Nov 25, 2024 | Change, Governance, Strategy
Should the ACCC have approved the $8.8 billion reverse takeover of Sigma pharmaceuticals by Chemist Warehouse?
Chemist Warehouse is by far the largest competitor in the $17 Billion retail pharmacy market. Sigma pharmaceuticals is a wholesaler serving all pharmacies, and holding a major share. On the surface the reworked Chemist Warehouse/Sigma pharmaceuticals company could exert undue competitive pressure on retail pharmacy competitors. They would be in a position to dictate price and terms by virtue of their scale. Surely not a good outcome for retail prices.
On that basis when recently asked my view I asserted that the ACCC had made a mistake in allowing this transaction. It seemed on the surface that the power of the combined group would logically result in higher barriers to entry, less innovation, the lessening of competition logically leading to higher prices.
However, on the flip side, is it the role of anti-competitive legislation to protect competitive enterprises in a vertical?
Retail pharmacies make anywhere between 25% and 65% of their revenue from non-prescription sales. The latter number being Chemist Warehouse share, the former being the bottom end of all other retail pharmacies. In effect, pharmacies operate as competitors to Woolworths and Coles for a big chunk of their revenue.
We have a paradox here reflected elsewhere in the economy, most particularly in the retailing of food and groceries. Should regulatory authorities be required to interrogate just the horizontal market for competitive pressure, or should they also reflect on the verticals in operation that serve as the supply chains?
Coles and Woolworths over the last 40 years have effectively created what was 20 years ago an oligopoly. They had swallowed up in one way or another almost all of the competitive retail chains, and the power of the wholesaler serving independent retailers was significantly diminished. To facilitate their own supply chains, they built and continue to innovate through the supply and logistics chain to squeeze costs out, in any way they can, while maintaining a good return to shareholders.
Aldi launched into the Australian market in the mid 90’s. They deployed a different business model offering a limited range of house branded products at discount prices in low rent locations. As the number of ALDI stores increased driving market share, so did their competitive impact on the market increase. Currently it would be wrong to consider Coles and Woolworths an oligopoly, as Aldi is a growing, and apparently financially viable competitor.
After consideration, I concluded that the ACCC had in fact made the right choice in allowing the Chemist Warehouse Sigma pharmaceuticals reverse takeover.
At the other end of the scale, we have the privatisation of natural monopolies where competition is next to impossible. The obvious example is Sydney airport, a privatised public monopoly that has conducted innovative programmes to gouge the travelling public. Such a natural monopoly should never be privatised.
It is stupid and naive in the extreme to think that a private corporation would not leverage their pricing power to the benefit of their shareholders when customers had no option, and no alternative was likely to emerge. Promises of regulatory profit limitation have proven to be a politically useful mirage, its true nature only apparent just after the ink has dried.
Aug 12, 2024 | Change, Strategy
2024 is very challenging for SME’s.
It is proving to be a time of an unusually high rate of SME mortality. This is driven by the problems that emerged with the Corona virus, followed by a period of historically low cost of capital, then a burst of inflation now being wrung out by aggressive rises in interest rates, the wars in Ukraine and Gaza, uncertainty of supply chains, and a host of other items.
It makes sense for every business owner to consider the value of their business. While having an exit plan is always a good idea, few are proactive in creating one.
While you may not be considering selling any time soon, (or going broke) it remains a valuable exercise to uncover the drivers of value, and double down on them.
Following is my list of value drivers, in a rough order, which will vary with circumstances and conditions in any specific market.
Cash flow.
Managing cash is the single most important thing every business can do to ensure survival, after looking after your customers. Cash is not subject to accounting rules, conventions, or differential tax treatment, as are the P&L and Balance sheet. You either have it or you do not.
Calculating free cash flow, the cash left over after capital expenditure over time, gives an extremely sensitive view of the health of a business.
Happy and committed customers.
