Pembridgecap

A Wealth Creation Journal

Category: Business (page 1 of 2)

Thoughts on great shopping malls

Given the threat of e-commerce making inroads on convenience/time-spend of shopping (innovations such as augmented reality improve online shopping experience further), what makes a shopping mall’s future relatively bright?

On some counts, offline has advantages, on the other hand there’s weak points that need to be minimized. I make a distinction on this basis and call them “pulls to offline” and “lack of push to online”.

Pulls to offline

  • Having a “great experience”
    • Beautiful and clean mall
    • Meeting friends
    • “M’as tu vu” (requires mall to be frequented by many shoppers, ideally local)
    • Day trip allure of a mall: a whole family can enjoy a day off in one place
  • For buying apparel: human advice
    • In-store advice and advice from friends. As online is making in-roads on human advice, I believe friends’ advice is more of a selling point

Lack of push to online

As buying online is efficient w.r.t time spent, this is a weak point for some offline shop. Mitigators:

  1. Easy-to-reach
    • great location close to population with disposable income: an outlet might be a pain to reach in the middle of nowhere versus a shopping centre next to a train/tube station, or simply on the way for tourists walking by
    • population density in the neighbourhood (think city centres)
  2. Access to multiple shops at once
    • Large shopping malls offer time-efficient access to many shops
    • High occupancy rate is a win for consumers as well in this respect
  3. Access to non-shopping stores that consumers need to visit anyway
    • Mall with gyms/restaurants/grocery/barbers
      • the sunk cost of getting to these places near other stores might even make shopping before/after more time-efficient than online shopping. These places might be the next shopping mall “anchors

The points in green are arguments for large shopping malls with many tenants from diverse categories such as gyms that cannot be done online.

If some shopping malls are indeed able to offer a “great experience”, this might even pull more footfall to these outfits over time as leisure time rises around the world.

The best shopping malls are aggregators of great brands for the best consumers. As such, there are some winner-take-all dynamics at play in this weak two-sided network (weak because the network is very local, but luxury brands and shoppers compound the network effect through increased possibility of building long-term relationship).

On property management

Best property managements are therefore long-term thinkers: willing to invest in renovations / repurposing to keep footfall and tenant quality high. For example, buying back shares at 8% current yield might optically look better than making a 7% ROI renovation, while the renovation can avoid atrophy in the type of customers, tenant base indirectly for years ahead.

It seems that the number of retail shops will certainly grow slower versus the growth in retail sales as the weaker brick-and-mortar links get shut out. The highest quality shopping malls meanwhile will still see a change in tenant base as tenants with products that are great to sell online disappear (uniform products with long-tail offerings such as books, films). Experience in managing tenant base is another important treat.

Brand advertising

Some companies such as Apple (Stratechery, Scott Galloway podcast), BMW use beautiful retail stores to raise brand awareness and customer experience. Some other functions that these stores serve besides selling products:

  • advertise brand (a superior physical impression is superior to an ad on a screen; what is in particular interesting is that the human brain better memorizes physical as opposed to digital impressions example 1, example 2). The superior physical interior, product design, aroma can convince the consumer that Louis Vuitton is for example superior to Zara in a way that digital ads cannot.
  • high-end product feature awareness, customer education
  • Genius bars in themselves are a point of differentiation as competitors do not offer this service

In short, these stores are but one piece in a consumer’s product experience. In Apple’s case, an iPhone is not only hardware, but also software (iOS) and experiences such as customer support and trying out new launches of features in Apple stores, underlying again how experience is becoming more important for shopping centres.

Conclusion

The economics of growing sales for brands is permanently changed because of a growing online sales share. Whereas in the past brands grew by growing quantity of offline presence because of the fixed link with sales, today, brands will want to occupy the best offline spots and rather not want to be associated with inferior malls. A “flight to quality” malls seems plausible.

To remain competitive, shopping malls have to pull consumers through strengths and avoid a push to online by remaining competitive on the strong counts of online (convenience, price). Multiple factors require malls to be

  1. In the vicinity of high-density affluent population or transport anchors (metro, train, highway) (time-saver, social aspect)
  2. Beautiful and well-kept (experience)
  3. Diverse tenant base with anchors such as gyms, restaurants that will largely remain offline experiences (time saver)
  4. Big (experience for a whole family)

The advantage that offline offers in terms of branding seems most relevant for luxury brands and hence luxury malls.

As malls ideally aggregate the best brands with local consumers, it is in a sense similar to the newspaper business: you want to own the number one mall in each city.

A major risk concerning e-commerce is that luxury brands themselves might become less important in an increasingly online sales world. We see this with Amazon trying to sell white-labels as consumers increasingly weigh functionality and price over brand as information asymmetry is smaller online (driven by e.g. customer reviews).

