Pembridgecap

A Wealth Creation Journal

Author: XC (page 3 of 3)

Information Flow – A Force of Nature

I have been going through old interviews by Meituan founder, Wang Xing. He is obsessed with the mechanism of information transmission in our society and technological advances that improves information transmission brings about drastic changes to how people interact and conduct their daily lives. And when people change their ways of conducting daily lives, it usually means formation of new businesses that take advantage of these changes. Incumbent businesses that rely on the older way of information transmission will be left in shatters.

Wang Xing likes to define information technology (IT) as technology that enables the flow of information. So in this sense, just like Internet and smartphones, older technologies such as printing press & books are also IT. In fact, three out of the four ancient Chinese inventions (papermaking, printing, gunpowder and compass) are about IT. Papermaking is about storage of information. Printing is about mass replication of information. Finally compass is about production of geospatial information.

Internet brought about a revolution in terms of information transmission. Not only does it lower the cost of information transmission, it also unlocks new ways to transmit information. For example, social networks built on top of Internet allows information to pass through the network of humans. We share news, products, services, personal experiences with our friends on social network. Direct to consumer businesses have taken advantage of this change. This is challenging the long-held belief that FMCG companies have impregnable moats.

Technology does not just reduce cost of information transmission. They also allow new types of information to be transmitted. For example smartphone allows the individual location information to be transmitted instantly and hence new businesses such as ride-hailing and food delivery platforms to emerge. Smartphones also allow companies like Meituan which is a marketplace for local services such as hairdressers, beauty salons and restaurants to market to potential audiences more efficiently than before. Meituan will show consumers nearby local services based on location information which are most relevant to the user.

The impact of information flow is even more nuanced than just allowing new business models to emerge. I believe that because the digital revolution has brought about reduced communication and management costs which has reduced the transaction costs within a firm. This partly explains why we are seeing companies becoming larger than ever. I don’t think this trend will reverse.

As investors, the appreciation of the magnitude of changes and the path of change can be very lucrative. For example Uber drivers have driven demand for vehicle hires and this demand for rental vehicle has driven fleet sales in Brazil. Since fleet sale is done at wholesale price, this meant that auto OEMs has to accept lower unit price and margin compression.

The increased digitalisation will transform the food industry in the next 10 years. The first step has been the arrival of the food delivery platform which brings food from the restaurants to the consumers. This can happen because the consumer side has been “digitalised” with smartphone. The next step is to digitalise the restaurant. Currently the bottleneck in terms of food delivery efficiency lies with waiting time at the restaurants. Digitalisation of the kitchen will allow the food delivery platform to predict cooking time much more accurately. Then it is about the logistics. Instead of delivering with clumsy human beings, the next step is to deliver with autonomous robots. Eventually, I believe that food production will be centralised and cost of food comes down dramatically. People will continue to go to restaurants for social experiences. But new flats might not have kitchens anymore.

After studying Wang Xing carefully, I am 100% with him that digitalisation will continue to change the society. And the next stage of change is mostly focused on the enterprise side. While Warren Buffett has derided “change” as detrimental to the investors, I think “change” can be quite lucrative if it is misunderstood by most.

The HLP Lessons

In the past couple of months, I spent a lot of time and effort researching Hang Lung Properties (HLP). It is a Hong-Kong listed commercial property developer and owner. HLP has a portfolio of prime retail properties in HK and mainland China. My initial interest in the company originated from my belief that despite the threat from eCommerce, well-positioned shopping malls in demographically strong areas should continue to do well.

There is a lot to like about the company at first glance. It was trading at close to 4% dividend yield, a strong development pipeline and have at least 2-3% rent growth from its existing shopping mall portfolio. The shopping malls are relatively high-end and located in some of the biggest cities in China. Most importantly, it seems to have a well-aligned management (HLP is family controlled) and a “legendary” capital allocator at its helm. I recommend you read the Hang Lung’s Chairman Letters where the CEO’s impeccable ability to time the real estate cycle and reluctance to overpay are both well documented.

It was almost too good to be true. You have 1) very competent capital allocator, 2) a high-quality retail properties portfolio, 3) a highly visible development pipeline, and 4) a cheap valuation for this business quality. I allowed myself to become very excited about the company as I devoured the Chairman Letter religiously. I am actively looking for evidence to further support my investment thesis. Sure there are a few problems but as a long-term investor, I can look past these “short-term” issues.

However, as I learnt more about these “short-term” issues, inconvenient evidence began to accumulate. The consumption power of Chinese Tier-2 cities does not grow nearly as fast those implied in Hung Lung’s Chairman Letters. The oversupply of retail space in Tier-2 cities would take so many years to digest that the return on incremental retail properties in these Tier-2 cities is just too low for the level of risk involved. However, the company seems focused on its Tier 2 city strategy in China. Not to mention the first mover advantage of the luxury mall in Tier-2 cities is so entrenched that it is a winner-take-most economics. Most luxury brands will not open two stores in a Tier 2 city in China and luxury brands need to co-tenant together. This means that once the first high-quality mall captures most of the large luxury brands in its mall. It is extremely difficult for the second and third mall to compete. You can build mid-end malls but then you would have so many similar malls that the low rent almost guarantees an unsatisfactory return. Chinese Tier-2 cities retail space is over-supplied from high-end to low-end malls.

At this point, I am just confused. Why would such a smart and rationale capital allocator commit to such an obviously sub-par strategy? As I spoke to people who are close to the Chairman, it became clear that this is an individual who has a huge ego. It would be extremely difficult for him to openly admit the mistake and change course. It is unclear to me if he is just too proud to admit the mistake or that admitting the mistake to something that is so central to his personal identity (he sees himself as the smart guy that never overpays) is just too difficult for him.

In any case, I learn quite a few lessons which I can take along with as I continue my adventure in the investing jungle.

  1. Don’t give too much credit to CEO / Chairman just because they can write fantastic annual letters
  2. When the business’s core operation is transformed in volume or in nature (in Hang Lung’s case from property management to property development), one cannot assume that the company will naturally be able to adapt
  3. Even when the manager is heavily invested in the company, the ego can still get in the way such that mistakes are not corrected
  4. Human irrationality is more powerful than you might think
  5. Past track record does not guarantee future success

Of course, I could just be wrong in thinking that building malls in Chinese Tier 2 cities is a sub-par investment strategy. I hope I am wrong.

