Who is to Blame for Lower Profits at Supermarkets?

Are Customers to Blame?

Heavy discounting drives volume in the supermarket industry.

The supermarket industry is very odd. One grocery retailer can report a 24pc fall in profits and be heralded as a success. And yet, another can report a 52pc drop in profits and be written off as a basket case, firing its chief executive as a result.

These two retailers are Waitrose and Morrisons, who both published their annual results on Thursday.

The difference in perception between the two grocers is stark. Waitrose has been bracketed alongside Aldi and Lidl, the discounters, as a winner from the dramatic changes in how we shop, while Morrisons’ shares lost 30pc of their value in 2014 and Dalton Philips was eventually ousted as boss.

Of course, the reason for this is that while profits for both have plummeted, sales have not. Waitrose is growing like-for-like sales and market share, while Morrisons’ like-for-like sales fell 5.9pc in its financial year.

However, the fact that both saw profits fall shows the unprecedented pressure on supermarkets as shopping habits change and lower commodity prices spark deflation.

Food retailers are effectively facing a zero-sum game. They can focus on growing sales or profits, but not both. Waitrose may have grown like-for-like sales and market share, but at a cost.

Until recently, the big three listed players – Tesco, Sainsbury’s and Morrisons – were focused on growing profits to placate their anxious shareholders. However, over the past 12 months this plan has spectacularly unravelled – particularly for Tesco and Morrisons – and now new management teams are attempting to pick up the pieces.

Tesco is trying to grow sales and market share again, but at the cost of profits. Dave Lewis and his team at Tesco are tackling the industry from a position of weakness. So, while Waitrose profits may have fallen, Tesco is not even making a profit in the UK and may not for the foreseeable future.

Given that Tesco still has 29pc of the UK grocery market and faces fierce competition, it is fair to ask whether Dave Lewis should be focusing on growing market share, or protecting what he has and making as much money from it as possible. Sainsbury’s, under Mike Coupe, has chosen to look after profits, warning that like-for-like sales are likely to fall for some time to come.

The reason that grocery retailers face this seemingly stark choice between sales and profits is twofold. First, they are operating in a market where prices are falling at the fastest rate on record. According to the latest Kantar figures, grocery prices are 1.6pc lower for the past three months than they were in the same period last year. This is the equivalent of £400m of sales disappearing from the market in the past 12 weeks.

The market is deflationary as the “big four”, which also includes Asda, try to close the price gap with the discounters Aldi and Lidl, who have thrived at their expense in the past few years.

This gap was allowed to develop because, according to leading industry figures such as Morrisons’ chairman Andy Higginson, the major grocery players focused on profit over sales.

Chief executives in the sector became more obsessed with return on capital employed than sales. This led to prices slowly creeping up and the discounters, who are impressive operators, became more appealing to families at a time when their incomes were being squeezed.

Now, mainly under new leadership, the “big four” are trying to close the gap by committing hundreds of millions of pounds to lowering prices. These price cuts are being accelerated by falls in the price of key commodities such as wheat and oil.

Retailers face a choice between cutting prices to attract spending or holding firm and trying to protect profits. An example from Mark Price, the boss of Waitrose, suggests the latter is not really an option, because ultimately not cutting prices results in losing the shopper and therefore any profit.

Price said that last year Waitrose initially held firm on cutting the price of milk after retailers, led by Morrisons, reduced the price they charged for a four-pint bottle to £1. However, the result of this was that Waitrose saw sales of its milk drop by more than 10%.

When you consider that milk is often an impulse or panic purchase, or just thrown into your basket with the rest of your shopping, that is an extraordinary statistic. It highlights how shoppers, even at seemingly upmarket Waitrose, are watching the price of everything they buy. As a result of the fall in sales, Waitrose cut the price of its four-pint milk pack from £1.39 to £1.

The second reason why retailers face a trade-off between sales and profits is the structural change taking place in the market. Retailers have to invest to keep up with the evolution in how we are shopping.

So, while Waitrose profits took a £40m hit from price deflation, they also took a £30m hit from investments into its existing stores, opening new stores, and developing IT systems.

Retailers are having to work harder to attract customers to their existing stores while at the same time investing in new ventures such as convenience stores and online.

The reason for this is simple – consumers have more choice than ever before. Not only has the internet allowed people to shop with any retailer in the world from their front room, but the recession reduced rents on the high street and allowed the discount sector to expand. Cheap rents made the business models of B&M, Home Bargains and Poundland viable and fuelled their nationwide growth.

In addition, Tesco and Sainsbury’s have opened convenience stores across the country, which has provided another challenge to their existing supermarkets.

A big question about online grocery retailing used to be whether it could thrive long-term, given it was less profitable than a supermarket. The model is less efficient than an out-of-town supermarket because it shifts costs from the consumer to the retailer. For example, it puts the cost of collecting products in a basket and delivering them to a customer’s home on the shop rather than the shopper.

However, it is now becoming apparent that online retailing will become competitive by dragging down the profits and margins of physical retailing, rather than by growing margins itself.

We are witnessing a reset of the entire industry. The issues facing the supermarkets are not going away – profits are moving to a permanently lower base. The question is whether other sectors will suffer a similar fate to the supermarkets?