You can make customers happy by giving discounts, but that is not a good measure of value. A committed customer will be prepared to pay at least the going rate for your products, and will not be moved by short term incentives from a competitor. Two of the best measures are Share of wallet and customer churn.
How much of a customer’s spend on a category you could supply, do you supply, and what is the ratio of customer loss and gain that is occurring. Committed customers will also be happy to refer you to others, simply the best form of marketing there is.
Customer & supply chain diversity.
‘Don’t have all your eggs in the one basket’ is a dictum that has proved true time and time again. Businesses that allow one customer to become more than about 25% of their revenue are dicing with trouble. In the event that customer goes broke, changes personnel at the top, gets taken over, or a myriad of other things that can happen in commercial life, you can find yourself out in the cold. This is the structural problem facing Australian suppliers to FMCG.
It is the same in your supply chains, but in reverse. Every business wants to be a dominating force in their supply chains, to be able to exercise some level of control. The pandemic has shown us how fragile our supply chains are, so resilience has become a key KPI for many who were previously reliant on single sourcing and JIT supply.
Differentiated in ways hard to duplicate that customers value.
Charlie Munger often spoke about building ‘Moats’ around his businesses. We all understand that a moat is a structure that repels invaders, in a commercial case, competitors. It is a lovely metaphor, and works irrespective of the scale and type of your business.
You build moats by being able to create customer value that competitors cannot or choose not to match, and if they try, their resources are consumed by the power of the Moat. This sort of protection is rarely a function of just one element, in the metaphor, the height of the moat wall and depth of the water. It is always a combination of many contributing strategic and tactical measures.
‘Tide’ detergent in the US retains 50% market share of the washing products market. Any quick look would indicate it to be a commodity market. Anyone with the right gear can make a detergent that does a good job, so how has P&G retained this share? It is a combination of time, disciplined brand building tactics, consistently very good advertising, continuous innovation, and an ability to ‘shape’ the market by being strategically smarter than everyone else. These have delivered first mover advantage continuously to P&G as the ways Tide delivers value to consumers have evolved.
Defined Process maps subjected to continuous improvement.
Imagine a potential buyer comes into your business with a serious intent to consider purchase. Anything you can do that reduces the level of uncertainty that they will feel about the value of your business to them is worth doing. If a buyer sees that business processes are mapped, consistently applied, and the subject of continuous improvement, it will be immensely reassuring. Such an environment will remove a significant source of uncertainty and risk.
Revenue Predictability
Revenue predictability is gold. Forecast accuracy drives not only sales up, but operational costs down, and revenue generation activity more directly connected to results, and therefore accountability.
Over the last 20 years, the nature of revenue has changed from one driven by sales, to one driven by subscription. Once you have a customer ‘signed up’ to some sort of process that delivers revenue automatically, they are both more likely to spend more, as they have a sunk cost to recover, and less likely to leave.
Amazon Prime is the most effective subscription model ever seen. Currently Amazon prime has 170 million subscribers in the US. For $14.99 monthly or annual subscription of $139, subscribers benefit from a range of ‘free’ services from across the Amazon ecosystem. Numbers vary, but solid research puts prime subscribers buying up to 4 times as much on Amazon as the average non subscribing Amazon buyer, up from around $500/year to over $4,000. Not bad when you can also manage the margins they are buying at, and have already banked $11 billion in advance.
My local coffee shop has a loyalty program, the 11th coffee free, so I tend to buy from them when it is convenient to do so. If the situation were reversed, and I had paid a membership up front in order to get a discount, the incentive to go there would be significantly stronger. Amazon Prime has harnessed this basic psychological driver to generate billions of dollars.
Having a clear set of robust leading indicators of revenues, margins and profit, offers certainty to any buyer of your business, as well as to you. They also offer the explicit platform for improvement.
Focus
To optimise your business, and thus enhance its value, it will pay to focus aggressively on the areas where you have some sort of competitive advantage that can be leveraged. This always come down to trimming product ranges, brands, geographies, technology bases, and market segments aggressively. While the analysis is tough, and the choices even tougher, you will inevitably find that the pareto rule applies, and aggressive application drives profitability. A mantra I use with clients is ‘Pareto the Pareto’, suggesting that this optimisation is a continuous process.