MC

Dart Group Memo – 25th Nov 2017

Dart Group (DTG) released its latest 1H FY18 results on 16th Nov 2017. Operating results were very satisfactory. The total number of passenger sector flown for the period between Mar-Sep 2017 increased by 41% while the ticket yield decreased by 17% from GBP 92 to GBP 76. With the competitive pricing, load factor remained at an impressive 93.2%. Consequently, leisure travel revenue grew 36%. Operating profit grew 22% which led to a continued margin compression of 12.3% as compared to 13.5% in 1H FY17.

Advanced sales grew by 38% from GBP 519m to GBP 713m which is indicating a strong growth for the Winter of 2017/2018. The growth in Winter programme corresponds to Jet2’s capacity expansion as the company grows its aircraft fleet. Strong free cash flow generation with impact from working capital is largely neutral. Capex spend is expected to be much higher in 2H 17 with aircraft delivery.

All things considered, this is a very impressive operation performance by the Dart Group management. The share price rallied strongly upon the release of the set of performance. The market seemed to value DTG very differently over a 5-month period. However, the intrinsic value of DTG most definitely did not change as much as that implied by the share price. I added to my position after Mr Market taking a dim view of the company’s prospect after results release in July 2017. I am glad that Mr Market has changed his view since then.

Post the recent share price rally, DTG is the biggest position in my portfolio by far (~30%). Naturally, I am re-evaluating the appropriate sizing for DTG. To arrive at what is the optimal position size, one would need to understand 1) the expected upside and 2) the downside risks.

DTG can generate further upside by 1) growing its free cash flow; 2) pay down of debt 3) expansion of valuation of multiple. While I do believe that the current multiple on DTG is on the conservative side, I typically do not count on multiple expansion for value creation. As such I would focus on future earnings growth and value creation to equity holder through debt repayment. DTG can generate further earnings growth by:

  1. Volume growth – this can be achieved either through 1) expanding to new airport and 2) adding new routes to existing airports

  1. Pricing growth – this can be achieved either through 1) increasing prices and 2) improving revenue mix by getting customers to purchase higher valued products

  1. Cost efficiency – given that the mix of aircraft is skewing towards new planes, one would expect some degree of operational efficiencies

  1. Operating leverage – as DTG continue to grow in its bases, it should be able to spread fixed cost over larger revenue and achieve some margin expansion. This is especially true at newer bases

DTG might be able to expand to new bases to generate further growth, but it would not be prudent to anchor an investment on such an aggressive assumption. I am happy to be wrong here. So in this analysis, I assume that future volume growth is only coming from adding new routes to existing bases. In the short term, DTG is likely to enjoy high single-digit volume growth due to the collapse of Monarch. In the longer term, DTG is unlikely to grow its volume above the market as competition in the airline/holiday industry is intense. Similarly, on the pricing side, I suspect pricing growth is very limited due to competition. But DTG does get some insulation from pure price competition because they are focused on holiday destinations and are currently very profitable while being very price competitive. Putting the two together, DTG’s organic revenue growth over the next five years is unlikely to exceed 10% while the risk of a cyclical downturn is more severe at current valuation.

By replacing older aircrafts with modern aircrafts, DTG should be able to realise cost savings through fuel efficiency and lower maintenance cost. But the impact of this should be fully incorporated by 2019. It is difficult to estimate this precisely, but I am not expecting a more than 1% of EBIT margin improvement. On the other hand, the risk of a higher fuel price weighs down on the cost savings from the new planes. Operational leverage might kick in with further growth, but this is difficult to quantify.

Putting the above together, I estimate that Jet2 will run at around 11-12m pax capacity with 91% load factor. Assuming a conservative pricing environment, I get GBP 2.4bn revenue in 2019. With an 11.5% EBITDA margin and no working capital benefit, I get ~ GBP 200m operating cash flow. The question of what is the right maintenance capex is a difficult one. I assume that with newer aircrafts in the fleet, the run-rate maintenance capex is close to GBP 60m. Deducting the maintenance capex, the FCF would be ~GBP 150m; implying a close to 15% free cash flow yield on GBP 1bn market cap. Assume that all FCF is used for debt repayment, equity value should increase while the FCF yield would decrease assuming that FCF doesn’t increase too much over time. In today’s world, 15% FCF is still a very attractive rate. Nonetheless, the upside on DTG is probably around 30-50% without any multiple expansion. Given that, I have investment opportunities with similar downside risk but 100% upside. It no longer makes sense to allocate such a large size to DTG.

However, Jet2 is still the best-valued package holiday business where it strikes a great balance between customer service, experience and price. The company is managed by an excellent management team and a well-aligned owner operator. Jet2’s position as value for money package holiday operator should prove to be most robust in a recessionary environment.

At this point, I believe 15% position size is probably the right one for DTG. I am retaining a large position size because I am very keen to partner alongside a competent and well-align management at a reasonable if not cheap valuation. However, I will be selling down more DTG shares.

MC

Why is successful investing so hard?

I am fascinated with the notion that investing is “simple but not easy”. The principles of investing look deceitfully simple, buy low and sell high, while the execution of these principles can be hellishly hard. And the execution is hard because the process of learning and improving from the mistakes in investing does not work in the same way as it does with other activities such as sports.

First, unlike most sports activities, investing lacks an immediate feedback loop where the outcome of an investment decision is presented at once and mistakes analysed. One must, sometimes, wait for years before knowing the outcome of an investment decision which meant useful learnings and improvements potentially come on the back of a string of mistakes. It is the equivalent of trying to improve baseball batting skills but only knows the result of each bat one year later.

Second, the quality of the feedback is very weak as the investment outcomes do not always reflect the strength of the investment decision, i.e. one can be right for the wrong reasons or wrong for the right reasons. The inability to determine the precise causes for a particular investment outcome is very dangerous as one can put huge confidence in the wrong lessons learnt. It is analogous to practising basketball shots in the dark. One would have to rely solely on the sound of the basketball hitting the rim to determine how much more or less strength to apply for the next time. The lack of information for shot calibration impedes the basketball player’s rate of improvement.

Third, most lessons in investing have nuances and contexts such that they can only be applied to certain conditions and environments. In another word, these lessons are seldom generalised. The trick here is to balance between following the broad prescriptions of investment lessons but also able to recognise the exceptions to the rule. For example, a shrewd investor would rightfully conclude that based on historical precedents to avoid heavy-indebted companies is a wise thing to do. However, John Malone’s TCI supported by its steady cash flow is heavily indebted, but it turned out to be a great investment.

