While the leading CPG brands (Heinz, Nestle, Unilever, Del Monte) are reporting increase in profits from price increases, the retailers are not happy with the price increase. Safeway is asking the brands to rollback their prices and is using their private label leverage. Safeway executive Steve Burd, told analysts,
I say wait and see, because we’re going to chew up on corporate brands
Mr. Burd makes his case based on falling input costs and hence the brands must pass on the savings to the customers. Again to repeat for the umpteenth time, costs are not relevant to pricing. These food brands were able to retain their price increase and grow their profits despite the drop in sales volume. This is because of the change in customer mix, the price sensitive segment has already moved on to private labels. The brands are doing the most rational thing, price products at what customers are willing to pay.
The retailers have a higher gross margin on the private labels and most private label products are produced by the same corporate brands Mr. Burd was talking about. The retailer margins are so thin that they need the large volume to make up for their high fixed costs. The retail operations are measured by dollars per cubic (or square) inch. The fall in volume of name brands due to their price increase is starting to affect retailers despite the increase in sales of private labels.
One questions we should ask is if a retailer can “chew the corporate brands” with their private labels, why not do just that? Why threaten to do this? I believe the loss to retailers with this move will be larger than it would be from a negotiated price agreement with the brands. Retailers depend on the same brands for supplying private labels, they need to spend more on promotion and stand to lose customer traffic if brands are pulled out of their stores.
What is the likely outcome? Brands are happy with their price increase and know that those who are buying now are their brand loyal customers. If a retailer pulls the brand off the shelves most customers will seek another store. But the risk exists that the brands will lose out in the long term. The most likely scenarios to happen are
- Brands will allow retailers to keep more of the price increase in the form of trade promotion
- Brands cut a better price deal with retailers on the wholesale price of private labels manufactured in their factories.
In any case it is time for retailers to start thinking about reducing their operational costs.
Marketers are usually obsessed with market share and top line growth. In the recessionary times when customers are feeling the pinch and switching to private labels one would expect a price war among the major CPG labels for market share. But exactly the opposite is happening. There are four news stories from recent Wall Street Journal issues:
Of course this increase in profit with increase in price point to pricing inefficiencies until now, marketers have been pricing it below their profit maximizing price, probably focused on market share.
So why will the prices go up with profit despite drop in revenues? With recession, as some customers shift to private labels those who are left and prefer these brands have a higher willingness to pay and are loyal to the brands despite the price. Until now the CPG companies were going after the wider market with lower price. Now they know that they can’t get the price sensitive segment and hence it makes no sense to leave their loyal customers with higher consumer surplus. Hence the increase in price.
But how can profit go up when revenues go down? The price increase is pure profit but when marketers lose sales volume the loss in revenue is not all profit. As long as the marginal profit from increase in price is more than the loss of profit from lost sales, the marketer will gain from the price increase despite loss in revenue.
So the strong brands are increasing prices not decreasing and they are reporting increasing profits despite drop in revenues for some. If you are a investor are you worried about drop in revenues or happy to get increase in profit?
In April 2008 I posed the question, Is Ruby Tuesday solving the right problem?. At that time Ruby Tuesday announced a $50 million restaurant and brand makeover. I did a simple estimate based on Ruby Tuesday’s own goal of increasing cash flow by 3% and did not include the economic problems. The quick analysis showed the investment to be net negative.
The fiscal second quarter results announced last week point to the restaurant’s woes stemming from the economic crisis. Ruby Tuesday suffered more than the restaurant groups due to its high makeover expense that did not payoff and due to fall in traffic to malls where many of its restaurants are located. The WSJ reports,
While most large restaurant chains are struggling, Ruby Tuesday has had a particularly difficult time. Since 2007, the company has invested heavily in a brand overhaul to make its food and atmosphere more contemporary, but the effort hasn’t reversed the slide in same-store sales. During the past year, its shares have fallen 82%.
The answer to the original question is an absolute No.
Hal Varian, Economics professor at UC Berkeley and Google’s Chief economist wrote an Op-Ed in WSJ stating private investments as the cure for economic downturn. This comes from the aggregate demand function that describes national income
National income = Consumer spending + Private Investments + Government spending + Net exports
Increase net exports is a problem when US is continuing to import oil and cheap products from China and the dollar continuing to be a strong currency. Consumers are tightening belts. The Government spending when done right will work except that it may run into problems related to who will buy the new debts. Varian says private investment is the solution.
China a major buyer of US treasuries is reported to be losing its interest in buying more US debts. For the US economy which has exhausted all options and now looking at deficit spending as the last hope this could spell more trouble. First a brief background.
President Elect Obama announced that the US deficit could reach $1 trillion for years to come. He has said that he will be passing multi-billion dollar fiscal stimulus packages to stop the free fall of the US economy. Fiscal policy is now the only available lever to pull given that the only other major lever, Monetary policy has been exhausted. The Fed had already reduced the target interest rate to 0-0.25%, there is no further room for the monetary policy. Even now the lax monetary policy did not stop the fall and is proving to be impotent. The only hope is fiscal stimulus.
But with any fiscal spending the first question to ask is, “How is the Government going to fund the spending?”. In other words, what gives? The only revenue source to the Government is the Tax collection. When the Government spendings exactly match the tax revenues collected we will have a balanced budget. Otherwise we get surpluses or deficits.
The Government does deficit spending by issuing debts, in the form of US treasuries. Any individual, institution or Sovereign funds from around the world can buy these. Until now a biggest buyer of US debt has been China. But with its slowing economy and its posed $1 trillion fiscal stimulus it is losing interest in buying US debt.
What does this mean?
The US Government has to find other buyers from locally or from EU. It may have to spice up the bonds issue by increasing the rate it offers on these bonds, but this means the interest rate for all US credits will go up. For an economy struggling under credit crisis, this will further staunch credit available to businesses and individuals and the effects may negate the positive effect from Government spending.
The net is, without a buyer for US debts at current rates, getting out of the economic crisis through deficit spending is not going to work.
If you do not subscribe to the WSJ, the print or online version, head over to the newstand near you and buy today’s paper.
The cost of $1-$1.50 you pay is a bargain considering the value you will get from the articles on the credit criss, Bernanke’s warning, why we use measuring cups and not kitchen scales, the European recession.