Pick n Pay - What went wrong?

When Raymond Ackerman listed his seven Pick n Pay (PnP) supermarkets in 1968 at 4c/share, it was the birth of a food retail champion. For 40 years, PnP continued to charm the market, keeping shareholders smiling all the way to the bank. In its year to February 2009, it reported a headline profit of R989m, earning for its shareholders a phenomenal 132,7% return on equity (RoE).

Then it all started to go wrong for the Ackerman-run family business. That super-normal RoE, three times that of its biggest rival Shoprite at the time, was a warning signal that PnP was under investing in its sustainability. “We were sitting back and raking in the profits,” concedes PnP CEO Nick Badminton. Non executive chairman Gareth Ackerman is equally candid. “We got behind the curve on investment.”

While PnP was raking in super profits, its market share was being steadily eroded by Shoprite and Woolworths. In the lower LSM (lifestyle measure) 4-7 categories, Shoprite was doing the biggest damage. In the upper LSM 8-10 , which PnP terms its “heartland”, Woolworths’ aggressive drive to grow market share in food retail was debilitating for PnP, as was Shoprite’s repositioning of its Checkers-branded stores.

Despite its steady decline, PnP was shielded from reality during most of the past decade by a growing economy and robust consumer spending.

However, SA’s first recession in 17 years brought these happy times to an abrupt end in 2009, exposing weaknesses in PnP’s business model.

In its year to February 2010, PnP limped home with headline earnings per share (HEPS) a mere 1% up on a year earlier. Comparatively, Shoprite reported a 13,5% increase in HEPS in its year to June 2010.

That was just the start of PnP’s bad news. In the year to February 2011, its profit performance was hit by a lethal combination of a fall in gross trading margin and a rise in trading costs. Despite a 5,9% rise in turnover to R51,9bn, PnP’s HEPS were down 22,9% and its RoE a deflated 47,2% (though still respectable). The result: the retailer had to cut its dividend for a second time since its listing.

The first dividend cut came in the year to February 1995, when the retailer’s profit was hit by a crippling strike. It was also a year in which PnP was declared to be an ex-growth company by many analysts. Raymond Ackerman, who had built PnP into SA’s biggest food retailer at the time from that group of four Cape Town supermarkets he had acquired in 1967, was determined to prove them wrong.

In 1995 Raymond Ackerman, then executive chairman, embarked on a restructuring that he promised would lead to a “rebirth of the company”. The strategy worked. In its 1997/1998 financial year PnP’s HEPS were almost 80% higher than the previous record set in 1994 and, by 2001/2002, they had grown by a further 138%.

But management erred in its approach. While competition in the market was increasing, Raymond Ackerman and Sean Summers, CEO at the time, kept their eye firmly on the profits and dividends, and neglected to reinvest in the company. History has a harsh message for corporates: reinvent yourself or face a bleak future. That message has hit home hard for PnP, which is now in the middle of a complex reinvention.

But can the retailer, in which Raymond Ackerman is still involved though he doesn’t have a formal operating title, pull off another “rebirth” in a space where competition is getting stiffer with Walmart’s entry?

Badminton, CEO since March 2007, is confident PnP’s new strategy to improve efficiency and lower operating costs will bring it back on track. He is candid, though, that it will be a mammoth task.

Nedbank Capital retail analyst Syd Vianello is positive about PnP’s future. “There is nothing intrinsically flawed with its business model. The supermarket is not outdated.”

He believes PnP is taking the correct steps to put it back on a growth path. Absa Capital analyst Chris Gilmour agrees: “Badminton is running a marathon race in a sprinting distance. But I believe he will succeed.”

Badminton will not be running the recovery race on his own. He will be accompanied by Richard van Rensburg who in October will begin a three-year contract as deputy CEO. Van Rensburg will head a dedicated transformation team responsible for implementing PnP’s change programme. He is also tasked with the IT and supply chain functions.

Van Rensburg’s appointment is another sign of positive change at PnP where the policy has always been to promote from within. “That’s changed,” says Badminton. “When outside skills are needed, we will get them. There are more to come.” Badminton is himself a “company man” and began his career with PnP 32 years ago at the age of 18.

Van Rensburg, a PnP nonexecutive director since 2010, has a solid retail background, having served on the boards of Massmart, Woolworths and Wooltru. He also founded IT services company Affinity Logic in 1996, which SA technology company UCS acquired in 1998.

Vianello believes Van Rensburg will get the job done. “He owes no-one at PnP anything. He will be able to hire and fire to his heart’s content.”

Though Badminton has been the key driver of change, the first step towards its second “rebirth” was taken during his predecessor, Summers’s watch. In 2005 a decision was taken to implement a completely new enterprise resource planning solution from SAP across the company. There was no alternative. PnP’s old in-house-built technology platform was in danger of “falling over”, says Badminton.

