The days when UK supermarkets could make operating profit margins of 5-6 per cent seem to have gone for good. Industry profitability has not recovered from the fallout of the 2008 recession. Back then Tesco (TSCO) and Asda were the price-setters, but that mantle has now passed to the discount supermarkets of Aldi and Lidl.
A decade or so ago these companies were seen as upstarts and disruptors and weren’t taken seriously by their bigger industry peers. What is now very clear is that their strategy of concentrated buying across fewer products in smaller stores has allowed them to sell groceries at prices that crushes the profitability of companies with very big stores and the costs that go with it. Walk around a Tesco supermarket today and you will see lots of banners telling customers about the products where it is matching Aldi’s prices. This is clear evidence of how the balance of power has shifted in the industry. While Tesco has done a good job using its immense scale and buying power to fight back, investors are right to question whether this will deliver growth in profits.
The internet now seems to be the main focus of growth for supermarkets. The change in shopping habits forced on many by them staying at home is likely to see many households stick with the internet for their weekly grocery shop. It is by no means certain that this will deliver big gains for investors.
The profitability of bricks and mortar supermarkets has been driven down due to the simple fact that there are too many of them chasing too few shoppers. Big towns and cities are literally saturated with places to buy food. The internet market could be going the same way.
In the response to Covid-19, supermarkets have massively expanded their internet capacity by increasing the number of weekly delivery slots, taking on staff and beefing up their click-and-collect offer. That supply is being filled at the moment as people worry about more lockdowns, but will it continue to be when things get back to normal.
Aldi has now entered the online grocery market. It has a partnership with Deliveroo and has recently launched a click-and-collect service. Interestingly, Lidl has scrapped plans to offer an online grocery service, but the likes of Amazon (US:AMZN) are throwing money at online groceries both on their own and in partnership with Morrisons (MRW). US warehouse retailer Costco (US:COST) has also launched an online delivery service, but on a very narrow range of groceries at promotional prices.
Can all these companies make money or will it be a case of throwing good money after bad?
Investors are right to be sceptical. There are good grounds for thinking that many supermarkets have plunged head first into selling groceries on the internet because they felt they had to. If they did not offer the service then customers would have gone elsewhere. Yet, none of the big supermarkets have come out and said what their sales and profits (or losses) from internet groceries are.
They can argue – with some justification – that as the internet business is run from their stores that it is difficult to split out the impact accurately. However, it is quite clear that selling over the internet and delivering them to households is nowhere near as profitable as selling them in stores.
Internet prices are the same as in store, but the costs of selling them are much higher. Unlike in a store where the customer picks their own products an employee has to do this and get paid for doing so. Then there are the costs of running a website and the costs of delivery, such as drivers, vans and fuel. Customers can pay very little for monthly delivery passes that do not offset these.
Given that profit margins in stores are wafer thin it seems likely that the extra costs of selling online make these even thinner or non-existent.
What does Ocado tell us about internet grocery profitability?
The only place where investors can go to get some idea of how profitable internet grocery retailing can be is to look at Ocado (OCDO), which sells entirely online and does not have physical supermarkets. Even then it is quite difficult to work out what is going on.
Ocado tells investors the revenues it generates from its UK retail business. It also gives decent disclosure on its costs to give an Ebitda measure of profit.
Ocado: UK retail revenues and Ebitda
Source: Ocado, FactSet, Investors Chronicle
Ebitda has increased significantly in 2020 and is currently just over 3 per cent of revenues. It is expected to be over 4 per cent by the end of the year and for the next two years. Morrisons, Sainsbury’s (SBRY) and Tesco are expected to have Ebitda margins of 6-7 per cent. So Ocado at the moment is not as profitable as store-based grocery retailers.
Ebitda is a very bad measure of profit because it excludes the cost of replacing assets, which is measured (maybe not accurately) by the depreciation and amortisation expenses. Assets such as delivery vans (depreciation) and software (amortisation) do not last forever and need to be regularly replaced. If this is taken into account, then what I call proper profits are much lower for Ocado.
The problem for investors is that Ocado does not split out its depreciation and amortisation expenses between its retail and solutions businesses. This is because it is quite hard to do as in the UK they share assets such as delivery vans and customer fulfillment centres (CFCs).
So it is not possible to know whether Ocado’s UK retail business makes an operating profit. What is known is that during the first half of 2020, the UK retail and UK solutions businesses had a combined Ebitda of £75m. Depreciation and amortisation expenses – which will almost entirely be attributable to both businesses – were £76.6m, giving a combined operating loss of £1.6m.
Ocado has always maintained that its investment in CFCs stacks up when they mature and put some numbers on them in its 2017 annual report. From what I can see, the returns on investment were based on profit contribution before administrative costs and depreciation and amortisation, which are real costs.
On this basis, mature CFCs would make a contribution margin of around 10 per cent of revenues, with its Erith CFC closer to 12 per cent. The contribution return on investment of Erith on its £225m was expected to be more than 50 per cent. Once all its CFCs had matured they were estimated to produce free cash flows after delivery van replacement costs of £125m.
