food ret conference 2016 - beragua › es › docs › redburn food retail conference 2016… ·...

Important note: this information is covered by our standard regulatory disclosures which are printed on all published research and displayed on www.redburn.com Redburn (Europe) Limited is authorised and regulated by the Financial Conduct Authority

Food Retail

1

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

-

5.0

10.0

15.0

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


2

• 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



3

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

25

30

Magnit Tesco Ahold Colruyt Mercadona X5 Delhaize Casino DIA Iberia Carrefour Biedronka DIA Iberia



4

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



5

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.



6

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



7

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.

-5

0

5

10

15

08 09 10 11 12 13 14 15 16

Total grocers Inflation

-5

0

5

10

15

20

-5

5

15

25

35

08 09 10 11 12 13 14 15 16

Aldi/Lidl sales growth Inflation (RHS)



8

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

food ret conference 2016 - beragua › es › docs › redburn food retail conference 2016… ·...

Documents