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Food Retail
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James Tracey | +44 20 7000 2067 | [email protected]
Food Retail
2016 Conference 24 October 2016
There are five important conclusions for investors from our recent
Food Retail Conference in London: 1) traditional supermarket
formats should continue losing share to discounters and category
killers in the USA; 2) UK grocery gross margins should decline due
to lower ‘back margins’; 3) ‘store pick’ is likely to be the dominant
online grocery model; 4) big boxes only work well in emerging
markets; 5) the growth of Aldi and Lidl in the UK is structural.
Redburn hosted its Food Retail conference in London on 12 October 2016. The aim of
the conference was to find the answers to the questions that most investors are likely
to be asking in 2017. The conference comprised of industry experts and former
executives. We made conscious decision not to host the current management from
within coverage universe, as we know you see them all the time and have already heard
most of what they have to say. We had five speakers address the five critical topics.
The dislocation of the US grocery market
Roger Davidson, former HEB and Walmart executive, discussed the dislocation of the
US grocery market: traditional supermarket formats are losing share to differentiated
premium chains and discounters with lower operating costs and prices (Fig 1).
Fig 1: Sales growth by USA grocer, five year CAGR to 2015 (%)
Source: Redburn, Planet Retail
Roger sees the five most important trends for the US grocery market in 2016 as:
• Healthy Living
11.2 8.6
6.0 4.5 4.9 4.0 3.0 2.6 1.9 1.8 1.2 1.1
-2.8
-9.2
10.5 9.2
7.8 7.3 6.7 5.9 3.5
-15.0
-10.0
-5.0
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5.0
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Whole Food
s
Trader Joe's
Wegmans
Publix
Kroger
Food
Lion
Sam's Club
Walmart US
Hannaford
Meijer
Giant F
ood
Stop & Shop
Safeway
A&P
Dollar Tree
Dollar General
Market Basket
Aldi
99c Only Stores
Fam
ily Dollar
Save-A-Lot
Premium Traditional Discount
Food Retail / 24 October 2016
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• Shift from Traditional to Alternative Formats
• Omni-channel
• Dawn of the Deep Discounters
• Deflation
Relatively generic US supermarket chains in the USA such as Stop & Shop, Giant and
Safeway should continue to lose share as has broadly been the case for the last five
years.
The direction of UK food retail gross margins
David Sables, CEO Sentinel Management Consultants and former P&G manager
outlined his view that the gross margins of the UK grocers should decline over the long
term. David’s firm advises FMCG companies on how to negotiate effectively with food
retailers.
There are a number of factors in the negotiation between retailer and supplier that
determine the margin. On balance David is of the view that the negative factors
including continued share gains of discounters, increased regulatory scrutiny and a
reduction in the return on investment on ‘trade spend’ should be more significant than
positive contributors such as improved shopper focus (Fig 2).
Fig 2: Factors influencing the gross margins of UK grocers
Source: Redburn, Sentinel Management Consultants
David discussed the implications of the shift from ‘back’ to ‘front’ margin. Front
margin is the mark-up on the invoice cost. Back margin is the money paid to the
retailer for additional shelf displays, promotions or bonuses for exceeding growth
hurdles. UK retailers are attempting to convince suppliers to shift the back margin to
the front as provides greater certainty for the retailer.
The front margin is fundamentally less certain for the supplier as it does not know at
the time of negotiation what future volumes will be. The supplier has to trust the
Food Retail / 24 October 2016
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retailer and this is generally lacking. Back margin is typically paid to retailers out of
money that has already been earned by the supplier. The uncertainty makes suppliers
reluctant to shift the full amount of back margin to the front and should result in lower
gross margins for the retailer overall.
The gross margin of the Big 4 UK grocers is substantially higher at 27-29% at present
compared with 26% in the year 2000 (excluding fuel) according to a former executive
of one of the major players. This leaves the gross margin of the UK grocers higher than
most international grocery retailers.
Fig 3: Gross margins of international grocers (% of sales)
Source: Redburn, company data, Beragua. Note: Tesco gross margin excludes fuel as of 1H16/17.
The economics of online grocery retailing
Kalle Koutajoki the CEO and founder of Digital Foodie discussed the economics of
online grocery retailing. Digital Foodie is a provider of a customised platform that
provides retailers with everything needed to run a grocery retail business online.
Digital Foodie has signed up more than 15 retailers to its platform including S-Group
in Finland (€10bn of revenues) and IGA (5,000 stores globally). Digital Foodie offers
retailers a choice of a 'store pick' delivery model and a store-pick 'click and collect’
model.