The SAP solution, the first of the big spends, has a price tag of more than R500m. Its implementer, UCS, justifies the spend as “a showcase of what a major grocery retailer can achieve by implementing a wall-to-wall SAP solution”.

The SAP solution provides an invaluable foundation for PnP’s makeover. Compared with other aspects of its restructuring, the immensely complex SAP implementation was the easy part. Badminton’s more challenging problems include an unsustainable labour policy, a fragmented corporate structure and an outdated approach to procurement and distribution.

Labour relations are arguably PnP’s biggest issue — one it is tackling with a “no more Mr Nice Guy” approach. “We have always aimed to be a good company to work for and offer our staff benefits that rank us among the top-five companies in SA,” says Jonathan Ackerman, director responsible for customer affairs.

“But we have lost our patience. We’re getting tough on labour issues.”

Operations director Neal Quirk adds: “Our cost per worker is the highest in the [food retail] industry.” Specifically, the company’s labour costs are two percentage points of turnover higher than they are for other food retailers.

For example, in the year to February 2011, PnP reported total employee costs of R4,32bn, an average of R87805/employee. Shoprite, in its year to June 2010, reported 91000 employees and total employee costs of R5,27bn. That works out to an average of R57912/employee, a third less than PnP.

Above-average staff remuneration would be manageable if PnP derived productivity and loyalty benefits from its staff which logic suggests should follow. But it hasn’t. “Productivity is one of our major problems,” says Badminton.

Despite its liberal employment benefits, PnP has been the target of far more than its fair share of strike action. It begs the question: why?

It appears that the more generous a company is, the more likely it is to be a strike target. Says Raymond Ackerman: “It disturbs me immensely. I was warned by a senior union leader that the tallest trees will always get the most wind.”

PnP’s biggest labour problem was incubated in 1995 when it agreed to a 9am-5pm working hour arrangement with the SA Commercial, Catering & Allied Workers Union (Saccawu), says Gareth Ackerman. That was before the days of a radical extension of shopping hours during the week and over weekends.

Saccawu’s determination to apply the agreement to the letter has forced PnP to increase its labour force way beyond what would be required if a more flexible approach to working hours were followed.

As an example, Jonathan Ackerman says the clothing store at PnP’s Boksburg hypermarket employs 50 people but, with a flexible approach to working hours, eight would be adequate.

The result of inflexible working hours is vividly illustrated by an 80% increase in permanent employees from 27300 in 2002 to 49200 in 2011. During the same nine-year period the number of corporate stores increased by 50%, from 332 to 500, and corporate store retail space by 23%, from 678000m² to 834000m² .

After a strike in 2005 the retailer and the union agreed to revisit their labour agreement. The negotiations proved fruitless. “We worked long and hard negotiating with them to change the agreement to permit flexible working hours,” says Gareth Ackerman. “We got nowhere and in the end went ahead and cancelled the agreement.”

The issue went to arbitration and in April this year the arbitrator resolved that PnP had the right to terminate the agreement.

“Though certain aspects of the arbitration are still subject to appeal, the findings were largely in our favour,” says Gareth Ackerman. “We don’t want to get rid of employees or alter our policy of being a considerate employer. We just want to get employees working when they are needed, or retrenchment is inevitable.”

Indeed, the retrenchment axe is about to fall on 3137 employees. “If we get consensus on changes that must be made, the number of retrenchments could be lower,” says Quirk.

Further emphasising the retailer’s tough stance, Badminton says: “If they [the unions] want to strike, they must go ahead.”

Gilmour says the retrenchments will serve as a wake-up call for employees. “They will come to realise that there’s a new regime in place based on hard-nosed realism.”

For PnP, reducing its staff by more than 3000 would, based on average cost per employee, cut costs by about R260m/year. In the retailer’s year to February 2011, this would have boosted its trading margin from a dismal 2,7% to about 3,2%. Shoprite’s trading margin in the six months to December 2010 was 5,1%. Badminton is clear that a Shoprite-type trading margin is the goal.

What else can PnP do to achieve this? Lower employee costs are not the only method. Another key part of the restructuring strategy is consolidation of its fragmented structure.

“Consolidation of our fragmented operating structure is also vital in achieving improved efficiency and lower costs,” says Badminton. “We see the potential for a big uplift in our [trading] margin through centralisation.” The first consolidation was of the three inland regional units which account for 65% of total business.

From a logistical perspective, the biggest change in PnP’s business model is a switch to centralised distribution — one used by Shoprite and the new competitor, Walmart, which has bought a controlling share of Massmart.

PnP has come under heavy criticism for not having done this many years ago, an oversight that has left it way behind Shoprite, which began shifting to centralised distribution 15 years ago.