Fortunately, we stand on the shoulders of giants today. We can study the life of great investors and learn from their success and mistakes. We can observe the rise and fall of companies to find patterns. However, there is no better way to learn and grow as an investor than to work alongside like-minded and very accomplished investors.

TC & MC

Dart Group – Memo post FY17 results

Thomas’s enthusiasm on religiously updating this blog has put me to shame and as such I will share my latest thoughts on Dart post the latest results release last week.

While many investors counsel against sharing investment ideas because it exposes one to commitment bias. Despite the commitment bias risk, I want to document my thoughts ex-ante so that I can remove any hindsight bias should my judgement prove to be wealth destructive. So here we go:

Post the results, DTG share price went on free fall – a whooping 20% drop in 2 days. Just like TC, DTG makes up ~25% of my portfolio. So this was emotionally hard to bear despite all the lessons of rationality that we keep reading about in books.

The market reacted violently because:

  • Operating profit probably did not meet market expectations given the run-up in share price before the results release
  • Huge uncertainty associated with the non-UK ownership issue

I suspect the issue surrounding non-UK ownership was the more important driver is pushing the share price down. As we all know, market hates and punishes uncertainty very punitively.

From an operational perspective, I was very happy with the progress that DTG is making for couple of reasons:

  • The capex numbers confirmed a previous assumption that DTG has ~50% discount on the listing price of the new Boeing 737-800s
  • Revenue growth in winter season continued which is critical as the newer fleet would have to be justified by better utilization rate all year round
  • Advanced revenue jumped 40% YoY which is STRONG indicator of the success of the new bases – Stansted and Birmingham
  • Net debt was very much under control helped by the cash flow generated by negative working capital with growth

The main reason for softer EBIT margin was due to one-off costs and cost ramp up in new airports (Stansted and Birmingham) i.e. the cost was incurred before the revenue came in.

When we decided to invest in DTG in Oct 2016, the biggest risk was that Brexit would lead to a sharp drop in demand for oversea package holidays which would be disastrous for DTG as it was taking on debt to purchase new aircraft. Increasing capacity through debt when demand is about to decline is a recipe for massive value destruction as witnessed in many of the commodity companies.

However the strong advanced sales and the revenue growth in FY17 indicated that the demand for package holiday in the UK has not been affected by the weaker Sterling post Brexit. This corroborates the UK holiday data released by ONS in May 2017. The strong growth in advanced sales is an important signal because it implies that people are booking their summer holidays as usual. In fact the strong demand for FY 2017 summer is particularly encouraging because Britons would have fully digested the impacts of Brexit and still decided to spend on holiday in the subsequent year.

The implication of the above point is that our worst-case scenario is increasingly unlikely to happen and as such the downside risk of an investment in DTG is diminishing. Operationally, the range of outcomes for DTG in the next 2 years is heavily skewed to the base and bull case. (Base case assumed growth associated opening 2 new bases and no growth afterwards and bull case assumes that there is still 5% organic growth in topline after the new bases are up and running at steady state)

Going forward, I think the value of DTG is driven by the following factors:

  1. Normalized run-rate FCF in base case in GBP 120 – 140m which implies an FCF yield of 17% based on the share price today
  2. Pay down of debt will lead to appreciation of equity value
  3. Given a mix of old and new aircraft in the fleet today, DTG can choose to retire old planes more quickly depending on the demand conditions. Full credit to TC for his insight on this point
  4. Multiple expansion as the company proves its success with the new bases and lower leverage in the steady state environment

As such I have added and will continue to add to my DTG position if the price goes down further in the absence of new information.

On the non-UK ownership point, the context is such that both EU and UK requires their airlines to be majority owned by EU or UK nationals. Before Brexit, UK airlines just have to comply with the EU regulations. Post Brexit, UK airlines have to ensure that the company is majority UK owned to maintain its operating license. DTG is proposing to add a new clause to the article of association to force any non-UK shareholders to sell his/her shares. Ryanair and Easyjet already have this clause in their article of association. The worst case is that we are forced to sell when the share price is very low as we are not UK nationals.

Firstly, DTG noted in its announcement that they believe currently non-UK shareholders make up less than 35% of the shareholder base. DTG is 40% owned by its founder, Philip Meeson who is a UK national. Secondly, the company will try its best to avoid activating such clause unless absolutely required. Thirdly, we still dont know how the Brexit negotiation will play out on this issue – maybe it is favorable maybe it is not.

So there is a good chance that this clause is not required. But the important question is if the company decided to trigger this clause how are they going to decide which shareholders to force sell. I.e. if there are 40% non-UK shareholders and DTG wants to bring that down to 35%. How do they choose which 5% of the non-UK shareholder base to force sell?

The company did not comment on this. But we decided to look at Ryanair and Easyjet for inspiration. It turns out that it depends on the chronological order at which non-UK shareholders register their shares with the company. For example, if you are the first non-UK shareholder to register with the company then you are the last one to be forced to sell. And they will first force sell the shareholders who have not registered with the company. So this gave me great comfort that as long as I register my shares with DTG asap, I should be okay.

So I am comfortable with the two issues and continue to hold the DTG shares. Of course I change my mind when the facts change to quote John Maynard Keynes.

MC

Grocery Retailing – History & Future

I would like to use this post to document my thoughts on grocery retailing based on books I have read, conversations with investors in grocery retailing industry and studying historical developments. In writing this blog, I was most inspired by the following books:

  1. Sam Walton: Made in America
  2. The Everything Store (See this great book’s review by my dear Belgian partner)
  3. Alibaba: The House that Jack Ma built
  4. The Story of Mass Marketing in America
  5. The Grocers: The Rise of Supermarket Chains

I believe that the “wheel of retailing” is bringing us into a new generation of grocery retailing. I hope that by reviewing the long run history of the grocery industry, I can draw useful (and right) lessons to better understand the grocery retailing industry today.