Clean books
Using the business as an ‘ATM’ for the owner is a danger sign for any buyer. When preparing your books for the inevitable Due Diligence examination by a potential purchasers accountant, the less items that are up for deeper examination the better. Ensure you have a ‘normalised‘ P&L available for scrutiny that identifies and explains or excludes all the items that may draw a question. Similarly, many SME’s claim to have some component of cash transaction in their business. Expect those claimed transactions and resultant cash to be completely discounted by a potential buyer as a source of value.
Steady growth history
Any potential purchaser is only looking at what you have done in the past, as an indicator of what might be possible in the future. They are only interested in understanding the future return on an investment they might make in your business. Therefore, a history of growth will be an indicator that all things being equal, there is evidence that the growth that will benefit them will continue. Growth that is relatively smooth is always better than growth experienced in fits and starts in the eyes of a buyer.
This applies equally to all financial and non-financial measures.
A strong management bench
Across functions, you need people willing and able to step up as you expand. A balanced and robust bench with solid succession planning through all levels is a hedge against the uncertainty that accompanies an acquisition, and benefits the value of the business.
An obvious culture.
Every business has some sort of culture, the ‘way we do things around here’. A consistent, explicit, and aligned culture that is aimed at delivering a well understood strategy is like cheese to a mouse: irresistible.
None of these are easy to address. If they were, the mortality rate of SME’s would be less than it is.
Jul 5, 2024 | Change, Governance, retail
The undertaking by Opposition leader Dutton, supported by the Nationals leader Littleproud, to break up the retail gorillas Woolworths and Coles is absurd. It is a gross example of stupid, short term populism and fear mongering that exhibit either utter ignorance of the current and proposed laws, how the supermarket supply chains work, or scary levels of ignorance.
Perhaps it is all of these mixed up in a broth of complete ‘short-termism’.
It seems to me that facts and long-term benefit to the economy and communities play no role in this ill-conceived appeal to populist, thoughtless ‘policy’.
Such a breakup is far more likely to increase retail prices to consumers, it will certainly not result in any reduction.
Let me be clear about the failures of this proposal, at least as I see them.
Supply chain mechanics.
- The current voluntary code of practice, and the proposed mandatory standards relate to the chains and their suppliers. In a minority of cases are these suppliers also the manufacturers of the consumer product, as well as being the farmer, and all the associated and necessary middlemen that provide the supply chain with the ‘Oil’ that makes it work. Therefore, the policy if implemented would do nothing for the small scale ‘farmers’ who are often held up as victims of retailer power.
- Scale breeds scale. Suppliers of fruit and veg have over time, built scale to squeeze out transaction costs from the supply chain. The Australian Fresh Produce Alliance is a small group of very large ‘consolidators’ that between them control roughly half the $9 billion fresh fruit and vegetable market. These businesses are farmers only in the sense that they might own, contract, or represent hundreds of individual farming locations. Several of the major players are owned overseas. A breakup of Coles and Woollies would only encourage them to increase prices, as the suppliers would then have greater scale than the chains, and would use it.
- The small, independent farmers of commodity fruit and veg is a part of the past. Believing otherwise is fantasy. Where those who choose to farm a small holding have opportunities are in specialty produce sold through channels other than chain retailers.
Legal considerations.
- Any breakup would involve legal action, probably to the high court. I doubt the retailers would take a breakup order as anything other than an order to self-destruct. This would be resisted fiercely.
- The mandatory Code recommended by Dr Emerson, and widely accepted is only marginally more useful than the current voluntary code. It still requires that suppliers lodge complaints. Whilst there are now to be penalties applicable by arbitration, the likelihood of complaints remains low, despite the ‘protections’ articulated in recommendations 3, 4 and 5.
