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:
the term curve of oil will flatten
geographic spreads will flatten
spreads between energy equivalent prices of fossil fuels will flatten
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).
the arab spring (e.g. disruptions in Libya)
oil sanctions in Iran,
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:
LNG terminals (requires huge upfront capex)
pipelines (see European and Asian projects)
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
optimistic GDP growth estimates
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:
compressed natural gas (CNG)
LNG for trucks, trains and ships
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
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.
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
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.
Don’t give too much credit to CEO / Chairman just because they can write fantastic annual letters
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
Even when the manager is heavily invested in the company, the ego can still get in the way such that mistakes are not corrected
Human irrationality is more powerful than you might think
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.
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.
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:
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
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
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
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
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)
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
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 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.
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
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:
Larger than traditional chain stores (5200 – 6400 sqft v.s. 1200 – 1500 sqft)
Cash only (Some chain stores still accepted credit)
Self -service (chain store would still have a clerk that sells to customers whereas in supermarket customers would pick out his/her own goods)
Huge parking space which reflected the rise of the automobile era
Out-of-town locations – cheap rent
Almost 100% nationally branded merchandise
Below is a comparative review of the two store formats:
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:
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.
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
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:
Fresh food has limited shelf life and place demanding requirements on storage conditions – ambient / cold / frozen environments
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
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:
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:
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:
Price competition + low switching cost + commodity nature of grocery retailing = Customerswill flock to the retailer that offers the lowest price
Negative working capital = growth itself can bring about cash flow that can be re-invested for even more growth – Self-financing of growth
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
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
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).
A source of structural operational efficiency
Ability to grow organically through existing operational cash flow
Huge reinvestment in the business to fuel further profitable growth
Willingness to share operational efficiency through lowering price for consumers
A track record that its current retail model is well-received by the consumers
Continued improvement in operational efficiency with scale (lowering unit cost with scale)
Preferably founder driven company
Strong culture of delivering superior value to customers
Before we move on to new books I am reading, I wanted to come back to my favorite read in 2016: The Everything Store. It is the story about Jeff Bezos and the creation of the giant that Amazon is today.
I hope my fallible memory is a great filter to sum up only great and memorable points.
Big things I learnt
I will largely frame my writing on Amazon’s values:
Customer obsession, frugality, bias for action, ownership, and high bar for talent, innovation.
On avoiding competition
Gaining edge initially: the decision to sell books
The thing that impressed me most was Bezos’ superior analytical thinking skills. As a new online store, Amazon needed an edge versus traditional brick-and-mortar stores. One of the ways he could achieve that is by having more customer choice (as brick-and-mortar have limited physical space to show and stock the product). He figured a product that has an immense variety in product offerings would maximize his edge. He went for books, hence the name Amazon, which aims to symbolize the variety of the rainforest. After Amazon became popular for books, he compiled a list of product categories with similar huge variety of choice and went for those as a second step.
There’s less competition for very long-term business plans
Most corporate agents are focused on the next quarter, year or years. A founder can afford to think longer term. There’s much less competition in plans that require patience.
Gaining and keeping edge longer term: market leadership
Gaining market leadership requires foregoing traditional financial metrics like GAAP earnings margins. Keeping market leadership requires relentless client/product focus and continuous cost consciousness. But that’s OK, Jeff knew very early on that market leadership gives you economies of scale in this new online business with huge fixed costs.
On customer obsession
Creating alignment through pricing
Amazon does not earn money on selling Kindles. Amazon earns when customers are satisfied with the Kindle ecosystem and buy Kindle books. This creates alignment.
We make money when we help customers make purchase decisions […] Merchants have never had the opportunity to understand their customers in a truly individualized way, E-commerce is going to make that possible. – Bezos
Creating customer oriented culture through rotation
Amazon has a mandatory rotation system to make every employee talk to customers through the Amazon.com call service. Engineers passing through customer service has also brought to light IT problems that were subsequently solved.
