Retail industry development in 2017
Growth and risk
Will The Block still define Mitre 10's advertising reach?
Will The Block still define Mitre 10's advertising reach?
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Changes made in 2016 and ongoing industry developments will influence 2017
HNN Sources
Forecasting has always been something of a difficult task. Generally speaking, forecasts either look at the immediate past and draw a direct line through recent events to predict the future, or they concentrate on one or two emerging forces that will take place, and use those as a basis for prediction. We've divided the forecast into these two parts, beginning with some direct consequences of 2016 on 2017, then detailing a more theoretical outlook on how retail in evolving.
From 2016 to 2017

There is no denying that a number of events that took place in 2016 will have a strong influence on 2017. The best news for independents is that the collapse of Masters Home Improvement will definitely improve the amount of revenue flowing into other hardware stores. It remains to be seen exactly how much of that revenue is captured by Bunnings and how much goes to independents, but it is in general a good news story.

Equally, with the threat of Masters removed from the market, it is likely there will be more of an easing in price competition by Bunnings. It may not be much, and it won't extend across all categories, but it will create a little breathing room for many retailers.
Independent Hardware Group

Of course, the biggest news for independents remains the acquisition of the Home Timber and Hardware Group (HTH) by Metcash to form the Independent Hardware Group (IHG). Coming on the heels of over a year of uncertainty about what would happen to HTH, most store owners feel that this has simply created yet more uncertainty for them to deal with during 2017.

It is also something of a case of going from frying pan to fire. The situation when HTH was majority owned by Woolworths was that its fate hinged on the performance of the Woolworths supermarket business. With Metcash that situation is repeated.

As Metcash showed through the sale of its automotive business to Bursons, it is quite willing to divest even well-performing assets to protect its core business. If Metcash cannot defend itself in the price war between Wesfarmers' Coles, Woolworths, and the ever-growing Aldi, HTH store owners could find themselves contracted with yet another wholesaler in another two or three years time.

In terms of what happens in 2017, this acquisition would seem to raise two critical questions: How does this benefit HTH store owners, and how does it benefit the end customer?

IHG's answer to the first question would likely be that the company will be able to get better prices from suppliers through its superior buying power, which would enable both IHG and its stores to get higher margins on sales. However, to obtain those benefits, the stores would need to buy from a narrow range of products identified by IHG. The question that independent store owners then have to ask is whether this will affect the volume of sales (and even customer retention in some cases), and if the improved margin will offset these potential losses.

Additionally, there is also the issue of service. Independents always place a very high value on service, both given to customers and received from suppliers. If suppliers are being forced to crunch their own margins, will smaller HTH stores find themselves in a good situation when they set aside long-established relationships with familiar suppliers and move to new ones?

There is a similar problem, really, when it comes to marketing. Mitre 10 has had a slightly bigger advertising budget than HTH, but with IHG operating no fewer than four separate brands (Mitre 10, Home, Thrifty-Link and True Value -- as well as Hardings and Hudson Building Supplies), it will be difficult to establish a "cut through" marketing presence.

If the rumours HNN has heard (repeatedly) prove true, then IHG may move to eliminate all trading brands except for Mitre 10 and True Value. That will help to restore focus to marketing efforts, but it also brings additional risk to store owners. Switching branding is always a tricky and difficult business, and a little unsettling as well.

It would, of course, make a whole lot more sense, if Metcash had not radically underinvested in Mitre 10 marketing for the past three years. The fact is that Metcash has used Mitre 10 as an efficient source of growth in earnings before interest and taxation (EBIT), without adequately reinvesting in the business. Given that underinvestment, the team at Mitre 10 has worked near-miracles in producing the EBIT it has. Despite these efforts, as a brand Mitre 10 is in radical need of a refresh.

Added to that is the fact that Home Hardware has won many of the Roy Morgan Customer Satisfaction Awards for 2016, beating out Mitre 10. HTH owners could be asked to surrender their identification with the leading hardware brand in Australia.