- The scale of penalties proposed by Dr Emerson is absurd. If the threat of implementation was real, nobody in their right mind would invest in retail of any scale. Imposition of the maximum penalty would send the retailer concerned broke. Assuming they are just ‘regulatory scarecrows’ with little legally independent investigation and enforcement power, they represent little of any real deterrent value, while adding friction to the supply chain. Friction generates costs, which will be recovered from consumers.
Competition falsehood.
- Coles and Woolworths do currently have somewhere around 65% market share of retail FMCG sales. That percentage is being eroded by Aldi, as it opens more stores and successfully takes market share.
- In regional areas of NSW and Vic particularly, but also SA and WA, there are a number of strong independent retailers. Drakes, Ritchie’s, IGA, and others are all competing successfully against Coles and Woollies. None would be able to buy disassembled bits of the gorillas, and even if they were, what would that do to the objective of decreasing retail prices? It would more likely put upward pressure on prices as the purchaser sought a return on the investment.
- It you were to breakup either of the retail gorillas, who is a likely buyer? I cannot think of any, except perhaps Walmart, who are also smart enough to assess the sovereign risk as being considerable, so they would not put anything like the expected value of the broken up businesses on the table.
- Some time ago, under Graham Samuel, the ACCC forced the removal of contractual exclusivity of Coles and Woollies in shopping centres under Section 47 of the Competition and Consumer act 2010. That move was a very sensible one, and has resulted in Aldi opening a number of stores in shopping centres in opposition to Coles and Woollies. (An extension to cover ‘land-banking’ might be a useful consideration.)
- While Coles and Woolworths are immensely powerful, they are far from the only distribution channel that exists. In a court they would point out the multibillion dollar and still fragmented food service channel, as well as the independent specialist retailers who continue to provide opportunities for small scale farming.
A final thought. Every Australian with a superannuation fund: i.e. most of us, would have Woollies and Coles in their portfolio, knowingly or otherwise. These shares have been good investments in terms of capital gain, and throw decent tax effective dividends. A breakup would threaten those investments.
For the Opposition leader to propose legislation, should they be elected to government, to break up Woolworths and Coles is nothing but an idiotic, populist, ill-considered appeal to voters without the knowledge to dismiss it with the contempt it deserves.
It is also an astonishing dismissal of one of the cores of the conservative parties: to limit the intervention of government in the workings of the economy.
We Australians deserve better from our ‘leaders’ than opportunistic and destructive policy statements.
Jul 2, 2024 | AI, Change, Strategy
AI is the latest new shiny thing in everybody’s sightline.
It seems to me that AI has two faces, a bit like the Roman God Janus.
On one hand we have the large language models or Generatively Pre-trained Transformers, and on the other we have the tools that can be built by just about anyone to do a specific task, or range of tasks, using the GPT’s.
The former requires huge ongoing capital investments in the technology, and infrastructure necessary for operations. There are only a few companies in the position to make those investments: Microsoft, Amazon, Meta, Apple, and perhaps a few others should they choose to do so. (in former days, Governments might consider investing in such fundamental infrastructure, as they did in roads, power generation, water infrastructure)
At the other end of the scale are the tools which anybody could build using the technology provided by the owners of the core technology and infrastructure.
These are entirely different.
Imagine if Thomas Edison and Nikola Tesla between them had managed to be the only ones in a position to generate electricity. They sold that energy to anybody who had a use for it from powering factories, to powering the Internet, to home appliances.
That is the situation we now have with those few who own access to the technology and anybody else who chooses to build on top of it.
The business models that enabled both to grow and prosper are as yet unclear, but becoming clearer every day.
For example, Apple has spent billions developing the technology behind Siri and Vision Pro, neither of which has evolved into a winning position. In early June (2024) Apple and OpenAI did a deal to incorporate ChatGPT into the Apple operating system.
It is a strategic master stroke.
