Lion cries over spilt milk
A warning for manufacturers regarding growth in Australian house brands
The Age reports that a large milk processor, Lion (owns Pura and Dairy Farmers brands) has moved to a loss due to the milk price war.
It looks like this is evidence that the price way is harming milk producers. But the details of the story don't prove that the supermarkets are selling below cost and I'm sceptical that the price war is harming farmers or consumers. I think a bit of mix analysis will shine some light. This story is an interesting case study for manufacturers affected by the private labels/home brands promised by Australia's two leading grocery chains. It shows how easily category margins can collapse with changes at the entry level.
The article, based on clear quotes from Lion, says that the cheap supermarket milk has caused a distribution shift away from expensive, high-margin retail (such as milk bars and convenience stores) to supermarkets, because the retail price gap has become too large for consumers to ignore. It's not mentioned in the article, but I guess that organic milk sales are suffering as well for the same reason. Another shift will be away from high-margin added-value products ('smart milk' with added vitamins etc) to plain milk.
Even if the price the supermarkets are paying doesn't change, this margin shift alone will cause a large profit decline.
In fact, nowhere in the article does Lion claim that it is facing lower unit prices for plain milk. Its profitability has been based around assumptions of a highly profitable distribution and brand mix, and the price war has changed consumer behavior. Overall, you'd guess that milk volumes would increase. But Lion says it has lost private label contracts. That's a bit odd: it is possible to "lose" contracts for quality or performance problems, but usually you lose them because you are too expensive. I'm not informed, but I'd guess Lion was consciously or unconsciously subsidising these contracts in the past with higher-margin sales, which have now disappeared. The price war has certainly put more pressure on the supermarket buyers to negotiate cheaper prices, but I greatly doubt the buyers were significantly over-paying in the past. Manufacturers are businesses with high fixed costs, and this a dangerous and uncomfortable situation ... to lose those volumes and the associated contribution margin. Meanwhile, those higher volumes have gone somewhere else.
In all of this, I don't clearly see how consumers are suffering from the price way, even in the long term. Sometimes price wars can hurt consumers in the long term because the price wars remove competitors, so when the war ends, the pricing is higher than before the war. In this case, though, the price war is mostly shifting the type of milk the people buy, and where they buy it. Almost certainly it is leading people to drink more milk. Possibly some of the creative added-value milk products that previously persuaded us to pay a lot for milk will disappear.
As for damage to farmers ... how much of Lion's formerly high margins were ending up with them? I don't know a lot about milk production, but I'm guessing that the farmers sell basic milk and the added-value was all Lion's. If they were dozy with their high margins and paying too much for basic milk, I'm not sure as a milk consumer I should be sorry to see that go. Part of the added value of the milk producer should be to source the raw product competitively.
Put it another way: opponents of the price war are arguing that entry-level products should be increased in price so that high-margins of convenience stores and fancy milk products are disguised. Consumers use low-price products in a category as a reference for the fair value of up-market products, so it's easy to see why brand-owners are keen for an end to the price war: in their eyes, the price war is destroying the added-value of the entire category. That's why more private label products will be uncomfortable for manufacturers accustomed to high margins. But you could also argue that perhaps consumers are realising that the premium charged for upmarket products just isn't worth it. It's going to be hard to get consumers to revert to previous attitudes even after the price war ends. (The surprise for me was the stated impact of the distribution shift away from convenience stores; I wouldn't have expected that to be significant, but apparently it is).
So put up prices, save jobs (and dividends) and everyone wins! I love arguments like this because they are subject to "reductio ad absurdum *" . If putting basic milk back to $2 saves jobs, why stop there! Imagine the job-creation power of increasing the price to $10 a litre. Meanwhile during the price war, poor kids are drinking more milk and less soft-drink, and there must be milk producers working on low costs and skinny margins who are happy at the extra volumes.
Back to commercial finance, the focus of this blog. Frequent readers will know what I'm thinking. The milk war is the type of fast-moving and hard-to-predict change that requires rapid and accurate response by manufacturers. They need to be nimble ... the price war could end as suddenly as it began (or shift to a new category). The timing of this is interesting: other manufacturers and brand owners could feel this pressure if the supermarkets carry through on their intention to dramatically increase the share of private label products.