Guest blog: Comparing and contrasting the business models of retailers and brand manufacturers

A wide choice of products at a range of prices across the country remains a good measure of an effective grocery market for shoppers. Retailers and suppliers play distinct roles in delivering this and it is important to understand the differences when considering policy. A refinement in one area may cause harm in another. Here we take a look at the financial models of retailers and brand manufacturers, highlighting their respective strategic priorities and suggesting that a comparison of their financial measures is unenlightening, being a comparison of apples with pears.

The retail model

Historically, the nature of bricks and mortar retailers has been to control the means of distributing fast moving consumer goods, from many branded and own label suppliers, to large numbers of domestic consumers in a concentrated space, in a cost-efficient way.

Small shops developed into larger stores and then into multiples and huge shopping centres like Bluewater. These retail emporia used to guarantee large store traffic and massive turnover often running 365 days of the year.

Retailers have controlled display and promotion in an intimate experience for consumers. That is why so much has been spent on the customer experience and enhancing the retail experience. It has all been about convenience, availability and service at a competitive price. Whether the consumer products concerned are food, electronics, durables or clothes, the principle is the same.

Traditional retailers have relied on high footfall and high spend with modest gross and net margins but with very large turnover. Fixed costs include, distribution, staffing, heating, lighting, rent, rates etc., all of which can be very high in absolute terms, so traditional retailers are highly geared in an operational sense. If they don’t keep the financial wheels turning and hit a certain level of turnover, they won’t even break even. If they don’t make enough to cover all these high operating costs, they rapidly fall into operating losses. This highlights the predicament of retailers in this Covid world.

While they may make relatively small margins on turnover, if they can keep absolute turnover high then the absolute margin they make can be financially attractive. This is known as high stock turn or high operational gearing. High stock turn leading to higher overall turnover at relatively low margins can still add up to a good return on capital employed at the end of the day, in a normal world.

The problem with retail is that if store traffic drops, if stock doesn’t turn over fast, if operating costs rise even a few percentage points, the whole business model goes haywire.

In the 1980s and 1990s Tesco, Sainsbury’s, Asda, Safeway and Morrisons were locked in a vicious grocery retail price war. Prices were driven down in the battle for market share and all small players were crushed. Aldi and Lidl created the same conditions with the same results.

At that time net margins on turnover decreased to no more than 2-3%.

When the price war was over and many competitors had been rationalised, the surviving players had achieved close-to-dominant market shares. By the 2000s Tesco had acquired over 30% of all grocery retail spend and it was often said that 1 in every 7 pounds spent in the UK went through Tesco tills.

After that price war the major players focused more on quality and novelty rather than just on price.  As a result net margins on turnover rose to as high as 7-8%. Tesco and the others became very profitable and highly valued in the stock market.

What Tesco shareholders cared about most was the absolute return on their invested capital not the percentage net margin on sales.

So the managers of Tesco, and similar  retailers, aimed:

1) to relentlessly drive down prices, stimulate customer loyalty and generate higher turnover,

2) to attack all operational costs, thereby boosting net operating margins on higher turnover and thereby drive up absolute net profits,

But also…

3) to drive down the amount of capital employed in the business so that percentage returns on capital increased. If you make the same amount of net operating profit with lower capital employed, you are achieving a higher return on invested capital which is bound to please shareholders!

In a vulgar fraction, quite an appropriate term in relation to down and dirty retailing, the higher the numerator (the net profit) and the lower the denominator (the capital employed), the higher the magic Return On Capital Employed (ROCE) percentage.

In pursuit of objective 1), retail buyers became notorious for driving hard bargains with all suppliers. I am sure this would be regarded as an understatement by many fresh produce and packaged goods suppliers to companies like Tesco. Low prices, free product, slotting fees, volume discounts, co promotional discounts, in-store advertising, retrospective discounts were all part and parcel of the purchasing function’s role to reduce prices, pass operating costs to suppliers and improve net margins.

In pursuit of objective 2), retail managers sought zero hours staff contracts, minimum wages, imported labour and reductions in all costs per square foot.

In pursuit of objective 3), directors of retailers made strategic decisions to sell their freehold properties, take capital out of the balance sheet and lease instead. This worked well for decades but backfired when rents and rates rose in recent years. Many retailers have been forced to renegotiate and restructure and they are all lobbying for business rates reductions.

They also sought to reduce working capital by demanding that suppliers retain ownership of stock right through the supply chain to the store shelf, thereby cutting the cost of stock and debtors on their own balance sheets. Taking this one step further, they have charged cash, or immediate credit card payment, for the products to customers but then paid the suppliers on 30, 60 or even 90-day terms. They effectively trade with no stock or debtors but hold the cash receipts until settlement.

These techniques to reduce capital employed can sometimes lead to very odd-looking balance sheets. It is quite normal for a grocery retailer to operate with ‘negative working capital’. This means suppliers are effectively lending their retail customers free working capital.

In a ‘normal’ manufacturing company there will be stock, work in progress, debtors and cash as assets employed, with some creditors reducing the need to fund all the short-term assets required to operate. The need for ‘working capital’ grows as a business grows and is normally financed by shareholders or by banks. This often creates a forceful squeeze on manufacturers as they grow.

But in the case of highly sophisticated retailers, there is no stock (because the supplier is left funding it), there are no debtors (because customers pay immediately), there is limited need for cash and there are usually huge creditor balances, meaning that suppliers fund the retailers balance sheets!

So, looking at a retailer’s balance sheet, it may have virtually zero property assets (because all stores are leased) and no working capital but large credit balances to suppliers and cash sitting around with nowhere to go except in dividends! At least that is how the retail business model is meant to run and for several decades did run.

But the wheels have come off in the last decade mainly because of the internet, online retail and discounters. The likes of Aldi, Lidl, Ocado and Amazon have cut the number of consumers going into retail stores. With lower overheads and costs, they have stripped demand from traditional bricks and mortar retailers. This means reductions in turnover, further pressure on margins and net operating profits falling. Meanwhile, the fact that online retailers have lower business rates and pay lower taxes has created a perfect storm for the retail business model. It is not surprising therefore that many retailers have gone bust in all retail sectors over the last 5 years. Company Voluntary Arrangements are at an all-time high.