Time will tell whether this turns out to be the case, and things have been complicated with the fire at the Andover CFC, but at the moment the UK Retail business is nowhere near this outcome.
What investors need to see from Ocado’s retail business is the benefits of leverage. So as the business expands and sells more, the fixed costs of the CFCs are leveraged and see profits grow faster than revenues. This will show up in higher Ebitda margins.
2020 is so far seeing a very nice improvement in margin due to the big increase in revenues. If current analyst forecasts are right then revenues will increase by £568m and Ebitda by £55m – an incremental Ebitda margin of 9.7 per cent. For 2021 and 2022 the leverage effect is more modest with incremental margins of 5.6 per cent and 5 per cent, respectively. It could be that analysts’ forecasts are too pessimistic and are underestimating the leverage effect. If they are then Ocado will begin to defy many sceptics of its retail business model, including me.
Investors can make up their own minds whether this kind of profitability is good enough, but my view is that for margins to be less than bricks-and-mortar stores – which in themselves are not very good – is not great.
One of the key problems facing all internet grocery retailers is that the marginal costs (picking and especially delivery) of additional sales are higher than they are in store and therefore the operational leverage effect is weaker.
Can internet grocers solve the profitability puzzle?
To succeed it seems that two things are needed. Retailers need more sales to leverage their fixed costs and they need to get the cost of picking goods and delivering them down. Whether any retailer can do this to get a source of competitive advantage and add value for its investors is another matter.
Ocado is trying to do this with automated warehouses, in-store picking software that helps supermarket staff become more efficient and a hub and spoke logistics business. There is no doubt that its robots and automated CFCs are more efficient than picking and packing groceries than humans, but this has yet to transform the economics of selling food or make it more profitable than stores.
In store picking is very inefficient. It also has the potential to reduce the in-store experience for shoppers as they have to find their way around staff filling baskets for internet orders.
Retailers such as Walmart are trialling innovative technology to improve the efficiency of in store picking. It is using something called ALPHABOT, which is an automotive picking machine that worlds in a dedicated part of a supermarket. It significantly improves the speed and accuracy of picks, but the products still have to be physically packed by supermarket staff.
Delivery costs are a major constraint on profitability. One way around this is to charge the customer higher fees to recover them, but supermarkets seem reluctant to do this for some reason. Costco’s UK online grocery service has a fixed delivery fee of £5.99 per order, which makes more sense. It also means that the customer is encouraged to spend more money to maximise savings and offset this cost to them.
Another alternative to the problem of delivery costs is to get rid of them altogether by not delivering. This can be done by offering click-and-collect services instead. This is not costless, though, as staff are still needed to bring deliveries to customers and dedicated space – with things like refrigeration – in stores is needed as well. It is interesting that Aldi has gone down the click-and-collect route as it has probably worked out that its lower margins get wiped out if it offers deliveries.
To get around the problem of reconfiguring existing stores for click-and-collect, the alternative is to have dedicated internet-only stores. These are known as “dark stores” where a former supermarket is closed to customers and redesigned to optimise the picking and packing for internet orders. Amazon has tentatively started doing this with its Whole Foods business in the US and it is possible that dark stores could become a major part of solving the profitability puzzle for internet grocery sales.
Does Morrisons offer Amazon a route to internet grocery success in the UK?
If dark stores take off, then it will be interesting to see what this means for UK supermarket companies. One possible outcome is that it could lead to the takeover of Morrisons by Amazon.
This kind of speculation is nothing new. However, Amazon already has a fearsome reputation for internet retailing and it remains to be seen whether it will be a success with groceries. So far, its acquisition of Whole Foods in the US has yet to show meaningful results, but the response of its competitors – who are investing heavily in internet grocery fulfillment – suggests that they think it’s only a matter of time before it does.
Amazon has already developed an internet grocery partnership with Morrisons. Morrisons supplies food on a wholesale basis to Amazon, but is also part of 'Morrisons at Amazon', which offers same-day grocery deliveries to Amazon Prime members. Food orders are picked in Morrisons stores and delivered by Amazon. This business is still small at the moment and is only offered in around 50 towns and cities with a big emphasis on London at the moment.
It may be that this relationship suits both parties well right now. It is also possible that Amazon might decide that outright ownership of Morrisons allows it to build a meaningful internet grocery business faster and better than it can now. It could be that Morrisons' near-500 stores in the UK would give it a national network of dark stores which when combined with a food manufacturing business and top-notch logistics allow Amazon to make internet grocery retailing stack up for its investors.
At the moment, Morrisons’ enterprise value – the market value of its assets – is around £6.6bn, which would be small beer for a company like Amazon even with a hefty takeover premium. It comes with annual operating profits of around £530m in return, but more importantly the opportunity that Amazon arguably needs to grasp if it is serious about selling groceries over the internet in the UK. It is a prospect that would be good for Morrisons’ shareholders, but could send shivers down the spines of its rivals.