The term “wheel of retailing” was first coined by Malcom P. McNair in 1958 to describe:

The cycle frequently begins with the bold new concept, the innovation. Somebody gets a bright new idea…… Such an innovator has an idea for a new kind of distributive enterprise. At the outset he is in bad odor, ridiculed, scorned, condemned as “illegitimate”. Bankers and investors are leery of him. But he attracts the public on the basis of price appeal made possible by the low operating costs inherent in his innovation. As he goes along he trades up, improve the quality of his merchandise, improves the appearance and standing of his stores, attains greater respectability. Then if he is successful comes the period of growth, the period when he is taking business away from the established distribution channels that have clung to the old methods…. The department stores took it away from the smaller merchants in the cities in the late 19th century and early 20th century; the original grocery chains took it away from the old wholesaler-small retailer combination, the supermarket then began taking it away from original grocery chains to the extent that the latter had to climb on the supermarket bandwagon. And today the discount houses and the supermarkets are taking it away from the department stores and variety chains.

Then the institutions enters the stage of maturity. It has larger physical plant, more elaborate store fixtures and its operating costs tend to rise…. The maturity phase soon tends to be followed by top-heaviness, too great conservatism, a decline in the rate of return on investment and, eventual vulnerability. Vulnerability to what? Vulnerability to the next fellow who has a bright idea and who starts his business on a low-cost basis, slipping in under the umbrella that the old-line institutions have hoisted.

While McNair’s original wheel of retailing idea relied more on incumbents trading up and allowing the operation to become less efficient and hence less able to provide value to its customers. My personal view is that the wheel of retailing is primarily driven by the emergence of a new format and/or innovation in retailing that is structurally more efficient than the previous one. History has shown that, for a variety of reasons, new entrants seems better suited to take advantage of new innovation and that incumbents, due to fear of self-cannibalization and institutional imperatives, are less likely to adopt the new innovation. (The Innovator’s Dilemma provides a good explanation of this phenomenon)

A word of caution – One of the most dangerous thing in investing is to draw the wrong lessons from history and application of wrong lessons into the future is hazardous to investor return! Hence I am always open to feedback, critique and new ideas. So please leave any comments/thoughts you might have.

The basics of grocery retailing

  1. Grocery retailing is, at its essence, a distribution business
    • Retailers buys goods from producers such as farmers, branded food manufacturers and then sell to consumers. The difference between the purchase price from producers and sales price to consumers is the gross profit earned by the grocery retailers like Walmart. Consistent with most distribution business, grocery retailers have a low gross margin typically around 20% depending on inventory accounting method and local competitive environment
  2. Grocery retailing is a negative working capital business because it takes goods from producers on credit whilst selling to consumers for immediate cash
    • Negative working capital business is highly desirable because as the business grows, the growth in sales itself generates cash flow from working capital which can be used to finance further growth
  3. Efficient operation & logistics is key to long term profitability and competitive positioning
    • Most supermarket chains / grocery retailers operates around 1 – 5% EBIT margin. Given the razor thin margin and inherently high operating leverage, efficiency is the necessary but insufficient condition to success in grocery retailing
    • E.g. Wal-mart, a best-in-class operator historically has been able to operate around 4-6% EBIT margin
  4. Grocery retailing is largely a commodity that largely (not fully) compete on price and winner provides lowest all-in-cost of grocery shopping
    • It is a commodity because if two adjacent supermarkets sell the same Coke, the only differentiation is price – price competition
    • All-in-cost of grocery shopping includes the sales price of groceries, time and associated travel cost
    • The best grocery retailer is one who can provide the lowest all-in-cost of grocery shopping i.e. a combination of low price and highest convenience of purchase
      • E.g. a grocer with normal price level + high convenience of purchase can trump a grocer with slight lower price level but very low convenience of purchase
    • This point is very relevant because changes in the components of the all-in-cost of grocery shopping have been driving industry-wide transformation
      • James Sinegal, founder of Costco, describes his business in the following manner:
      • My approach has always been that value trumps everything. The reason people are prepared to come to our strange places to shop is that we have value. We deliver on that value constantly. There are no annuities in this business – James Sinegal, Costco

      • The interesting thing to note here is the notion of “strange places” which means that customers are willing to travel to remote location to buy the same things that they might be able to buy in their neighborhood. They are only doing that because the price reduction in Costco exceeds the travel cost and extra time incurred – lowered all-in-cost!
      • Costco model would not be possible before the era of mass car ownership and well-developed public roadwork because the reduction in sales price is not enough to offset the exorbitant travel cost. (More on this later)
  5. Grocery retail is mostly considered a chore and not enjoyed by most people
    • Most people do not enjoy grocery shopping, especially young parents, and hence would prefer to spend as little time on it as possible
    • Costco is one exception to this “rule” where they managed to create a treasure hunt like shopping experience
  6. The complex logistics surrounding grocery retail does not naturally lend itself very well to the online channel
    • Perishable fresh food dictates time sensitive which means highly efficient transport and multi-temperature range storage facility. Perishable food also means that stocking a large amount of inventory without immediate large-scale sales channel can be very costly
    • But important to note that if grocer with right technology can kick off the new “wheel of  retailing” with online grocery, it is a potent secular force to be reckon with by all industry participants (more on this later)

Historical observations of grocery retail industry

I will focus on US grocery market because it is very representative of the general industry trend globally. As an investor, it is important to study the long run history to appreciate the full context of the industry development.

In my view, the US grocery retailing market is broadly divided into four phases of development. I will specifically look at the history of two companies – America’s Pantries (A&P) and Walmart – to better understand the industry’ transformation over time.

Phase 1 – Independent Retailers before 1900s

Phase 2 – The Chain Store Revolution between 1920s – 1930s

Phase 3 – The Supermarket Domination between 1930s – 2000s

Phase 4 – Rise of e-commerce from 2000s – present

Phase 1 – Independent Retailers before 1900s

In Phase 1, the independent retailers are typically small shops that serve the local community. These stores sold goods such as tea, flour, sugar, liquor, axes and spices. Gerald Carson, in The Old Country Store, described these 19th century stores in beautiful details.

“A great deal of time was wasted in looking for articles that were not in place or had no place…flies swarmed around the molasses barrel and there was never a mosquito bar to keep them off. There was tea in chests, packed in lead foil and straw matting with strange markings; rice and coffee spilling out on the floor where a bag showed a rent; rum and brandy; harness and whale oil. The air was thick with an all-embracing odor, an aroma composed of dry herbs and wet dogs, or strong tobacco, green hides and raw humanity”

Grocery retailers in Phase 1 heavily reliant on a complex network of wholesalers to supply the goods to them. Retailers sold mostly goods that they can get access to rather than the goods that their customers want. There is no direct link between food producers and retailers. Many store owners also go on shopping trips to New York to stock up on the latest wares. Otherwise they relied on travelling salesman, middlemen and jobbers. It is a rather inefficient system.