TC

Book Summary: The Energy World is Flat by Parilla

I read this book because its author proved to be correct on oil.  This is a non-exhaustive book summary I made last year. In the meantime, other events prove another call in the book: the book predicts convergence of global energy prices: oil has come down and the cheapest natural gas in the world (American) is rising.

The Energy World is Flat offers a refreshing view on the oil market. I found it through one of the better Real Vision interviews with Diego Parilla two years ago. The title is a variation to Tom Friedman’s best-selling book on globalization The World is Flat. Lastly, Diego Parilla and I are alumni from the same oil & gas business school.

I only read the book now as I realized that the author’s first call on the flattening of oil call has already proven profitable. These are the main calls the book makes:

  1. the term curve of oil will flatten
  2. geographic spreads will flatten
  3. spreads between energy equivalent prices of fossil fuels will flatten
  4. oil price volatility will lessen

If we compare the oil term curve between the publishing date (1/1/15) and now, we find that it has flattened considerably.

Chapter 1: the Flattening and Globalization of the Energy World

In the oil shock of the ’70s, oil was displaced for power generation and industrial uses in favour of coal, natural gas, nuclear and others because the primary consideration is price in these industries.

Today, oil still reigns over other fossil fuels for transport purposes despite its higher price (e.g. oil was 10X more expensive per energy equivalent than natural gas in the US in 2012). The main is reason is that oil is exceptionally compact both in terms of volume and weight per energy equivalent. Over the short-term, transport is very price inelastic.

Geopolitical events that created volatility sowed the seeds for more buffers ‘flatteners’: storage, demand destruction, new technologies and discoveries. A result can be found in 2014 when the exceptional combination of the below supply disruptions failed to make the oil price spike (the move was limited to 10$/barrel from bottom to peak).

  1. the arab spring (e.g. disruptions in Libya)
  2. oil sanctions in Iran,
  3. conflicts and disruptions in Sudan, Syria and Iraq

Chapter 2: Lessons from the Dotcom bubble

The tech revolution (and bust) created huge capital inflows that led to miserable investor returns over the cycle. The big winners were consumers that benefited from stranded assets such as fiber-optic broadband.

The revolution of fracking and horizontal drilling is similar. Although there is still a lot of skepticism towards shale for environmental reasons, Parilla draws a parallel with ultra-deep-water drilling that faced critics in the early ’90s but developed into a very safe technology. Peak oil sentiment similarities to the tech revolution includes huge capital investment into:

  1. LNG terminals (requires huge upfront capex)
  2. pipelines (see European and Asian projects)
  3. E&P
  4. demand efficiency

One trap for energy investors is to follow consensus according to Parilla. The sector is driven by extremely optimistic assumptions of demand growth. Every year, demand growth estimates are revised down an average of 15-20% from the January estimates (IEA, OPEC). Since 1998, only one year, 2012, has seen meaningful upward revisions. Main reasons are

  1. optimistic GDP growth estimates
  2. using the rear-view mirror correlation between GDP and energy demand that has been breaking down since 1998

Another parallel with the dotcom boom is the diversified ‘venture capital’ approach. In the energy world a lot of capex is being made in new technologies, with a lot of losers. The mentality for

  • big integrated O&G company boards is to ‘be’ invested in new areas as it looks better on paper
  • investors to be invested in all new areas as “you only need one winner”

Examples in the transportation world are:

  1. compressed natural gas (CNG)
  2. LNG for trucks, trains and ships
  3. electric and hybrid vehicles (EV’s and HV’s)

Note: according to Parilla, governments have delayed EV’s by subsidizing combustion-engine car sales (and bailing out the companies) post-recession by a 6-to-1 investment factor to EV subsidies.

Last parallel: the bubble accelerates the impact of the revolution. The runaway oil price in 2007 set in motion a huge supply response by oil producing and oil consuming countries alike.

Diego warns that a sum-of-the-parts valuation for companies that invest in many fashionable new technologies can be very dangerous with bad capital allocators, as the good parts might subsidize loss-making ones, and that focused companies should be welcomed.

Chapter 3: The 10 Flatteners of the Energy World

Interesting excerpt:

During the super-cyclical run up in corn prices in the 2000s, most commodities were making historical highs, from crude oil, to coal and natural gas, to copper and corn. Correlations had notably increased, which was often used as an argument to justify that speculators were driving prices. And of course, high fuel and food prices were generating inflation and increasing the risk of financial stability. One again, politicians and regulators were quick to blame the speculators. “Food inflation, how dare they?” Corn was considered too expensive and would impact the poor the most and increase inequality. How cynical.