Raymond Ackerman takes issue with PnP critics on the centralised distribution issue. “In the 1970s we already realised that direct [store] delivery was inefficient and that centralisation was the way to go,” he says. “But all our major suppliers were opposed to a change and promised us that we would receive the best discounts if we stuck with direct delivery.” He won’t say whether they honoured that promise.

Delving deeper into the distribution issue, Vianello explains that when Shoprite began with centralised distribution, it faced opposition from the major food producers. But Shoprite’s market share began growing rapidly and it found itself increasingly in a position to put pressure on suppliers to do its bidding. “That’s when Pick n Pay got caught. Whitey Basson [Shoprite CEO ] began dictating the rules.”

PnP’s first centralised distribution warehouse, the 65000m² Longmeadow facility in Gauteng, became fully operational in mid-2010. But the R628m facility, which handles half of PnP’s inland grocery stocks by value, has had huge teething problems. “Last year Longmeadow cost us R100m more than expected,” says Badminton.

Centralised distribution centres in Durban and Cape Town will come on stream in 2012 with the final completion of the R2bn centralised distribution system, which will include a second inland facility, expected in 2014. Benefits are already evident, says Badminton, including a big increase in product availability in stores.

He adds that closely linked to centralised distribution is a sweeping change to its procurement strategy. “We are consolidating the buying process. It’s a move we perhaps should have made before we tackled centralised distribution.” The strategy, he explains, is to eliminate proliferation of essentially the same products on shelves. “We could, for instance, have 10 brands when we need only three.”

The average PnP supermarket stocks about 20000 different products and, at present, about 1200 new product types are added every month.

Another key element of the company’s strategy, says Badminton, was the launch of its Smart Shopper loyalty programme in March. Cardholders earn points equal to 1% of the value of purchases. Smart Shopper is a “huge thing for us”, says Badminton, pointing out that while seemingly small, the discount equates to one third of PnP’s net trading margin.

About 4m Smart Shopper cards have been issued and about half of them are being used actively, he says. He acknowledges, though, that it will be a financial drain during the current year but believes it will prove to be a sound investment. “Since Smart Shopper’s launch we have for the first time in a long while seen our market share stabilise.”

Longer term, he says the programme will provide invaluable data on customer behaviour. “We believe this will give us a considerable competitive advantage.”

PnP is also determined to catch up in another area: new store openings. “We have not been opening enough stores,” says Badminton.

By the end of this year, the retailer hopes to have opened 12 corporate stores, seven franchise stores and a total of 55 clothing and liquor stores. Under the brands targeting the lower LSM sectors, Boxer and Punch, 25 stores will be introduced. Total trading area will grow by 5%-6%.

The retailer might also soon be rid of its Australian unit Franklins, which has been a big drain on capital and management time. In PnP’s second foray into Australia, and one of its biggest strategic blunders, it acquired Franklins in 2001 for A$131m, then around R600m. In 2010/2011 a loss from Franklin s wiped 24,5c (13%) off PnP’s HEPS.

The SA retailer’s decision last year to sell Franklins to Metcash Australia for around R1,6bn was torpedoed by the Australian competition & consumer commission and is now the subject of a federal court hearing. “If sanity prevails, I believe we will win the case,” says Gareth Ackerman.

It is hoped he will be proved correct, at a time when PnP and other local retailers are facing their stiffest challenge yet: the advent of Walmart since its acquisition of control of Massmart.

Raymond Ackerman says the latest restructuring will position it well to meet the challenge. “We’re making sure we are world-class and ready. Had we not gone ahead [with the restructuring], I believe that in two years we would have faced a serious problem.”

He points out that in the UK, retailers such as Tesco and Sainsbury’s have faced the challenge of Walmart’s entry into the market through its acquisition of Asda but have successfully embraced the new competition.

Ironically, it is speculated that those UK retailers could potentially acquire PnP.

Gareth Ackerman does not underplay the challenge posed by Walmart but is also confident that PnP is on the right path. “Within the next few years, Pick n Pay will again be a strong cash generator. But don’t expect much in the short term.”

He warns: “To get onto a new growth curve, you sometimes have to go backwards first.”

Getting onto that new growth curve will not happen overnight. “Another 12-18 months of spending and change lie ahead.”

Adding to the sense that another negative profit surprise lies ahead, Raymond Ackerman notes: “I am cautious on profits this year.”

But what PnP is doing to restore itself to its former glory is in no way a trip into the unknown.

Centralised distribution has been tried and tested by large retailers worldwide and it is only a matter of time before it begins paying off for PnP.

There is also little doubt that Van Rensburg’s IT background qualifies him admirably to extract the most from the new SAP platform. This was, says Gareth Ackerman, a key consideration in his appointment.

For investors willing to back a management team that is systematically doing what is needed to be done, PnP is likely to reward their patience handsomely over the next few years.

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