The primary difference between Digital Foodie and Ocado’s 'platform as a service' is
that the Digital Foodie model utilises the store as the online distribution hub - a much
more capital light and flexible solution than the Ocado customer fulfilment centre, in
our view. The Digital Foodie solution can be introduced for as little as €295 per
month per store versus tens of millions of Euros for an Ocado solution. The speed to
market of the Digital Foodie solution is a matter of weeks rather than years for an
Ocado solution. This explains why models such as Digital Foodie and Instacart are
more successful at attracting retailers to their platforms.
We conclude that Ocado is unlikely to sign a value accretive international licencing
deal. The addressable market for Ocado is fairly limited, especially in the USA - the
most attractive international market.
Most of the large national retailers in the USA such as Walmart, Albertsons and
Kroger (30% of the market) have already invested significant amounts to develop their
28.5 27.7 27.125.3 24.6 24.5 24.3 24.2 23.6 23.4
21.9 21.4
0
5
10
15
20
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30
Magnit Tesco Ahold Colruyt Mercadona X5 Delhaize Casino DIA Iberia Carrefour Biedronka DIA Iberia
Food Retail / 24 October 2016
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own online grocery solutions; this makes them unlikely to sign with Ocado. Most of the
small independent retailers (40% of the market) don't have the scale to justify an
Ocado solution. The mid-market retailers (30% of the market) may decide to sign
deals with Ocado, however we expect most will adopt store pick solutions such as
those provided by Digital Foodie or Instacart due to higher up-front and operating
costs of the Ocado solution (Fig 4). We suspect that Ocado is trying to transition into
the online grocery technology provision business as the economics of its core UK retail
business are deteriorating. Ocado's sales growth has slowed in September and October
2016 according to Kantar and its gross margins continue to decline.
Fig 4: The USA online grocery market opportunity
Source: Redburn, Digital Foodie
The primary disadvantage of the Ocado customer fulfilment centre model is that it
does not provide scalable same-day delivery; it is not suitable for ‘click and collect’ and
it has higher delivery costs. Ocado’s cost to deliver is £12 per order compared to Tesco
at £7 on our estimates, resulting in Tesco having a 5% of sales delivery cost advantage
online. Tesco's lower delivery cost can be explained by the fact that it can deliver from
its 730 hypermarkets and superstores in the UK whereas Ocado has to service the
customer base from only two fulfilment centres. The higher picking efficiency of
Ocado's more automated solution is unlikely to compensate for this delivery cost
disadvantage.
Morrison’s CEO David Potts helped to develop Tesco's online grocery business when
he was in charge of its UK business. We suspect this explains why Morrison has
insisted that Ocado allow it to employ a 'store pick' model under an arrangement
where Ocado merely provides the website and some routing software and Morrison
does the picking and delivery itself. If the Ocado model really was more efficient then
Morrison would run all of its volume through Ocado fulfilment centres.
Big boxes only work in emerging markets
Javier Fernández Rozado, founder and Managing Partner of Beragua Capital Advisory
outlined his views on European food retail, including possible M&A opportunities.
The growth prospects of a grocery chain are very much dependent on the maturity of
the market - as measured by share of modern trade - and market concentration - as
measured by market share of the top 5 players (Fig 5). High concentration and mature
Food Retail / 24 October 2016
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markets have lower growth potential for a grocery chain and ought to be avoided for a
growth investor, unless the company is suitably differentiated.
Fig 5: Understanding the maturity and concentration of market is key
Source: Redburn, Beragua
Cash and Carry formats only really work well in ‘initial stage’ markets such as India
and China where modern retail has low market share and the overall grocery market is
fragmented. This explains why Metro has been unable to grow earnings consistently
for the past decade: most of the markets in which it operates are now mature due to
the rapid space addition of better run local competitors.
Big Box formats work well in markets with less than 65% modern retail penetration
such as Argentina, Mexico, Romania, Bulgaria and Russia where these stores are
destinations. In most Western European markets hypermarkets lack customer appeal
as they do not offer the customer cheaper prices and there are too many stores relative
to the population. LFL sales growth of Big Boxes in developed markets has lagged
inflation for most of the past decade (Fig 6).
Fig 6: LFL sales growth of hypermarkets versus food inflation (%)
Source: Redburn, company data, Beragua
Convenience and specialisation are the critical success factors for a grocery chain in
mature markets including the UK, Sweden, Germany and France. Convenience
describes both online grocery and proximity formats. Specialisation refers to the
concept having a unique selling point such as superior store ambience as is the case for
Waitrose or cheaper prices for equivalent quality as is the case for Aldi.
Food Retail / 24 October 2016
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Growth assets that would make good acquisition targets include Zabka in Poland and
Profi in Romania. Legacy assets that could be sold to private equity or trade buyers
include Delhaize Serbia, Tesco Hungary and Carrefour Poland. Esselunga is an Italian
grocery chain that is up for sale which could be an interesting acquisition target for
Carrefour or Ahold Delhaize.