Apple will build a giant toll booth into the hyper-loyal and generally cashed up user base of Apple. Going one step further, they have branded it ‘Apple Intelligence’. In effect, they have created an ‘AI house-brand.’ Others commit to the investment, and Apple charges for access to their user base, with almost no marginal cost.
Down the track, Apple will conduct an auction amongst the few suppliers of AI technology and infrastructure for that access to their user base. To wrangle an old metaphor, they stopped digging for gold, and started selling shovels.
Masterstroke.
It means they can move their focus from the core GPT technology, to providing elegant tools to users of the Apple ecosystem, and charge for the access.
What will be important in the future is not just the foundation technology, which will be in a few hands, but the task specific tools that are built on top of the technology, leveraging its power.
Jun 24, 2024 | AI, Change
We’re all familiar with the standard XY graph. It shows us a point on 2 dimensions.
AI does a similar thing except that it has millions, and more recently, trillions, of dimensions.
Those dimensions are defined by the words we write into the instructions, built upon the base of raw data to which the machine has access.
The output from AI is a function of the data that the particular AI tool has been ‘trained’ on and accesses to respond to the instructions given.
Every letter, word, and sentence, generated is a probability estimate given what has been said previously in the database of what the next word, sentence, paragraph, chapter, and so on, will be.
Generative pre-training of digital models goes back into the 1990’s. Usually it was just called ‘machine learning’, which plays down the ability of machines to identify patterns in data and generate further data-points that fit those patterns. The revolution came with the word ‘transformer’, the T in ChatGPT. This came from the seminal AI paper written inside Google in 2017 called ‘Attention is all you need’.
The simple way to think about a transformer, is to imagine a digital version of a neural network similar to the one that drives our brains. We make connections, based on the combination of what we see, hear, and read, with our own domain knowledge history and attitudes acting as guardrails. A machine simulates that by its access to all the data it has been ‘trained on’, and applies the instructions we give it to then assemble from the data the best answer to the question asked.
The very first paper on AI was written by Alan Turing in 1950 was entitled ‘Computing machinery and intelligence’. He speculated on the possibility of creating machines that think, introducing the concept of what is now known as the ‘Turing Test.’
The original idea that drove the development of the transformer model by Google was a desire to build a superior search capability. When that was achieved, suddenly the other capabilities became evident.
Google then started thinking about the ramifications of releasing the tool, and hesitated, while Microsoft who had been also investing heavily through OpenAI, which started as a non-profit, beat them to a release date, forcing Google to follow quickly, stumbling along the way.
Since the release of ChatGPT3 on November 20, 2022, AI has become an avalanche of tools rapidly expanding to change the way we think about work, education, and the future.
Header cartoon credit: Tom Gauld in New Scientist.
Jun 19, 2024 | Change, Governance, Leadership
Many years ago, I worked for Dairy Farmers Ltd. It was a large dairy co-operative operating in the dying days of milk regulation in NSW. The business had two divisions, reporting at EBIT. The first and biggest by a very large margin was the regulated milk business.
All milk produced in NSW at that time was by regulation vested in a statutory authority, which then ‘sold’ the milk to processors to be processed and distributed as fresh milk. It was a highly regulated and price-controlled industry from the cow to the consumers fridge.
Milk in excess of the requirements for fresh milk was termed ‘manufacturing’ milk. The farmers were paid directly by processors at a market rate.
At the time, the price paid by the diary corporation for fresh milk was roughly 2.2 times the price the co-operative paid for manufacturing milk by the second division, the Dairy Foods division that produced all dairy products beyond fresh milk.
Manufacturing milk was unregulated in any way beyond food safety.
The commercial imperative for the dairy farmers was clear, albeit not viable long term.
After 8 years of struggle, the Dairy Foods division had recovered from being a commercial basket case, one step from the corporate mortician to a significant and profitable player in the national market. The culture that supported that huge improvement was highly competitive, productivity focused, and financially disciplined. By contrast the milk division was a cost-plus business operating as a regulated monopoly, and so had become fat and lazy.