Phase 1 retailers typically have very low turnover and are correspondingly compensated by high margins. This feature is defined by the social demographics of the era. A largely rural population and high cost of travel ensured that many families are self-sufficient and visit the grocery stores very infrequently.

Surprisingly, grocery stores in Phase 1 exhibit high level of service. Purchase made using credit is an ubiquitous feature. Many urban stores also install telephone and offer delivery service (and we think that grocery delivery is a modern concept). By the end of 19th century, many retailers began to offer trading stamps (discount coupons) to encourage customers to pay by cash. Customers who collect the trading stamps can later exchange the stamps for a sizable reward. Groceries did not have clear price tags, and customers did not directly pick out the goods themselves. Customers were serviced by the storekeeper who stood behind the sales desk.

In summary, Phase 1 grocery retailing have the following characteristics:

  • High margin, low turnover and low sale volume – higher sales price
  • No direct relationship with suppliers and instead depended heavily on a complex network of wholesalers, middleman and jobbers
  • High level of service such as credit, telephone orders, trading stamps, and making deliveries
  • High degree of specialization by product line – meat shop, coffee shop and vegetable shop
  • Goods and groceries are undifferentiated commodities and hence compete purely on price (no national brands)

Phase 2 – The Chain Store Revolution between 1920s – 1930s

Through chain ownership and management of retail outlets and the backward integration, a “revolution in distribution” was in full swing by the 1920s. The centrally organised and managed chain store system is far more efficient when compared to the independent grocery stores. In the next decade, chain stores relentlessly replaced the independent stores.

American & Pantries (A&P)’s beginning as a mass retail winner

American & Pantries (A&P) was at the forefront of the chain store revolution and it later went on to become the unquestionable retailing giant of its time. A&P’s early success came in 1860s when it sold tea through direct-mail distribution method. Local communities would pool their demand for tea together and send the tea orders to A&P. I suspect this was only possible because the transport cost was lowered by the already advanced railway system. A&P’s tea offered up to a third discount from the price of the independent grocers.

A&P’s choice to launch its direct-mail business with tea is worth further examination. By the standard practice of that time, tea was priced relatively high to subsidize competitively priced commodities such as sugar, salt and flour. US in the 19th century was a rural nation that grow much of its own food if store price escalated but tea was a specialty product for which this was not an option.

Average grocers depended on tea to generate big chunk of its profit but consumers wanted to buy more tea at a lower price. A&P concluded it could make profit through increased volume on tea.

Over time A&P extended into other product categories such as baking powder, spices and extracts. By 1900, A&P operated couple of traditional physical stores and had sales of USD 5.6m with a profit of USD 125k. These physical stores were operated like any other independent stores where it extensively used trading stamps, provided credit and offered telephone orders and delivery service. However by this time, A&P already began to source goods directly from producers and bypassing the wholesalers.

The Economy Store

A&P started the Chain Store Revolution in 1913 when it introduced the Economy Store. The new store format is as follows:

“In our so-called “Economy Stores”, we do not make any deliveries, we have no telephone communication, we close the store when managers go to lunch, we sell strictly for cash, we give no premiums, trading stamps or other inducements. In our regular stores we do give trading stamps, we do make deliveries, we have telephones, in some instances give credit……”

 While the Economy Store format was not unique to A&P, they wholeheartedly believed in its inherent efficiency and pushed this format harder than any other retailer.  I suspect A&P’s conviction in the Economy Store was a reflection of John A. Hartford’s vision to sell quality food at low prices. John Hartford was the second generation owner-operator of A&P. He declared that:

“I have always been a volume man and unless we can operate in the future along economy lines, I do not believe I can put my heart in the business”

The new format lowered the operating cost and part of the operational savings were passed along to customers. (Indeed sharing cost saving with customers has always been part of the wining formula in retail) A&P expanded rapidly to take full advantage of the new format. These Economy Stores have very similar store design. Richard Tedlow detailed A&P’s expansion in The Story of Mass Marketing in America:

“Having established its new formula, A&P embarked on a policy of saturating its major markets by opening stores at a rate that was unprecedented in the history of American retailing. From 1914 to 1916, George and John Hartford opened 7,500 stores, and closed over half of them to weed out the weakest.”

A&P, the pioneer of Chain Store Revolution, emerged as the clear winner with a sales of ~USD 1bn in 1929 which was greater than Sears, Ward and Penney combined. Its profit went up ~7x from USD 4.8m to USD 35m between 1920 to 1930. The table below documents A&P’s extraordinary rise as Phase 2 retail winner.

A&P Financials

A&P launched the chain store revolution that brought the industry from a high margin / low turnover model to one of low margin and high turnover. Other national chains such as Krogers, American Stores Co., Safeway and First National Stores all adopted the chain store model at varying pace. As a group market share of large chains went from 4.2% in 1919 to 27.6% in 1930 according to A. C. Hoffman.

Why was chain store so successful?

A. Chain stores offered lower price v.s. independent grocers

There was abundant evidence to show that chain stores offered lower price than independent stores.  Based on the range of studies done below, chain stores’ price are cheaper by ~3% – 11%. As mentioned above, grocery is largely a commodity and coupled with low switching cost (assuming switching to a nearby competitor’s store involve minimal cost) means that customers flock to the store with lowest cost.

Price Comparison - Part 1

Price Comparison - Part 2

Source: The Story of Mass Marketing in America

It is important to note that chain stores were MORE PROFITABLE WHILE OFFERING LOWER PRICE.

The national grocers were highly profitable in the 1920s. The rate of return for A&P was in excess of 20% in the 1920s. The other four national grocers recorded 17% return on investment in 1928 while A&P achieved 26% in that same year. By comparison, average rate of return on investment for all US corporation that year was 14.8%. It is fair to say that independent stores were probably under performing the average US corporation.

This leads to the next logical question – what is the source of chain store’s ability to offer lower price while earning high profit?

B. Chain store’s source of competitive advantage

In my humble view, I believed that chain store’s ability to participate in ruthless price competition was due to structural operational efficiency. The operational efficiency gains were passed on as price cuts which allowed companies like A&P to offer structurally lower price and enjoy higher profit margin at the same time.