The main reason why corn prices were going up was the surge in demand for corn-based ethanol in response to both high energy prices and the regulated mandates. Corn, which had traditionally been “food and feed”, had become “food,feed, and fuel”. [..] In 2012, following an acute drought in North America, the prices of corn reached historical highs, 400% of 2005 prices. “The speculators are taking advantage of the situation.” Yet, that year over 40% of the physical harvest went to ethanol to “feed” the car. The quantities were mandated by the government as “fuel” forced the demand destruction of “food and feed” via high prices. It was the cattle and hogs who had to change their diet, not the car. By mandate.

Do spot prices converge to futures prices, or is it the other way around? A causality study by Merill Lynch, and Parilla, say futures converge toward the physical fundamentals of the spot market. Speculators will discount future fundamentals in the price. If they improperly discount future risk factors into prices, they will lose money as the future prices converge toward the in-the-future-prevailing spot fundamentals.

TC

Should you invest in franchises or managements? It depends.

Note we wrote this post last year.

Many investors categorize themselves and either say

  • they make judgment call on management or
  • rather focus on the franchise or business (it’s rather cool for some in the value investing church to say not getting to know management is a good thing)

Should we focus on the horse or the jockey?

Investor Robert Vinall is known to focus a lot on management. He believes it’s a hard but important question. Important, because it is difficult to quantify, and therefore there’s less competition from conventional investors and quant funds.

Guy Spier, on the other hand, likes to think of himself as a merely good investor, with lots of limitations, such as judging management. He therefore avoids talking to management. Getting to know managements opens us up to get manipulated by their – often perfect – act.

On bad business turnarounds Warren Buffett has said this:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

While we definitely think there’s great arguments for both point of views, we think the relative importance of analyzing franchises versus managements changes a lot with one critical variable: growth.

Focus on the racehorse and on the show jumping jockey

As the entrepreneurial HBS author of the book Buying a small business often repeats

With revenue growth comes new customers, and with new customers come new (types of) problems

In other words, growth brings change. While changing companies are not necessarily growing (e.g. turnarounds in the above Buffett quote), growing companies are always changing.

Another recent observation I had redrafting this post one year later is that venture capitalists tend to focus much more on the founder or team.

From the above, we make a case for focusing on the franchise in mature companies in markets with stable competitive dynamics.

In fast-growing companies, management becomes much more important as they need to make a lot of judgment calls in execution and capital allocation of growth investments.

In show jumping, the horse needs the jockey.

Lastly, the only competitive differentiator in commodity companies is management (companies with fast-changing circumstances).

We believe there is an opportunity in looking at jockeys in commodity industries as 

  1. investors hate commodity/capital intensive industries
  2. investors are focusing on “great franchises” right now (peak quality?) while growing more sceptical of looking at management 
  3. we believe management can be the (non-durable) competitive advantage for these businesses

While media attention tends to go to the folklore of billionaire jockeys of once-fast-growing start-ups, some examples of great commodity Jockeys: 

  1. Philip Meeson in Dart Group plc
  2. Belgian owner-operator Luc Tack in Picanol and Tessenderlo
  3. Buffett overseeing (mostly incentives) in (re-)insurance operations

We’d love to hear your under-the-radar commodity jockeys and thoughts!

MC & TC

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

Summary of French Bollore documentary

For those that understand French, I very much recommend this excellent documentary on Vincent Bolloré. I found it to be quite unbiased, surprisingly.

Disclosure: long a bit of BOL (main thesis being that a full simplification is a catalyst for the unlocking of the NAV which is at ~2X the share price by virtue of the economic share count which stands at around 50% of the total share count, after accounting for the circular ownership loops. The timing is very unclear, but in the meantime NAV is compounded at a decent rate. The author did a very similar exercise as the highly recommended Muddy Waters analysis that came out just months after)

For everyone else, I have summarized the documentary:

  • in France, Vincent Bolloré has the nickname “two-faced smiling killer”
  • Bolloré has a smartphone app counting down the moment he steps down. I think this shows he is obsessed by providing the “right” company to his family successor (whatever that is, importantly it could include a simpler structure)
  • when Bolloré started at the family company after his Rothschild banking experience, he managed to negotiate a 25% wage cut in his family’s rolling paper factory legacy business when the factories faced cyclical headwinds. This is almost unheard of in France and it shows his influencing skills.
  • the name Bolloré in Africa is very famous. Bolloré uses his abundance of smarts, political connections (including personal friends Sarkozy, Hollande* and Macron), capital and synergies from the media business to gain profitable contracts in many African countries

I didn’t build my empire from one franc by being a passive investor, it’s not in my genes, I am an activist. – Vincent Bolloré at the Havas board meeting.

*Although Sarkozy is one of Vincent’s personal friends, the documentary shows an example where a Hollande visit to Africa allegedly helped Bolloré win a bid for a Cameroon port concession.

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

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