Pembridgecap

A Wealth Creation Journal

Tag: Industry Insights

Notes on IBKR’s November results and Peterffy at the ’18 Goldman Sachs conference

Disclosure: both a happy investor and client of Interactive Brokers.

Improve your net returns by massively saving on costs (i.e. the only thing you have 100% control over as an investor) now and become an Interactive Brokers client.

It is a well-known human bias to neglect large absolute trading commissions because we look at them relatively to the even bigger amount of money we invest. I am a big believer in minimizing any friction in the investment process (trading less which lessens commissions and frees up time to think long term; paying less for trades by being an IBKR client, although the cheapness creates a “casino effect” of wanting to trade more frequently).

Intro

We will cover IBKR’s November month results that were released this week. Founder Mr. Peterffy had interesting comments about them on the Goldman Sachs 2018 conference that took place yesterday.

First I’ll explain how I go about thinking about the IBKR’s monthly metrics in general.

Executive summary

  • most important monthly KPI to track: user account growth (it drives LT equity growth which is IBKR’s most important value driver)
  • November user account growth was “disappointing”, yet still in line with the last 10 year historical pace of 18% CAGR. The disappointment was driven by China curbing remittances to stellar grower – and intro broker to IBKR – Tiger Brokers
  • IBKR will start paying interest on smaller accounts
  • Israel markets will be added to IBKR
  • important question for the thesis: will exchange volumes keep on losing share to internalizers?

Let’s get started…

IBKR’s monthly metrics mental model*

*Hate using this snobby term but it made for the shortest title.

Although equity growth is the value driver for IB going forward (driving interest income) , account growth is the most useful reported number to gauge future LT equity growth, as

  • monthly equity growth numbers are affected by short term stock market movements
  • equity growth lags account growth because people only start depositing large chunks of money into their account once they are familiar with the platform (i.e. half of end-of-first-12-months money only arrives after >6 months)

Commission growth is also very noisy ( ~f(volatility)) and only 1/3rd of earnings.

In short, closely track MoM account growth to know if IB is on pace for LT equity growth.

Account growth + (ST NOISY= Clients adding deposits + asset inflation) = LT Equity growth

So I observe account growth and know that (ST NOISY) was historically 10% and should be at least 4% on avg. going forward, i.e. observed account growth + 4% =  conservative LT equity growth.

Let’s discuss the latest results and the interesting conference.

November numbers & Peterffy on the GS Conference

  • On the November numbers, IB swung up 8% intraday & ended slightly down on the day
  • I agree with the directional close-to-closing price given the numbers
    • Short-term value driver commissions were great (market volatility) while
    • accounts growth disappointed at +1.3% MoM (vs huge growth last months of course, even the annualized disappointing MoM pace is still 17%, +- on par with the 10-year CAGR of 18%)
      • Peterffy revealed on the GS conference that MoM account growth was affected by special measures by Chinese govt that constrained mainland Chinese customers to deposit money into their Beijing-based intro-broker Tiger Broker app accounts (i.e. IB bank accounts in Hong Kong). Probable reason: Yuan is under pressure and growing money outflows put further pressure on Yuan
        • Tiger Brokers grew at a stellar rate last years (now processing >200BUSD in trading volume p.a.) & has a great app with local support, advertising and investors in the mainland (the Robinhood of China but with a smarter client base as unsophisticated Chinese retail investors are not interested in global investing) but back-end of the app is 100% IBKR and the bank account is with IBKR HK
        • My take: a yuan devaluation event should be positive as the restraint can be more easily lifted afterwards & as more Chinese would consider investing outside China after a deval

Notwithstanding current market correction, IB’s LT equity growth (main value driver) should be at least 4% p.a. above account growth as clients deposit more money into their existing accounts and asset prices rise in long haul. In fact, historically the equity CAGR was 10 %-points above account CAGR. As interest rates rise and IB pays even more interest on client cash than competition, there is no reason the pace of client deposits should slow so 4% seems very conservative.

Even annualizing these disappointing MoM numbers gives us 17% account growth or in my view 21% conservative LT client equity growth, which is still 2 pp above my model of LT equity growth at 19%.

Recent additions to the platform Peterffy discussed:

  • Israel markets (next week)
  • New screening functions for IB’s bond platform (direct electronic access)
  • IB features in recent past makes them more & more of a bank:  IB is now considering getting banking license abroad & US. In US, broker-dealers can do almost anything but  limitations abroad are generally more extensive
  • Effective 1st of Jan IB will start paying interest for small clients with total equity lower than 100k (previously 0%). The rate these clients will get will be linearly ramping from 0% to benchmark minus 0.5% with account size from 0 to 100k, e.g. 60k client would get 60%*(bench-0.5%) on his cash

Recent SEC action on the payment for order flow “PFOF” competitor broker’s practice

  • Competitors burdened with more disclosure requirements to clients

Peterffy voiced his concern that brokers who’re accepting PFOF (the vast majority) are routing their orders increasingly to “internalizers” that execute customer orders against their private “parallel” market (e.g.  HFT arm of Citadel, public firm Virtu Financial):

  • This means less and less retail orders are going to the exchanges
    • Because retail orders are the lifeblood of market makers as they are viewed as profitable “noise”, there’s less incentive for market makers to provide liquidity-adding orders limit orders to the exchanges
  • thinks the decreasing real liquidity on exchanges is a “disaster waiting to happen”

I read the Virtu Financial prospectus, and the story is not that simple it seems: exchanges are monopolies and they have been inflating their commissions and data fees over the last years at higher than inflation. IBKR IR themselves complained about that to me when I asked about that cost item. Customers using internalizers save exchange fees that could theoretically be shared amongst client, broker and internalizer. In practice however, this windfall (and slightly worse execution when using an internalizer) goes to internalizer and broker. I still think the internalizer model is a threat to IB’s 100% direct-exchange model as this ongoing exchange trading substitution may continue. This is mitigated by IB’s tiny market share that can grow much bigger in 3 or 4 out of 5 client types (prop shops is saturated &  sophisticated individuals is saturated but only in the US).

Somewhat distressing is Peterffy exaggerating JPMorgan’s new “free trading app” clients being patsies:

Well, obviously, businesses have to make a profit or at least break even. So one day advertise no commissions. They may have to make it up somehow, and so that is partly in selling the orders, partly not paying interest on the deposits, partly charging higher margin rates. I understand that Robinhood does this, and that’s okay. But to the extent JPMorgan is doing this, I think it’s a big mistake. People don’t like to be taken for a patsy, and it’s going to be — they will regret this, I think.

There are huge differences among brokers how much they take as PFOF as they negotiate how good the client execution should be. Fidelity and Schwab have ~10x better price execution than RobinHood and earn less from PFOF. As stated above, theoretically PFOF could be compatible with great execution as exchange fees are saved.  The difference between IB’s price execution and the more established brokers is really a few basis points (insignificant for individuals), while for Robinhood it’s >20bp.

Growth

Interesting point was that not only Asian intro broker clients are growing fast. A lot of European private banks are becoming intro brokers too as they can’t keep up technologically.

TC

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

© 2019 Pembridgecap

Theme by Anders NorenUp ↑