Obsess over customers, not competitors
On innovation and frugality
AWS and getting out of the way of the customer
Jeff is not a fan of wasting time, so he especially hates the idea that many of his employees would waste time together. Amazon’s culture was shaped early on to avoid meetings (e.g. standing up during meetings, no TV screens). Another slogan was “communication is a sign of failure”. No wonder that Amazon preferred IT systems talking to each other without human friction through good API’s. However, the IT needs for Amazon.com became eventually so big that considerable time of API designers went to asking and interfering with how the internal API clients were going to use the service.
This growing internal demand led Amazon to define basic computational building blocks, or “primitives” and make them really scaleable in order to sell these services to external clients as well. This way Amazon.com would recoup these large fixed costs to improve internal operations. The initial primitives were storage, computing, payments and messaging. This became what is known as Amazon AWS and the rest is history.
This innovation was based on the idea to get out of the way of developers and provide them all required building blocks with no questions asked. It is reminiscent of electricity generation becoming centralized in the 19th century, removing capex requirements on the consumer side.
When a platform is self service, even the improbable ideas can get tried because there’s no expert gatekeeper ready to say ‘that will never work!’” – Jeff Bezos
Frugality to drive innovation
Although Jeff always loved optionality and funded many long-shot projects, it has to be stressed that he likes cheap optionality by being frugal. Another advantage of frugality on top of lower costs is reflected in the following quote.
We try not to spend money on things that don’t matter to customers. Frugality breeds resourcefulness, self-sufficiency and invention. There are no extra points for headcount, budget size or fixed expense.
Leaders are intellectually curious, but commit to execute their decisions
The following is a quote by Bezos that was also covered in Superforecasting that we summarized. It marks the decision-making process of a great leader: be always questioning, but once you decide, show commitment to the execution of your decision.
Leaders are obligated to respectfully challenge decisions when they disagree, even when doing so is uncomfortable or exhausting. Leaders have conviction and are tenacious. They do not compromise for the sake of social cohesion. Once a decision is determined, they commit wholly. – Jeff Bezos
Always keeping the bar high
“If that’s our plan, I don’t like our plan.”
“I’m sorry, did I take my stupid pills today?”
“Do I need to go down and get the certificate that says I’m CEO of the company to get you to stop challenging me on this?”
“Are you trying to take credit for something you had nothing to do with?”
“Are you lazy or just incompetent?”
“I trust you to run world-class operations and this is another example of how you are letting me down.”
“If I hear that idea again, I’m gonna have to kill myself.”
“Does it surprise you that you don’t know the answer to that question?”
“Why are you ruining my life?”
[After someone presented a proposal.] “We need to apply some human intelligence to this problem.”
[After reviewing the annual plan from the supply-chain team.] “I guess supply chain isn’t doing anything interesting next year.”
[After reading a narrative.] “This document was clearly written by the B team. Can someone get me the A team document? I don’t want to waste my time with the B team document.”
Defining non-GAAP KPI’s and what it means for investors
The following point relates to my previous book summary “The Outsiders”. I realize that the ability to creatively define the right key performance indicators is shared among great CEO’s and founders. Last post, we covered EBITDA defined by John Malone. Jeff Bezos is definitely another example of a founder who defines success by many unconventional metrics (e.g. long term absolute free cash flow, not GAAP profit margins).
In my opinion, investors trying to identify great CEO’s by checking if they use unconventional metrics is misguided however. Fraudsters are known to be very creative in defining new metrics. Many short-seller reports are full of criticism on creative metrics. Ultimately, the hard task for the investor is to think independently and check if these metrics make sense from a business owner perspective.
The value of a business is ultimately determined by a multiple to its absolute cash flow generating ability, not a percentage of GAAP earnings.
We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.
Our decisions have consistently reflected this focus. We first measure ourselves in terms of the metrics most indicative of our market leadership: customer and revenue growth, the degree to which our customers continue to purchase from us on a repeat basis, and the strength of our brand. We have invested and will continue to invest aggressively to expand and leverage our customer base, brand, and infrastructure as we move to establish an enduring franchise.