Vertically integrated food enterprises

Food retailing is big business. In small markets it can be very lucrative business. Most countries have established food enterprises that display a great deal of market power. There are 2 types or models that I have observed:

1. Developer-retailers: This model is particularly popular in Asia, with the likes or Robinsons and Shoe Mart (SM) in the Philippines, and Seibu in Japan. It is in the developing markets where they have captured the greatest market share. The strategy of this model is to develop large shopping malls built around your retail capacity, with the added attraction of integrating those retail-shopping experiences with rail transport and residential property developments. SM and Robinsons have been very successful with this approach. In such cases the companies tend to function as independent stockers of local and international food. The intent of such malls is to buy large areas of land in strategic locations and essentially build cities around them. This model works well in Asia because you need the support of government to get cheap land and for approval of any and all subsequent development. In Australia, these enterprises would have to follow local zoning rules, and they are less likely to be bent for the sake of a developer. Certainly not in a systematic way that would be evident to competitors. They would also have to win over residents, some who don't always value the almighty dollar.

2. Farmer-retailers: This model tends to be more prevalent in the Western countries because retailers don't have the same development power. The shopping mall developer is thus a more independent beast catering to all food retailers in the market. The shopping mall developer Westfield is a case in point. It offers floor area to the largest malls like Woolworths and Coles in Australia. Woolworths was previously advised by the former Wal-Mart CEO. Their approach is to develop shopping centres in key locations with the intent of dominating retail with integrated services. Of course if its 'competitive bidding' it must be good right? Well no. In Australia and NZ (Countdown) you will find 2 brands competing for the same markets - which means no competition at all, thus food prices are determined by your ability to pay (i.e. Average household incomes). This is because you can bid more if you can hold more regional market share, so customers don't have a choice. Their intent is to offer greater convenience so that you would not even bother to go to the competitors because you could not be bothered to waste time determining who is offering the cheapest cost item for the 50-odd $3 items you buy every 3-4 days.

Is this not just good old fashioned capitalism? Well, I don't think so. The problem is that the market is divided between two major players in most countries. This creates a huge incentive for price collusion. There are often more competitors in the bigger countries, but these tend to be merged into just a few. The largest companies are entrenched because no other competitor can hope to match the efficiency of their distribution system. That is an effective barrier to entry because only a silly idiot would try to match their low unit costs. Small players can only go after the smaller rural markets offering smaller returns. These areas are open to outsiders because they are in a position to source local product and there are larger profit margins for the majors elsewhere. The majors have another strategy. They invest in growing profit margins in the city so during the boom times so that their earnings are not overstated in the bull market, but stable in the recessions. This allows them to further entrench their monopoly in the recessions because other players don't get the same benefit. This problem occurs because of our history of government regulation and high barriers to entry. It’s partly due to property zoning laws, but other laws also play a part. When the government regulator is asked to investigate the 'monopoly powers' of the regulator as the Australian Competition and Consumer Commission (ACCC) was asked to do, they find that the food retailers earnings are normal, but they investigate the wrong period, and they don't consider the increase in margins, instead focusing on profits. Why? Because they can conceal retained earnings reinvested in future growth. You can understand the 'political power' of an organisation of Woolworths, and the desire of the government to help them so long as they don't look bad. And the support of the ACCC, which has in previous years been a valuable agent for consumers might not longer be considered in the same light. I would also suggest that the ACCC is under-resourced, and even if it wins a few battles, the war is tilted towards those false prophets of capitalism.

The major food retailers have another strategy. They have this powerful market position of knowing what customers are buying. They can look at their best selling items and then go out into the market and offer contractors a new opportunity. For example, let’s say Woolworths was buying cucumbers from ABC Farm Coop for $0.5/kg. It could go out into the market offering a new player a 10 year contract to supply cucumbers at $0.30/kg. The capital expenditures allow the contractor to amortise costs over a long time, in the process wiping out the competitor, and forcing other retailers to buy from them. The great aspect of this business model is that its highly efficient. The negative aspect is that it is causing a structural shift in the market from which local food producers might never recover. The problem of course is the lack of market disclosure or unequal market power. The large integrated retailers are changing the way business is done. For example, for years I have been buying processed fruit packs from Golden Circle. Golden Circle must have increased their margins or food prices have risen because I have been paying a lot more in recent years. Recently Woolworths started offering a similar product at a discounted price. No doubt it is hoping to steal market share away from one of its food suppliers. More interesting is that the food is supplied from Swaziland. This is of course a logical development. These countries should be producing fruit because they have cheap labour. The same company in Swaziland is likely supplying Wal-Mart. This could create a competition problem. The laws in Swaziland might allow the local subsidiary of Woolworths to refrain from competing with it. i.e. Coles in Australia might be unable to buy the same fruit from the same producer. Should this bother customers?
This actually looks like an unfair development but actually this is an inevitable development which is good for food consumers, good for poverty-stricken developing countries, excellent for shareholders, a bonanza for directors with company options since food is fairly recession proof. Probably the biggest problem is the fact that the rural farm sector which is dominated by family owners will just not be able to compete. They will not be able to conceive of shifting their operations to Africa. They would not even know where Swaziland is.
What is the significance of that? Australia or NZ have even lower currencies one suspects? Or Australia and NZ become nice places to live, but if you intend to run a business, it will need to be a non-food, service business because there is no longer any money in food. Of course if you live on the coast you can sell your farm for retirement living. The question is - what happens to all that land in high cost Western markets? It is well suited to pastoral uses as well as highly mechanised farming. Can we not then expect countries like Australia to retain its lead in wheat, cotton? We might expect the less thirsty crops to win the day given the scarcity of water. Expect also a great deal more farm consolidation on a global basis in order to ensure security of income and supply. We can expect these corporations to preserve large stockpiles as well, and to trade them accordingly.
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Andrew Sheldon www.sheldonthinks.com

Strategic trends in farm economics

Check out the following insights into the strategic direction of food retailing worldwide. It has implications for all farmers.