In Phase 2, grocery retailers’ operational efficiency came from:

1. Centralized and direct supply chain

  • Cost savings by cutting out the value leakage to traditional network of wholesalers
  • One could argue that a centralized direct supply chain is inherently more efficient by reducing the number of distribution points between the producer and customer. The diagram below illustrates this mechanics for the flow of fruits and vegetables in New York Metropolitan Area Markets in 1936.
    • As illustrated by the diagram, the goods that did not went through the wholesale market had reduced mileage, lower charges for loading, storage, order processing; and most importantly avoided the profit earned by the wholesalers
  • Integrated retail and wholesale system also meant that there was better co-ordination in terms of inventory management
    • For example, suppose a customer entered a small independent grocery store in 1930 and asked for goat cheese. The grocer probably did not keep goat cheese in stock and would have had to order it from wholesaler. If the wholesaler also did not carry the item, he would have to order it from a producer. Now the wholesaler would face the dilemma of either ordering a carload of goat cheese and risk not being able to sell more than one order or not satisfying his customer and lose future business. The wholesaler simply is not close enough to the consumers to size demand except directly through his customers, the independent retailers. In an integrated supply chain, like the one from A&P, the wholesaling department in A&P receiving weekly orders from its vast network of chain shops would be able to better size the demand and hence better inventory management
  • By comparing the chain store turnover with the retail + wholesale turnover leads to interesting analysis:
    • Chain store system has an annual turnover of 10x
      • Implying that it took 36.5 days to move groceries from producer to final consumer for chain stores
    • Independent retail stores have a turnover of 11.75x and the wholesaler has a turnover of 5.35x. The retail+wholesaler model has a collective turnover of 3.68x
      • Implying that it took 99.28 days to move groceries from producer to final consumer for retail+wholesale channel
Wholesale Network Diagram

Flow of Fruits and Vegetables in New York Metropolitan Area Markets, 1936

2. Dramatically reduced services offered at store level

  • Offering credit was a very costly activity for grocers as credit assessment done on an individual consumer level was not the grocers’ core competence. Grocers are in the distribution business; and not in consumer credit business
  • Various academics estimated that offering credit and making deliveries accounted for ~3%-4% of the sales of the independent grocers offering them in 1924 (Source: Malcolm P. McNair, Expenses and Profit in the Chain Grocery Business in 1929)
  • Naturally this is very high for a business that is earning low single digit net profit margin

3. Organisation efficiency through job specialization

  • Independent store keepers would have to everything by himself from buying goods, stock keeping, sales and accounting
  • Organised chain store was more efficient in terms of backward integration with dedicated real estate management team, finance support, logistics and supply chain infrastructure

It is important to point out one popular misconception about chain store’s ability to compete at lower price. came primarily from lower purchase price due to national grocery chain’s ability to negotiate lower price from suppliers. Federal Trade Commission data showed that approximately 15% of the chain’s price advantage resulted from lower purchase cost but the remainder (which is the bulk of the price advantage) must be attributed to lower gross margins and operating expenses. After the chains attained scale, it did help them to lower purchase price but it is not core to the chains’ ability to price compete.

Transition from Phase 1 to Phase 2 grocery retailing

Grocery retail moved from a high margin and low turnover business to one of low margin and high turnover. It was during this transition that early structure of modern distribution infrastructure took place and that grocery retailing became a negative working capital business as chains only accept immediate cash payment instead of credit. This grand scale industrialization of the distribution business lay the foundation for the industry’s next transformation.

In Phase 2 retailing, grocery stores stopped making food deliveries and offering credit to customers. Another way to look at it is that grocers in 19th century were not efficient in making deliveries and the resultant excessive operating cost was reflected in the higher grocery price. Hence it was better off for the customer to pick up grocery in-store themselves and enjoy the lower grocery price. The reduction in grocery price was more than enough to offset the customers’ travel cost such that all-in-cost of grocery shopping is lowered.

Grocers are not good at making credit decisions and consumers who want to purchase groceries on credit should get a consumer loan from financial institutions that specialize in making credit decision.

Phase 3 – The Supermarket Domination between 1930s – 2000s

In 1930, Michael J. Cullen wrote a letter to the president of Krogers to propose a new store format that is later known as supermarket. Needless to say, his proposal was ignored and of course Mr Cullen would decide to strike off on his own.

The keystone of Cullen’s strategy is low price:

When I come out with a two-page ad and advertise 300 items at cost and 200 items at practically cost, which would probably be all the advertising that I would ever have to do, the public, regardless of their present feeling towards chain stores, because in reality I would not be a chain store, would break my front doors down to get in. It would be a riot. I would have to call out the police and let the public in so many at a time – Michael Cullen letter to Kroger president in 1930

Cullen’s proposed store would have:

  1. Larger than traditional chain stores (5200 – 6400 sqft v.s. 1200 – 1500 sqft)
  2. Cash only (Some chain stores still accepted credit)
  3. Self -service (chain store would still have a clerk that sells to customers whereas in supermarket customers would pick out his/her own goods)
  4. Huge parking space which reflected the rise of the automobile era
  5. Out-of-town locations – cheap rent
  6. Almost 100% nationally branded merchandise

Below is a comparative review of the two store formats:

Chain Store v.s. Supermarket

Note that while Cullen’s supermarket format sacrificed 10% gross margin but the format was robust enough to be more profitable on the bottom line – a whopping 2.5%!

Supermarket beat chain stores at its own game because supermarket’s model was able to provide even lower price and higher turnover. I believe supermarket’s superiority in operational efficiency came from:

  1. Out-of-town locations – cheaper rent. The rise of automobile in the States dramatically lowered the travelling cost for the public. “Strange locations” became accessible for the public.
  2. Larger store format means larger sales volume – the fixed cost associated with operating a store does not scale up proportionately with store size. Hence by utilizing a larger store format, one can spread the fixed cost over a larger volume – economies of scale
  3. Self-service – self-service allowed the store to handle large increase in customer volume without corresponding need to increase workforce which means savings on labor cost

Supermarkets also largely stocked nationally branded merchandise. The chain stores, like A&P, had a large private label merchandise at the time. The food manufacturers wanted to capture more value through brand. Supermarkets as the emerging competitors were largely willing to let the manufacturers to do the selling / marketing for them. And the food manufacturers were more than happy to comply. Interesting that the industry came back full circle with private labels coming back with full force through Aldi and Lidl today.

