Essentially, in the current climate, major retailers are faced with two significant drains on profitability. First, the high cost of fulfilment compared with B&M retailing makes online business dilutive of overall profit. Secondly, as consumers shop smaller, faster, closer, this makes 20% of out-of-town big space redundant, thus depressing outlet productivity, or rate of rotation of the store asset.
In other words, this results in negative impacts on Net Margin i.e. Return on Sales, and Capital Rotation, or Sales/Capital Employed, the two components of ROCE (Return On Capital Employed).
Understanding how it works in practice will help you appreciate, and resist, excessive demands by your customer, and also show you how best to help, on a fair-share basis.
Essentially, as you know, ROCE = Return/Sales x Sales/Capital Employed. If ROCE meets stock market expectations, the share price goes up, reducing the cost of borrowing, and can make it less expensive to acquire other retailers via a combination of shares and cash. However, more importantly, a good ROCE increases the value of buyers’ share options and autonomy in running the business. As the share price falls in response to diminishing levels of ROCE, the opposite occurs.
This may explain why supplier-retailer relationships are becoming more fraught and increasingly personal as B&M retailers begin to understand the real profitability of online fulfilment coupled with the growing problem of large space redundancy on overall company profitability…
Online as profit dilutor
Given that it is one of the only real growth areas in retail, major retailers cannot afford not to optimise the full online potential of their brand. However, compared with the relative simplicity of serving a customer instore, meeting a consumer’s online needs means additional fulfilment costs including picking, packing, shipping and handling returns.
Online grocery is even more complex in that a typical online shopping basket contains more low value and bulky items, reducing the number of orders per van and thus dilutes van productivity. In addition, consumers are generally unwilling to pay for delivery.
As a result, given that a home delivery costs £20, and that the consumer is unwilling to pay more than £5 per order, the retailer loses £15 per drop, only partly recovered via the margin on the goods delivered. Incidentally, those retailers hoping to improve online profitability by shifting their emphasis onto more lucrative categories (i.e. bigger-margin non-foods), then pick up the additional profit-dilutor of online returns, where shoppers send back goods at four times the rate of returns made to B&M stores…
As B&M retailing can be more profitable than online, it follows that, as a retailer grows their online business faster than their B&M sales, the overall profitability of their business will be diluted.
Big space redundancy
In ideal times, B&M retailing can be more profitable than online. However, given the structural changes taking place in UK retailing, with discounters and local convenience stores growing at the expense of large space out-of-town players in a flat-line market, so the scale advantages of the major mults are diminishing.
In other words, large space retailers are finding that at least 20% of the store space is redundant, meaning that whereas it was possible to generate £1,000/sq. ft./annum, these sales have to be spread over a greater sales area.
For example: Say a retailer sells £1k/sq. ft. in a 120,000 sq. ft. outlet = £120m sales/annum. With 20% space now underutilised, the store sales become £96m i.e. 95,000 effective space @ £1k, reducing the sales productivity to £800/sq. ft./annum on the 120,000 sq. ft. store, with an equivalent impact on net margin and store utilisation or capital rotation.
Moreover, having conducted range culls to eliminate overlap and duplication, retailers are finding that 80% of sales are generated by 20% of the SKUs, resulting in a ‘long tail’ sales profile, whilst at the same time reducing product choice via the cull.
However, given that space – and its cost – are irrelevant online, in that a product tail can be as long as the number of products available, albeit selling less than one item per quarter, a B&M retailer can be even more tempted to develop their online offering in order to offer the consumer more choice, thus leading to more profit dilution via the fulfilment costs…
On balance UK B&M retailers are heading towards a future of permanent net margins of 2.5% or less, having grown – and built their share prices – on the basis of 5%+ net profit before tax…
It is impossible to increase prices, or significantly reduce operational costs, thus leaving the supplier as the main source of help…