to come out of the fierce price war between Coles and Woolworths, it is that life will get a lot tougher for their suppliers as the supermarket giants face the spectre of lower earnings growth and a potential derating of the sector.

In the case of Coles, it has introduced a program called ARC (Active Retailer Collaboration) to identify possible efficiency gains, potential cost reductions and data sharing for an up-front fee. More than 200 suppliers have signed up to ARC agreements, but several of them are complaining that it is anything but collaborative and is being used as a tactic to screw them further on prices. With Coles and Woolworths dominating the grocery industry with more than 70 per cent of market share, suppliers have little option to put up or shut up.

The brutal reality is that in the past year the food and liquor discounting between Coles and Woolworths — and more lately Metcash — has never been as ferocious and the cries from suppliers never louder. It has refocused the debate on the concentration of Australia’s grocery industry and the long-term toll it is having on Australian suppliers. First it was the dairy farm industry that complained, then the bread industry, then beer giant Foster’s pulled tens of thousands of cartons of VB off its trucks last year after it found its product was about to be sold below cost, a move that would chip away at its brand and hurt independent liquor outlets. More recently Coca-Cola Amatil has been the target of the supermarkets, particularly Woolworths. And food manufacturer Heinz, which operates all over the world, recently said the Australian market was the most difficult and “inhospitable”.

The price wars have prompted a national debate about what can be done, and what should be done. Everything is being considered including a grocery ombudsman and setting up a small business and farm tribunal with powers to monitor the behaviour of the supermarket chains. The problem is price wars are good for consumers as they benefit from cheaper products. Coles estimates price deflation of 2 per cent a year since the start of 2009, and matching competitor price reductions, has saved Australian consumers more than $2 billion a year in total.

But there is a dark side to discounting. If enough suppliers and smaller competitors are driven out of business, it will reduce choice and eventually drive up prices.

The one known in all of this is the debate will intensify in the coming two years as the supermarket giants ratchet up their price discounting to drive volumes and hopefully earnings.

A thought-provoking report by Merrill Lynch analyst David Errington warns that the big two retailers, Coles, Woolworths and the wholesaler Metcash, will need to boost their earnings by $1.3 billion in the next three years if they are to make an acceptable return on the billions of dollars of investments made on acquisitions and capital expenditure. This is on a total earnings before interest and tax (EBIT) pool of $4 billion for the retailers.

To put it into perspective, in the past year the profit growth of the entire sector has shrunk. This includes Coca-Cola Amatil, Goodman Fielder, international suppliers such as Heinz and the supermarket giants. Errington’s report says that in the first half of 2012 the big two food retailers plus Metcash delivered a combined $150 million EBIT growth, which is a far cry from the $400 million a year earnings growth that is required to make an acceptable return.

In the case of Wesfarmers, it paid $15 billion to buy Coles in 2007 and spent and additional $1 billion on capital expenditure over depreciation. Wesfarmers has made no secret that it has set aggressive financial targets for its senior executives and if they meet them they will be rewarded handsomely. Errington believes that Coles’ target will be to reach a 10 per cent return on capital by 2014. This translates into an EBIT of $1.6 billion in 2014. Given Coles reported an EBIT of $1.05 billion in 2011, it will need to grow its EBIT in absolute dollars by nearly $200 million a year for the next three years to meet this target. “In the first half of 2012 Coles’ EBIT increased by $57 million … meaning that Coles needs its EBIT growth to materially step up … if it is to reach its targets by FY14,” Errington says.

The stakes are high on a personal and company level. The speculation last year was that Coles boss Ian McLeod would pick up a bonus of more than $30 million if he meets certain targets by 2014.

If Coles, Woolworths and Metcash fail to generate suitable returns on capital in the next couple of years investors’ patience will run out and they will they suffer a derating.

It goes a long way to explaining the intensifying price war between the supermarket giants as Coles tries to snatch market share to justify its investment. Ditto for Woolworths and Metcash. A former senior executive at Foster’s said he had never seen such tough treatment of suppliers in all his years in the business. The boss of a listed food manufacturer said “cliffing” was becoming a common occurrence where suppliers are asked to stand at the edge of a cliff and agree to certain discounts and if they don’t they are told to look over the cliff and see if they like that better. Another said cliffing was a choice between quick suicide or death by a thousand cuts. With the debate now entering the political arena, the supermarket chains will have a lot of explaining to do.

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