While rise of national brands were important to the supermarket era, the dominant force was the popularity of automobile. It fundamentally changed the travel cost and hence the composition of all-in-cost of shopping.

A&P in the supermarket era

Like most successful company facing a sudden industry disruption, A&P – the industry leader – initially adopted a head-in-the-sand attitude and called the supermarket revolution – “an imagination of disaster”.

However, it did not take long for John Hartford, the company patriarch, to realize that indeed the new format is the store of the future because it is able to deliver better value for its customers and yet remain more profitable. John Hartford always believed that 2 pounds of butter at 1 cent was a better business than 1 pound at 2 cents. He held on to the idea of providing the best value to his customers – lowest price in the market.

After years of experimenting, A&P began a remarkable transformation that saw a massive closure of small chain stores in city center and opening of large supermarket in out-of-town locations. Between 1935 and 1941, the number of stores more than halved from 15k stores to 6k stores while sales per store more than tripled from USD 22k to USD 60k. John Hartford understood the supremacy of low price in the grocery retail space. He acted with more urgency compared to other national chains of the time. But the transformation was not easy – he remarked that “it is easy to build up a complicated and expensive structure, but very difficult to adjust and reduce it to the demands of time and conditions.”

However, the industry giant slipped slowly into oblivion after the 1950s when the founders of the business, John and George Hartford passed away. Successive professional management under invested and mismanaged the business. As the industry moved to even larger stores, more nationally branded merchandising program and expanded into non-food categories, A&P stuck to its private label program due its existing heavy manufacturing infrastructure.  Finally a West German company bought A&P in 1979.

The wheel of retailing in the supermarket era

A succession of rise and fall of retailers, such as Kmart, was predictably based on the premises that the operator with the lowest price wins. Variants of the supermarket format was experimented to varying degree of success. For example in one model, supermarket was used as a traffic builder and the real profit was made through concessions such as radio supplies, auto parts and general hardware.

In my personal view, the general structure of supermarket format remained unchanged. I would carefully conclude that between 1940s and 1960s, no retailers developed sustainable competitive advantage and hence it was more a question of management quality and execution. However this changed with the arrival of the next retail giant – Walmart.

Walmart – the ruthlessly efficient retail operator

Sam Walton, an incredibly driven retailer, started Walmart in Bentonville in 1950. Walmart’s early expansion strategy focused on small towns with less than 10,000 people which no large national discounters were going after. For example, Kmart would not expand to towns with less than 50,000 and Gibsons would not go much smaller than 10-12k people. In Sam’s autobiography, he explained that this strategy of focusing on small town was not after careful assessment of the market dynamics. Rather it was because Sam’s wife, Helen, did not want to live in towns with more than 10,000 people. Or more practically, Walmart could not afford to compete with giants like Kmart in larger cities.

Walmart’s saturation strategy of expanding concentrically from a geographic perspective was critical to lowering the distribution cost. High local store density lead to distribution efficiency Walmart expanded by filling out the areas that is within one day’s driving range from its distribution centers i.e. it would establish local monopoly before expanding out to new geographies. The operational efficiency from distribution was subsequently shared with customers which lead to ,wait for it, lower prices. And this structural advantage allowed Walmart to become more profitable despite selling goods at a lower price versus competitors.

Walmart kicked off its own wheel of retailing and Walmart in the 1980s was a period of relentless growth and value creation. The negative working capital and winner-take-all nature of the business accelerated the rise of Walmart. Similar to other retail giants before Walmart, it grew with the market but also ruthlessly stole market share from its competitors.

Again the formula here is the same as before:

  • Walmart obtained a structural operational efficiency which allowed Walmart to price lower than its competitors
  • Cost savings is shared with customers in the form of lower price
  • Growth itself accelerated more growth due to negative working capital and negotiation power bestowed by scale
  • Walmart’s source of operational efficiency, superior distribution efficiency due to local sales density, does not diminish with scale (but its source of efficiency also does not increase with scale) – as it expanded concentrically
  • This continued to ensure reasonably high return on incremental investment on opening new stores

Here is an interesting infographic showing how Walmart expanded geographically.

Summary of Phase 3 retailing:

  • The transition from phase 2 to 3 was driven very fundamental changes to the society in the US notably mass ownership of automobile and penetration of mass media such as TV and radio
  • The new supermarket format allowed for even lower prices than chain stores due to its structural superiority such as lower labor cost per unit of sales and higher turnover due to larger store format
  • Walmart was the clear market leader in this era as it has a structurally lower distribution cost versus its peers which allowed it to consistently price lower while generate higher operational margins

Phase 4 – Rise of e-commerce from 2000s – present

As we finally enter the 21st century, a completely new format of retailing – e-commerce is kicking off the wheel of retailing again. With the advent of Internet, a website can host unlimited SKUs to consumers. E-commerce operators can save on operating physical stores and consumers can save time by not having to travel. However e-commerce operators need to run a highly efficient and sophisticated delivery infrastructure.

Amazon has proven that for many retail categories, such as books, electronics and household goods, online retailing is a winning proposition as it effectively able to lower retail prices and provide convenience to the customer at the same time. However, the grocery retailing, especially involving fresh food, has been more resilient to online retailing because the logistics is much harder to achieve for the following reasons:

  1. Fresh food has limited shelf life and place demanding requirements on storage conditions – ambient / cold / frozen environments
  2. Picking of groceries is much harder versus traditional merchandise like books because:
    • The order of putting goods into the bad matters (eggs cannot be below watermelon)
    • Picking of groceries is much more labor intensive as fresh food require much more sensitive handling
    • Groceries are less commodity-like for example no two apples / tomatoes are exactly the same
  3. Grocery suppliers tend to be local in nature and hence difficult for online retailers to establish scale shortly

The economics associated with all-in-cost of shopping becomes as follow:

Can the e-commerce operators deliver lower all-in-cost of shopping by saving on the operational expenses associated with traditional physical stores (such as rent and labor costs) while not spending as much on delivery of goods to consumers?

