Why We Sold Out Of Patties Foods: The Ugly Coles And Woolworths Duopoly

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by Carlos Gil, Chief Investment Officer at Microequities Asset Management.

The disconcerting exit of the CEO of Microcap pie maker Patties Foods ((PFL)) should not be construed as a damning report card of what was quite a successful tenure by the departing Greg Bourke. Rather, it is another chilling example of the long chain of victims that our unique retail duopoly is creating.

We have the most uncompetitive retail grocery market structure of any Western nation in the world. As worrying as that market structure should be, given we rely on that market to service our basic needs as consumers, what is really worrying is that it’s causing irreparable damage to one of the few sectors Australia can legitimately claim to be endowed with natural competitive advantages: food production and distribution.

Two years ago, our flagship Microequities Deep Value Microcap Fund exited Patties Foods with a sizable positive return. We did so not because we thought there were imminent storm clouds on the earnings front, but rather because we were concerned with the market structure of Patties Foods’ biggest customers, Woolworths ((WOW)) and Coles ((WES)), and how that would impact the long term future of the company’s earnings growth.

Woolworths' and Coles' combined market share of Australia’s grocery market is around 80%. That’s a tremendous concentration of power for any market. But what is most concerning is that Woolworths and Coles have in recent years embarked upon a combination of policies that is undermining the economics of companies like Patties that supply to them. Both have chosen to aggressively discount, weathering away suppliers’ margins and reaping into brand equity.

It is not just local food producers that are under tremendous pressure. Legendary brands like Coca Cola have come under the crossfire of their aggressive price cutting. Some readers may welcome price declines, however these price declines are not market driven outcomes, but policy directives by the two players that effectively control the market. It is tantamount to the government imposing price limits on goods; only it’s not the government that is imposing them with a well thought out social and economic policy, but a corporate duopoly flexing its power for self-serving short term gain.

For a relatively small producer like Patties, this market structure imposed pricing pressure is perilous. For the industry at large, it inhibits R&D into the products, halts product innovation, and reduces the ability for a company to differentiate its product’s brand via marketing and advertising. It eats away at the core features of brand equity and product development. It is an extremely worrying market dynamic and one that should worry the newly installed government.

Some proponents of this destructive policy will advocate that Coles and Woolworths have done a wonderful job at running their respective businesses; that it’s really management ability and execution that is providing their remarkable EPS growth (Woolworths average EPS growth over the last 12 years has been over 12%).

One might ask: if their strong EPS growth stems from this unique management ability, and/or a business model method or superb execution; why aren’t Coles or Woolworths exporting this unique success elsewhere?  Why are they not attacking new geographical markets overseas?

Certainly, successful overseas retailers like Wal-Mart, Aldi, or Carrefour have all expanded internationally with varying levels of success. Our big two have not exported their amazing business models. Woolworths recent exit of Dick Smith and subsequent turnaround under new private ownership certainly doesn’t inspire confidence in the argument that behind their success is management ability or a superb know how of retailing.

Private equity bought Dick Smith from Woolworths for $94m, under this new private equity management the business operations have improved markedly. So much that 12 months later, Dick Smith might be floated with a suggested valuation price tag of $500m+.

One would expect a key management competency of a retailer is retailing. It is worrying that a new management team can turn around an asset that Woolworths had been managing over a decade. But perhaps it is only another evident signal that what is really behind Woolworths' and Coles' remarkable growth and profitability does not stem from superb retail management, or a fantastic business model, or superb execution or strategic vision. Perhaps what it clearly demonstrates is that behind their numbers is an ugly reason for their success, an unfair market structure, a duopoly with exuberant power.
 

Microequities Asset Management is a value investor specialised in Australian microcaps. Its flagship fund –the Deep Value Microcap Fund– has a 5 star Morningstar rating. For further information visit microequities.com.au. Content included in this article is not by association necessarily the view of FNArena (see our disclaimer).

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