A newly arrived Managing Director decided to merge the two divisions. His reason, supported by a report by a highly paid consultant, was that the commercial culture of the dairy foods division was needed to be patched onto the milk division, facing the reality of deregulation at some point.
As a newly appointed GM of the dairy foods division after those 8 long years of struggle, I resisted this change as strongly as I knew how. I argued that culture could not be ‘copied and pasted’ from one organisation to another, even those working under a common ownership and centralised head office structure that allocated capital. It seemed to me that the much larger still regulated business would reject the completely different culture of the smaller unit, which would in turn erode the competitive culture of the dairy foods division they were trying to spread.
That is what happened, resulting in Dairy farmers becoming another sovereign corporate casualty.
- Processes that ordered, allocated and paid for milk for the regulated fresh market dominated the cash flow of the merged divisions. The Dairy Foods division cash flow processes and management became lost in the quagmire of the regulated cash flow of the much larger former milk division. Focus and discipline went out the window.
- The board of the business, was made up of farmers with 2 exceptions, the chairman and MD. The rest of the board were dairy farmers who unanimously rejected the notion of deregulation. It was clearly in their short-term financial interests to retain the existing regulated system. There was simply no formal recognition that the regulated system was an economic basket case. Privately, several of the board members did recognise that fact, but the power of the status quo prevailed formally.
- Major customers, the supermarket retailers were able to bring significant pressure onto trading terms given the previously completely separated divisions were now one. This pressure seemed to me to be a catalyst that brought forward the date of deregulation. The retailers started to bring fresh milk across the border from deregulated Victoria, and discounting in NSW in defiance of the state regulations, citing Section 92 of the Australian constitution, which bans constraints on interstate trade.
- The financial discipline beyond managing cash flow exercised by the former Dairy Foods division was lost as the reporting was merged. It was further complicated as Dairy Farmers set about ‘merging’ (Co-Operative speak for taking over) other Co-ops in NSW, QLD and SA. These co-ops were all different, but all were afflicted by lack of commercial and competitive focus on customers and consumers.
All of these point to the fact that culture is organic, and like all organic systems requires time, investment, alignment across the broad stakeholder population, and nurturing.
What should have happened but did not.
- There was no attention paid to the differing cultures that existed. Little useful thought was given to the practical challenges of merging them. The merger came via announcement, and a revision of the organisation chart. The two were simply incompatible. While a sensible review would have highlighted that fact, it was ignored.
- There was no integration plan that ranged from the strategic to the tactical and operational. Again, it was driven by the revised organisation chart, with little effort made to successfully articulate the reasons for the merger to anyone, including senior management.
- Any attempt to articulate a ‘vision’ for the merged entity was missing in action. The justification was all about the imagined financial benefits that would flow, and the risk mitigation coming from the probable deregulation of the fresh milk business at some future point. Both were reasonable expectations, but there was no thought about how to turn reasonable expectations into cash. Somehow, by some unknown osmotic process, it was supposed to just happen.
- There were no objectives for the integration that reflected the strengths of both, the holes that needed filling, and the resources necessary to achieve the restructured strategic objectives.
- There were no financial or operational objectives beyond budgets generated by spreadsheet aiming at an EBIT that was by decree, rather than by any disciplined process. The budgets of the two separate divisions were just merged, with the mythical improvement index applied.
- There was always going to be considerable resistance from both sides of the merger. Almost universally, (most certainly by me) the merger was seen as a retrograde step, ignoring the very different challenges faced by the two entities.
The great irony I see from the perspective of 30 years, is that Bega Co-operative virtually broke on the back of cheese factory expansion that had run significantly over budget, was saved by a cash injection by Dairy Farmers. Bega has since evolved into a major producer of branded packaged goods to supermarkets. Dairy Farmers has disappeared as a commercial entity.
The lesson: Cultural change is complex, messy, and potentially terminal in the absence of skilled leadership, complete transparency, and what at the time would seem to be significant over-communication.
Header cartoon credit: www.Gapingvoid.com