One has to gain an understanding if the online grocery retailing method is structurally more efficient than the traditional brick & mortar ones. To understand that I looked back at the historical development of the distribution system:

Distribution Network

I would think that there is one clear trend from the diagram above – as the distribution infrastructure becomes more efficient, there is less inter-mediation between producers and consumers. For example, the transition from Phase 1 to Phase 2 saw the elimination of wholesalers and middleman and rise of centralized distribution network. In the supermarket era, the back-end integration of supply chain with food manufacturers leads to further removal of friction in the distribution process by bettering improving the flow of information from consumers to the suppliers.

Online grocery retailing promises to continue to simplify the distribution processes by reducing the contact points between consumers and suppliers. As shown in the diagram above in an online retailing model, goods move from warehouse / fulfillment centers to households directly as opposed to the stores and then to the consumers.

However, it is not at all 100% clear that online retailing is more efficient. Below I lay out the cost components associated with online retailing:

Grocery retailing cost components

As per the diagram above, online grocery retailing can save on rent and labors costs but have to figure out how fulfill and deliver orders to customers efficiently. One key point to note is that if the online grocer is able to deliver a basket of goods at the same price as its traditional competitor after accounting for the delivery cost, then online grocer has the lower all-in-cost of shopping because of the convenience of not having to visit a physical store.

If we assume that online retailers can take advantage of technology to solve the picking & delivery (robotics / better picking algorithm / automated delivery van), then it is almost a certainty that online grocers can offer the most competitive grocery pricing through its efficiency in distribution. The next question becomes can online grocers over time develop better technologies to increase automation of picking and delivering such that unit cost associated with per item of sales is reduced. If we look at some of the recent technologies below, the evidence points to a resounding yes. The question then becomes when would online grocery retailing become dominant rather than if.

See examples of cutting-edge technology below:

Given that online retailing model has very high initial capital and fixed cost structure, the unit cost would decrease quickly with scale. Hence I find the arguments that current model of online grocery retailing is not sustainable because of the higher unit cost to be unsatisfying. However there are start-up online grocery business in India and China that rely solely on cheap labor to conduct delivery. I find that model to be inherently unsustainable and not scalable.

Online grocery business that is based on technological advances i.e. an inherently more efficient distribution model, to be very sustainable even if the unit cost is still relatively high as it would decrease with scale.

One should also note that brick & mortar grocers attempting to rely on its network of stores for online delivery while might be rewarding in the short run but reduces motivation to invest to build a technology-based online retailing system.

I am not predicting the doom of all brick & mortar grocers. I am predicting the rise of online grocery retailing. That is different because Walmart can still develop its own online grocery system. And it is likely that we would see an omni channel way of grocery retailing. But the share of online grocery retailing is bound to rise. Retailers ignore this trend at its own perils.

The wheel of retailing is spinning to the favor of online retailing which is proving to be a structurally more efficient method of distribution. History has taught us that new organisations are better adapted to implement the new retailing innovations. It is possible for the old guards to change; the odds are just not in their favor.

 

Final thoughts – what it all means for investor today

As each new generation of retailers found a new way to provide customers with the best value, i.e. lowest all-in cost, the winner of the new generation of retailer will experience a long period of growth at the expense of the less efficient retailers. There are structural factors that lead to the “flywheel effect” experienced by the most efficient retailer:

  1. Price competition + low switching cost + commodity nature of grocery retailing = Customers will flock to the retailer that offers the lowest price
  2. Negative working capital = growth itself can bring about cash flow that can be re-invested for even more growth – Self-financing of growth
  3. Scale does not itself constitute competitive advantage but it will reinforce the current competitive advantage enjoyed by the winning retailer (Wal-mart & Costco in 1990s & Amazon today)
    • For example, Wal-mart adopted a saturation strategy and expanded by filling out the areas that is within one day’s driving range from its distribution centers i.e. it would establish local monopoly before expanding out to new geographies
    • The cost-savings from the operational efficiency of this strategy was used to reinforce Walmart’s low price strategy
    • This then in turn helps to attract even more customers and as Walmart gains scale, it is able to exert more discount from suppliers and spread the high fixed of its distribution network over a larger revenue base
    • In this way, scale reinforces Walmart’s competitive advantage as it establishes local monopolies through the saturation strategy. But scale itself is not the source of Walmart’s core competitive advantage
  4. Grocery retailing is one of the largest market in any country that allows for long growth runway

The concept of “wheel of retailing”

The wheel of retailing works because grocery retail is mostly price competition and there is little switching cost. The retail market is huge and allows for a long growth runway as the new retail format grows by replacing the older format. From an investor’s perspective, riding on the “wheel of retailing” can be extremely profitable and to some extent very predictable after initial signs of the wheel began to appear.

Stage 1 – Kick starting the wheel

  • A new retail format which can be a new store format /or a more efficient distribution system that have inherent operational efficiency that allows for cost savings to be achieved
  • Cost savings is shared with customer through lower purchase price

Stage 2 – Accelerating wheel

  • Standard corollary benefits of scale start to kick in due to
    • Negative working capital – growth itself produces more free cash flow which can fund further growth
    • Negotiation power with suppliers increase with scale
  • Operational efficiency’s relationship with scale
    • Depending on the source of the low price, the new retail format’s efficiency may or may not increase with scale
    • For example, A&P’s chain store format did not eek out much more efficiency with scale because incremental profit margin from incremental growth is flat or diminishing. As further growth primarily came from opening new stores which more or less have the same operating margin
    • However incremental profit margin being flat does not mean growth is not profitable. It just means rate of return on capital is flat but it can be flat at a very high rate
  • Continuous sharing of cost savings

Stage 3 – Sputtering of the wheel

  • Organisation inefficiencies associated with large companies began to outweigh further efficiency gain from growth
    • Management complacency
    • Lack of vision
    • Unwillingness to self-cannibalize
  • More critically is the inability to adapt to the new retail format

Finally, with great circumspection, I will offer a few signs to look for in the next long retail winner (Amazon is an obvious one).

  1. A source of structural operational efficiency
  2. Ability to grow organically through existing operational cash flow
  3. Huge reinvestment in the business to fuel further profitable growth
  4. Willingness to share operational efficiency through lowering price for consumers
  5. A track record that its current retail model is well-received by the consumers
  6. Continued improvement in operational efficiency with scale (lowering unit cost with scale)
  7. Preferably founder driven company
  8. Strong culture of delivering superior value to customers

MC

Newer posts »

© 2020 Pembridgecap

Theme by Anders NorenUp ↑