Discounter growth is structural
Dalton Philips, former CEO of Morrisons addressed the question of “Is the worst of
discounter disruption behind us?". His view is that the growth of the discounters is a
structural rather than cyclical. He suggested that the impact of Aldi and Lidl on the
UK grocery industry may be as dramatic as that of Ryanair on the airline industry.
Whilst the percentage sales growth of the discounters in the UK market has slowed the
absolute rate of market share gains has remained relatively steady for the past five
years (Fig 7). The idea that the LFL sales growth of Aldi and Lidl is close to zero is a
red herring as deflation at the discounters has been consistently lower than the Big 4
(Fig 7). Aggressive price cuts have ensured that the discounters have maintained a
price position 15-20% cheaper than the Big 4 over the past few years.
Fig 7: Change in market share of the UK grocery market YoY (bp)
Fig 8: Inflation of the UK grocers
Source: Redburn, Kantar, company data
Source: Redburn, Kantar
Inflation is generally positive for the profitability of the grocery industry, but only
when it is the ‘good’ type. Good inflation is caused by rising demand and strong real
wage growth. Bad inflation is that caused by input cost shocks such as currency
devaluation. Inflation in the UK grocery market has consisted mostly of the bad type
since 2008 which explains why increases in inflation in 2010 and late 2012 did not
lead to improvements in the market growth rate (Fig 9). When the price of beef goes
up customers buy chicken and when prices go up across the board more customers
shop at Aldi and Lidl which is 15% to 20% cheaper (Fig 10).
-250-200-150-100-50050100150200
2011 2012 2013 2014 2015 2016
Big 4 Aldi & Lidl Residual
Food Retail / 24 October 2016
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Fig 9: Sales growth of the UK grocery market versus food price inflation (% YoY)
Fig 10: Sales growth of Aldi and Lidl UK vs. food price inflation (% YoY)
Source: Redburn, Kantar, ONS
Source: Redburn, Kantar, ONS
Inflation is likely to return to positive territory in the UK in 2017 due to the fall in the
value of the pound. Since this is ‘bad inflation’ industry growth is unlikely to pick up
materially. This means the inflation should be a negative for industry margins due to
trading down.
The discounters are set to be structural winners in the UK grocery market because they
have the lowest cost operating model and have won over the UK consumer by the
improvements made to the operating model since 2008 including:
• Range increased to 2,500 SKUs from 700 previously
• An increase in the range of national brands
• Good-better range hierarchy extended to good - better - best
• “Better" range now of equivalent quality to national brands
• Improved customer service, especially availability and checkouts
• Extended shopping hours
• Strong promotional calendar vs. occasional treasure hunts previously
• Savvy shopper appeal versus an uncool image previously
• Significantly higher share of marketing voice
• 15% price advantage versus legacy retailers for product of equivalent quality.
Previously the quality of the products was sub-par.
Dalton thinks that there are four strategies that legacy retailers can adopt in order to
respond to the improvements of the discounters:
1. Protect versus legacy: Focus on protecting share vs. Big 3 through
continuous improvements in the core. Assumes discounters are a cyclical
threat.
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Total grocers Inflation
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Aldi/Lidl sales growth Inflation (RHS)
Food Retail / 24 October 2016
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2. Protect versus discounters: Introduce a differentiated customer
proposition through assortment, provenance and service or alternatively
develop a discount format like HEB's “Joe V’s”. Assumes discounters are a
cyclical threat.
3. Transform: Re-invent the current format to look like Spain’s Mercadona.
Introduce a different customer proposition to legacy retailers and discounters
with an outstanding own brand proposition. Assumes discounters are a
structural threat.
4. Manage returns: Defend margins and spend as little on capex as possible in
order to optimise free cash flow. Assumes discounters are a structural threat.
The best solution, in Dalton’s opinion, is that the operating model of supermarkets is
reinvented in the mould of Mercadona, the leading food retailer in Spain. Dalton
thinks the price gap with the discounters needs to be reduced to 7-8% from 15-20%
currently, which can only be profitably achieved with a c50% reduction in SKU’s.
Without such a radical transformation the incumbent supermarkets won’t be able to
compete on operating cost and therefore price. Whilst companies can protect historic
margins and generate cash in the short term, the higher asset turn and lower cost
structure of discount competitors is likely to lead to continued store expansion and
share losses for the Big 4. The discounters are not burdened by having to make
pension deficit reduction payments which amount to c0.5% of revenue for Sainsbury
and Tesco.
James Tracey Food Retail Research
Redburn 10 Aldermanbury London EC2V 7RF
D +44 20 7000 2067 T +44 (0)20 7000 2020 M +44 7921 603 120 E [email protected]
Emily Want Food Retail Research
Redburn 10 Aldermanbury London EC2V 7RF
D +44 20 7000 2069 T +44 (0)20 7000 2020 M blank E [email protected]
www.redburn.com