The price is right?

Last week, new chancellor George Osborne received his first letter from Bank of England governor Mervyn King, explaining why inflation is running at 3.7% when the target is 2%.

Consumers are feeling the pinch with the price of fuel, tobacco, spirits and women’s clothing all raising the cost of living. But look beyond those average figures and the picture for retailers is quite different. The grocers, in particular, are operating in a period of relatively low or negative food inflation, and it is plausible that this drastic slowing of price rises is going to make life tougher than anything they experienced during the recession.

In the past couple of weeks both Asda and Morrisons have reported poor comparative trading - Morrisons’ like-for-like figures were up by less than 1% and Asda’s actually fell by 0.3% in the first quarter. The British Retail Consortium and market research company Nielsen estimate that food shop price inflation was 2% in April - a quarter of what it was a year ago - and the prices of certain foods have suffered deflation in the past year.

Deloitte strategic retail adviser Richard Hyman says that lower food inflation, combined with an expected period of upward price pressure on non-food goods, will lead to much tougher market conditions.

“A bit of inflation doesn’t half paper over some of the cracks and make for a much less pressured trading environment,” says Hyman, adding that in the past few years, “all the majors have been able to report growth. That tells you everything about just how benign the trading environment has been for the supermarkets.”

So in the near future the grocers cannot rely on a rising market to allow them all to achieve like-for-like gains. In its results statement, Morrisons admitted that food inflation has been virtually eliminated, leading to lower market growth.

Morrisons finance director Richard Pennycook says: “2010 is shaping up as zero inflation and low growth.” However, he adds that the grocery sector had seen deflation for a quite a while up until around 2006 to 2007, so this is not a new phenomenon and one that the retailer should be able to handle.

OC&C Strategy Consultants partner James George says of food retail: “I think there will be pressure on pricing for the foreseeable future. Inflation has been handing retailers 5% like-for-like growth. It changes the competitive dynamic as the more exposed you are to food then the harder it is going to be.”

He adds: “In March, April and May last year we were seeing 10% retail price inflation in food.” Food retailers benefited because they don’t see big downward swings in volume if prices rise. But by the same token they don’t see volumes increasing to entirely compensate for prices now growing more slowly or even turning negative.

While Pennycook argues that volumes are improving to compensate for lower inflation, he says it is too early to talk about recovery.

“Inflation wasn’t retailer-driven, and it was being passed on to consumers,” he adds. “The challenge for retailers is to bring prices back down in line with falling food prices.”

Share and share alike

Stable, low inflation for food until the end of the year is predicted by BRC economist Richard Lim, unless there are any substantial supply shocks, such as the price of oil rising massively.

PricewaterhouseCoopers UK retail and consumer leader Mark Hudson says the grocers with the widest product ranges should be most insulated from the impact of low inflation, but they must try to take more of their customers’ total disposable income.

“If you have got low inflation or deflation in food, the only way you can increase like-for-likes is to get people to trade up or sell more units,” he says.

“The population isn’t growing, and it is difficult to take share. There is lots of scrapping for market share and I expect there to be some gain for majors from the independents by opening stores, but that won’t necessarily improve like-for-likes.”

A source close to major FMCG suppliers says the grocers need to market deflation to their customers well. “If they do pass on lower prices they can trumpet it as them being an advocate of the consumer,” he explains.

Hudson says the grocers are also using petrol as a weapon, with the goal of taking as much spend as possible.

In the past few weeks, Tesco and Sainsbury’s have both launched fuel promotions offering 5p off a litre of fuel when customers spend £50 in the store. Ploughing discounts into targeted offers on a product - fuel - that consumers know is rising is one way to achieve this.

Asda has instead opted to try to tempt shoppers with its price match offer, and Morrisons says it is offering “eye-catching and innovative promotional offers”.

However, Hyman believes the pressures consumers are under means grocers in particular will have to steal market share if they want to grow. “Growing your business was not necessarily a function of gaining market share,” he says. But going forward: “Growing your business will mean growing market share. The difference between the strong and the weak will be those that gain or lose market share,” Hyman adds.

Lim explains that as 60% of food is sourced in the UK, its price is less susceptible to global forces, unlike non-food, where the majority of product is sourced from abroad.