Product marketing - Japan style

When I travel around Australia it amazes me how little Australian farmers know about the Japanese market. There are some good ABC programs that give people a guide as to the best approach to these markets. Its not easy because you really need to live there to understand the culture. You will not understand Japan by talking to or employing Japanese sales consultants. There are just too many uncritical thinkers. What I realised about Japanese marketing is just how non-intellectual it is. Certainly huge resources go into design. What I think is not realised is how much of these resources is wasted by a lack of critical thinking. Even the giants like Sony don't really have good design teams. What they do have is have MANY design teams. Living in Tokyo you come to appreciate how many bad products are designed and produced in order to find one that works for the consumer. Of course more resources go into the good designs and the poor designs are dropped. I sense that Sony cut back on its range of products several years ago, and they seem to have fallen into obscurity since. But they clearly recognised the weakness because they established a JV with Ericson.
The food business is a little different. In Japan, the Japanese have long considered lamb to have a too 'gamey' taste for their pallet. This miraculously changed with the rising incidence of mad cow disease, such that lamb is very popular in Japan now. Why the change? Well simply, when US beef was rejected by Asian buyers, the price of beef went up. Japanese importers recognised that they could make higher margins on lamb than beef, and so they started promoting the 'health benefits' of lamb.
As an Australian I grew up having roast lamb 1-2 times a week. It was only recently however that I learned how to get the best possible taste from lamb. If you buy diced lamb pieces from the butcher and cook it in a steamer you will find it has a much nicer taste. I love steaming because I can cook 'hard vegies' like carrots and potato, then after 3-4 minutes I add the 'soft vegies' like broccoli, carrots and peas along with the lamb pieces. The benefit of using lamb pieces is that you can evenly cook the lamb without the steam drying it out. Its easy because you can simply rotate your meat type and retain the vegetables each night.
The Japanese don't seem to eat lamb at home so much. I think they don't know how to cook it. In my case I got into all sorts of problems trying to teach my Japanese ex-wife how to cook it. I was young then, so I warn you, you don't want to say "I'll show you how to cook lamb the way my mother did". I would never have expected to fight over a desire to do the cooking, or fight over lamb, but food is important to the Japanese. :)

Determinants of farm valuation

Like any business the value of a farm comes down to anticipating its future stream of incomes. In assessing those cashflows its normal for the market to go through cycles of under-appreciation of the business value to periods of excessive optimism with respect to farm output. These cycles often relate to speculative cycles based on credit (interest rates), market developments and technological innovation.

When we think about the value of a property we need to consider:
1. Potential farm output: What commodities is the farm able to produce?
2. Potential value add: Are they any opportunities to differentiate the farm product as a premium product in order to extra more farmgate revenues? This might involve further processing prior to shipping, or just better brand definition or recognition.
3. Soil fertility: The productive capacity of a farm depends on natural as well as synthetic inputs.
4. Climate: The climate, whether its a natural dryland climate or a modified (irrigration) climate has a isignificant impact on yields per hectare as well as the number of crops. There is the prospect of climate change changing farm values. Farms in the north of Australia are receiving record prices at auction because of the trend towards higher rainfall in those areas. Its inevitable that greater infrastructure spending in those areas will further increase the value of these lands over time.
5. Risk management: There are a number of risk factors posed to farmers, whether its drought, floods, locusts, rodents, cyclones, bushfire, soil erosion, weed infestations or competing land uses like mining or quarrying. We need to look at strategies to reduce the risk of these elements on our business. Some of these factors are harder to manage than others. Ever-present among these risks is the market price risk. We can of course use various financial instruments to manage these risks, but we need to understand that we are not removing risk, we are changing its form. Financial institutions don't carry risks for free, and when you offload a risk, you accept a different type of risk such as a financial or counter-party risk.
6. Capital requirements: Access to debt or equity finance is particularly important where rainfall is unreliable since a farm needs to be able to finance equipment, land acquisition, overheads and inputs, and be able to meet loan obligations in times of tough climatic conditions.
7. Market dynamics: The fundamentals of the grains and lifestock market have become more complicated. Diets are changing, grains have increasingly been used for fuel production, and the land available for agricultural utilisation is declining.
8. Market Structure: In Australia 98.5% of all farms are in the hands of families. A far greater share of farm capacity however is controlled by large agricultural enterprises. The level of enterprise involvement in farming is higher in other OECD countries, particularly the USA and EC.
9. Water availability: Water is a critical resource determining what products can be produced from a property. Availability is important in two respects: The pricing of water and its reliability as a farm input. Inadequate water can severely impact farm yields.
10. Farm management: Increasingly farming is becoming an increasingly sophisticated business. Despite the growing levels of specialisation in the industry, the agricultural sector largely remains conservatively managed. This is a global factor. Enterprises have had little success penetrating this industry. In some cases, corporations have made progress by buying excess water rights.
11. Commodity prices: Like in all sectors we are concerned with real commodity prices.
12. Farm size: Closer to cities there is a tendency for farms to be broken up into smaller fragments to suit urban development or fringe lifestyles. Maintaining the productive capacity of a farm is the key to productive capacity. Larger farms have greater economies of scale. A farm has value as a going concern, or for higher value applications like urban development. An some point urban development is inevitable for fringe lands.