Real Food For Thought

With recent televised drama and the upcoming political inquiry, supermarkets (and the consumer staples sector as a whole) have seen a derating relative to the rest of the ASX200 and – as of writing – is the worst performing sector in the past year having declined ~7% (the tech sector has rallied ~54% in the same timeframe).

In this insights article, we discuss recent concerns with regards to price gouging and the prospects for supermarkets ahead.

Australians have, correctly, pointed out that due to market share stability and the lack of entrants or exits, incumbents within the supermarket industry (such as #WOW and #COL) have what we call pricing power.

Pricing power is defined as the ability to increase prices of products without affecting demand. A company’s pricing power is very much dependent on the competitive environment in which the company operates. Companies with large competitive advantages and a lack of competitors usually exhibit more pricing power.

I believe that it is important to differentiate between two types of pricing power – nominal and real pricing power. Nominal pricing power refers to the ability to raise prices to keep up with inflation whilst real pricing power allows for price growth beyond inflation. Harvard Business School Professor Felix Oberholzer-Gee says that real pricing power is reserved for businesses with products that are mispriced, products that have not captured the extent of the value they create.

Even then, there is only a certain amount of real pricing power that a business has before it reaches the maximum price per unit that it can operate at without negatively impacting demand. To sustain real pricing growth, businesses need to increase their customers’ willingness to pay or lower their suppliers’ willingness to sell. Oberholzer-Gee says that this is fundamental to long-term value creation.

Supermarkets provide value (and thus increase willingness to pay) to consumers on two fronts – convenience and cost. They can also lower willingness to sell (and thus lower costs) by optimising efficiency, improving productivity, and having better relationships with suppliers. For example, one of the core tenets of a supermarket’s competitive advantage is that by ordering in bulk, the average amount that a supplier is willing to accept is lower as the increase in volume will make up for the difference in price that they would otherwise place on the product. This allows larger supermarkets to have, on average, lower costs per product and earn a larger margin then its smaller peers.

Therefore, to exert real pricing power, Woolworths and Coles (or any other business for that matter) need to continually increase willingness to pay or lower willingness to sell. If the value stick is not extended in either direction, then consumers will (and rightfully) lash out and demand will fall.

That brings us to the present day. Over the past few years, in their attempt to expand firm margins in a high inflation environment, we have seen supermarkets reduce customer delight (the gap between willingness to pay and price) and supplier surpluses (the gap between cost and willingness to sell). Price increases have been pushed through despite no more convenience being added to the shopper’s experience and there have been many reports of major supermarkets coercing suppliers into unfair terms, exploiting the profitability of farmers to keep costs lower (whilst still also blaming suppliers for price rises!).

In hindsight, there has been no good reason why supermarkets should be able to have real pricing power and that was always going to come under threat.

As investors, it is necessary to understand how supermarkets can create and attach likelihoods to certain scenarios. Beginning with willingness to pay and increasing value for consumers through convenience and cost, we are beginning to see this occur in the form of price reinvestment (discounting across products). In the short term, this will lead to a contraction in firm margins as price is lowered to satisfy customers. We postulate that for supermarkets to maintain higher margins longer-term, they must ultimately deliver on providing greater convenience and service – the main avenues for such will be done through digital and delivery. We note that both Woolworths and Coles have made significant investments in both areas, but penetration of online products remains low with the public yet to resonate. Regardless, progress is finally being made with value-adding programs (and there are many of them!) likely to be accelerated with the support of government reviews.

The perception that supermarkets have gouged both customer and suppliers is a problem of value creation, or the lack thereof. Large investments into customers (which have already been made) will eventually lead to high willingness to pay which will, in turn, lead to a better public perception. We think the improving customer experience will become more prevalent both in-store and online over the coming years and are satisfied with the strengthening value proposition from prior and current investments. The perception for suppliers on the other end of the stick is also important. Suppliers need to feel that they are being duly rewarded for their efforts and are at least covered their cost of production. As inflation abates and price stability returns, we expect supermarkets to provide fairer and more desirable terms of trade through higher purchasing volume and longer agreement periods.

Ultimately, we are not worried about the ability for supermarkets to create long term value and we think that supermarkets remain attractive for income investors long-term. In our view the government inquiry is very unlikely to lead to adverse earnings changes (supermarkets are much more likely to voluntary take a hit to protect brand image) but note that growth in FY24 and FY25 may flatline (which is arguably priced in with the derating). We have good clarity on earnings accretive investments coming online in that time which should be justification for sentiment to recover and we like the prospects of margin expansion despite what looks to be slowing revenue growth in a lower inflation outlook.