Hyman says that the trend in food and non-food inflation has swapped after a period in which non-food prices were either growing slowly or deflating. “We are seeing an increased polarisation and, actually, this is nothing new,” he says. “There has been a wholesale swapping of positions.

A year ago we had double-digit selling price inflation in food. Although it has always been volatile, history would show that it’s quite rare to see such a significant change from double-digit to nothing.

“In non-food it has been negative for the best part of a decade. Retailers have been able to drive more volume and consumers have been able to buy more,” says Hyman.

However, he thinks the faster pace of growth and relative weakness of sterling is going to lead to inflation in the cost of non-food products from suppliers being imported from the Far East. At a time when UK consumers’ incomes won’t be rising much, if at all, it is going to be hard for retailers to pass on price increases. Hyman says this will “widen the gap between the strong and the weak”.

He adds: “Price is a bit of a metaphor for what is happening across retail. The supermarkets are having to deal with these two phenomena.” Hyman says the winners will be value players that are able to drive volume, and those at the higher end offering something different and innovative that consumers value. Even more so than during the recession, the players in the middle could find themselves squeezed.

No margin for error

But like-for-likes aren’t the only financial measure that inflation could impact. Margins could also suffer.

The FMCG source says that when commodity prices were rising quickly the full impact of inflation was not passed on to the grocers; however, the grocers were able to pass on the full amount to consumers, pocketing the difference in improved margins.

George explains that OC&C analysis suggests the commodity prices spike was passed through to consumers. “A 10% increase in commodity prices translated to a 2% increase in retail product prices,” he says.

However, retailers are trying to cling to margin they have gained now that inflation is less prevalent. “Inflation has cooled off massively. Commodity and producer prices have turned negative, but we have not seen retail prices turn negative,” says George. “Retailers have not been keen or quick to hand over reductions to consumers.”

Perhaps one of the reasons for this is that, like consumers, retailers are likely to experience inflation themselves in the form of higher wages, rents and other bills. Hudson says: “Where you have no inflation in pricing but inflation in costs, the question is who takes the hit. It all depends on who has the power in the chain. Those with the power end up with the biggest slice of the pie.” He adds that there is less of a struggle when inflation is higher and everyone can benefit more easily.

“There is lower inflation in pricing but headline inflation is higher, so staff will be looking for increases. National minimum wage increases put a floor on wages.” Hudson agrees there will be investment in self-service and a further move to shelf-ready packaging to try to offset rising wage costs if product price inflation is low.

But all this could be in vain. Hyman says it is not difficult to imagine a combination of economic factors that could wipe out margins.

“Increased bought prices, increased VAT, salaries capped, unemployment ticking up; even if interest rates go up by one percentage point it would make a huge difference,” says Hyman. “With retail sector margins at about 6%, a 2.5 percentage point higher VAT rate and interest rates up by, say, one point, with sterling weakening a little more, and I think we are in for a very difficult time.”

What will happen to VAT is, of course, the other issue that retailers are trying to factor into their business plans. If it is to be raised to 20% before the end of the year it could hit non-food retail hard, says George. “A lot of retailers - and especially clothing buying teams - are thinking about 20% rather than 17.5% VAT in the planning to hit their margin and price points.

“It is potentially adding 5% inflation into the market with no positive benefit to retailers. In some categories it would mean 5% less money in consumers’ wallets, which will have a big effect, especially in discretionary categories such as clothing.”

A preference for round-pound pricing and the expectation that VAT will rise, or even be added to new categories such as food, means retailers and suppliers are already thinking about re-engineering their products. Hudson says: “From a supplier point of view they must work with retailers to get products to price points where they can both make a good margin.”

All of this could lead retailers to the conclusion that they should try to diversify their businesses as much as possible, particularly their internet offer and international expansion. But Hyman concludes that for most UK retailers that don’t already have substantial international businesses, trading will be so difficult in their domestic market that they must give it their focus.

“Doing too much different against this type of background, the risks are magnified and there are no easy answers,” he says. “You’ve got to focus on the core of your business. If you could wave a wand and open stores in economies growing at 5% to 10% then great. But you can’t wave a wand. People are seduced by having upbeat things to talk about - but their fortunes are based on their UK businesses.”