Profit margins on ice

Profit margins are being squeezed by decreased spending power of consumers. That is true, but it is also not the full story. Competitive pressures, buyer and supplier power dictate sustainable margins in the medium to long term.

#23/365 - As cold as ice?
Creative Commons License photo credit: abooth202 has a story this morning around Shoprite’s results and pricing strategy going forward.

The CEO of pan-African retailer Shoprite, Whitey Basson, says the company is prepared to sacrifice profits to remain “the cheapest food retailer in South Africa”.

So far that sounds right honourable, but let’s see what comes next:

“We can’t afford to let that area of our branding slip,” said Basson

Which makes sense. This is not a question of sacrificing profits to benefit struggling consumers. This is about reducing margins now in a price war with other retailers so that they maintain their strong market share and increase margins in future, leading to higher profits. Strategically accepting lower profits now for higher profits in future is smart, but it’s not about helping the consumer.

Profit margins are being squeezed not solely by decreased customer spending, but by competition acting to lower prices. From anecdotal stories I’ve heard from key suppliers it seems there has been a growing price war starting 4th quarter last year already. Price wars can push prices below an equilibrium point where components of the value chain are not making a fair return. I don’t know whether we are there yet or not.

As margins at the sharp-end (my-speak for final sale to consumers) shrink, it’s only natural that retailers look upstream to decrease input pressure in an effort to maintain margins.

Still from the Fin24 article:

In late January, Pick n Pay CEO Nick Badminton sent a letter to 30 of that company’s biggest suppliers urging them to “exercise serious restraint” with their increases.

Again, on the surface this sounds like a reasonable request. Except that suppliers have shareholders (and employees who want to keep their jobs) who want the same fair (or greater) return that PnP and Shoprite are aiming for.

It gets yet more interesting as the margin pressure backs one step further up the value chain:

After a meeting between the parties in February, suppliers blamed their suppliers, in turn, for persistently high prices and suggested there were areas of monopolistic practices in the packaging, tin, paraffin wax, glass and fertiliser sectors.

Now are Competition Commission has been very busy over the last few years making it very clear that there has been a host of anti-competitive, price-fixing, cartel and monopoly-like actions which may have kept prices above equilibrium with greater competition. I admit that my previously held views on the natural state of perfect competition were wrong.

What we are seeing is the natural outcome of balancing of Michael Porter’s Five Forces in that those with strong power (through weak suppliers and buyers, high barriers to entry, weak competition and substitutes) means that those who can create monopoly-like structures benefit from higher margins.  Framed this way, it becomes yet clearer that profit margins are squeezed by a combination of final demand and competitive forces.

To show how far the icy margins give rise to skidding and spinning:

Asked whether Shoprite had taken similar action with its suppliers, Basson told “We have been controlling our suppliers for 30 years and not just in the last month when it became nice to talk about it.”

Can you hear the exasperation in Mr Basson’s voice? Pick n Pay has somehow managed to make a virtue out of squeezing suppliers and their margins and their shareholders and their ability to create jobs. I’m not saying that this isn’t exactly the right action for Pick n Pay and their shareholders, or that the effect it might have in keeping consumer prices low isn’t wonderful. Shoprite and Pick n Pay’s motivation here is primarily shareholders (and their direct stakeholders) first, and warm fuzzy feelings around consumers second.

“The problem is that SA has too few suppliers. It’s probably not very difficult to just read two or three supplier prices and match prices in that way. The base of suppliers and products in SA is just too small by world standards.”

Why do I doubt that the suppliers would agree?  With giant retailers of the likes of Pick n Pay, Shoprite, Spar and Woolies dominating the retail space? Each of these retailers has enormous power, which has just been established through “30 years of controlling suppliers”.

So who really has the power, and who really has the margins? And how much spinning on ice will go on about “low prices for consumers”?

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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