This leads us to the other question, about how customers will benefit from the acquisition. At a guess, IHG would see this as being delivered by the slow rollout of its premium "Sapphire" store design -- which is exclusive to Mitre 10 branded stores. As HNN has remarked in the past, this is quite a good store design, with good implementation of the paint area, good signage, and a "neat and tidy" appearance.

However, it does not come close to some existing store designs in HTH. In particular, the Hume & Iser Home Hardware in Bendigo, VIC, would serve as a far better model for store development. Aside from having a very good garden section, it also has a very workable kitchen display area, something that is quite rare in Mitre 10 stores. (Though, equally, HNN is sure there are Mitre 10 stores that are as good, and easily exceed the Sapphire standard.)

In the end, the process being followed by IHG would seem to be overly product-centric, rather than customer-centric. Instead of seeking to engage customers so as to understand their needs, they are instead providing a familiar list of products, with improved margins for the retailer (and themselves).

What needs to be heard from IHG is whether they will resolve the marketing issues, and drive investment in a new, innovative approach to hardware retail. That would make it worthwhile for store owners to invest in the brand change process. A simple retread of Sapphire, and some lower wholesale prices, will not.

Meanwhile, even as it benefits from the exit of Masters and perhaps looks to improve some of its thinner margins, there is no doubt that Bunnings remains the single most significant competitive factor facing independent hardware retailers in Australia. One of the concerns that HNN voiced in the past regarding the merger of Mitre 10 and HTH was that this would create conditions where Bunnings would feel less restrained in competing with independents, as gained market share would be less likely to raise concerns from the Australian Competition and Consumer Commission (ACCC) and others.

At the moment, IHG is likely looking at around $1.9 billion in revenue for its FY 2017/18 (next financial year). HNN would not be surprised to see Bunnings gear up to shave $100 million off of that, and $150 million off in the subsequent year.

One factor with Bunnings that has received inadequate attention is its acquisition of a total of 15 ex-Masters sites from the Home Investment Consortium Company Pty Ltd. Two of these are development sites, for future building, which will be leased directly from Home Consortium. A normal development process must be undertaken, including permissions, before these sites can be used.

Six of the locations will be leased directly from Home Consortium. Once the arrangement has been completed, Bunnings estimates it will take a further five months to convert these to Bunnings Warehouses.

Of the six building leases and two development leases, Bunnings says seven will be used to replace what it refers to as "under-scoped Bunnings locations".

The remaining seven of the 15 sites are leasehold trading locations, where arrangements with other landlords must be reached. Four of these sites will be replacements for existing "under-scoped" Bunnings stores.

So, to summarise, 11 of the fifteen sites will be used to consolidate existing regions for Bunnings, while four of the sites will be expansions into new trading areas.

This will enable Bunnings to ramp up its competition in a highly efficient and quick way, likely before December 2017, once Woolworths' negotiations with Lowe's Companies over their joint venture, Hydrox Holdings concludes -- which will likely be in June 2017.

It's worth noting that the ex-Masters stores Bunnings will be moving into will not only be much bigger than the stores they replace, but also have been built to provide a higher level of amenity, costing something around 20% more to build than comparable standard Bunnings Warehouses.

This improved amenity is significant. As HNN has noted over the past two years, one of the challenges facing Bunnings in expanding its market share is how to retain its "Aussie battler" core customer base, while also moving upmarket to embrace more affluent customers. Bunnings already sells quite expensive outdoor furniture, and it has added expensive "designer" barbecues to its range over December 2016. The higher amenity stores might provide a better platform to integrate these ranges more fully with its overall offering.

The other vector for Bunnings to grow its market share may also make use of higher amenity. While the retailer's ultra-compact, ultra-dense urban stores, such as in Collingwood (VIC), have proved successful, it is seeking to diversify its metro offerings. Recent planning documents have revealed the design of a new "mini-warehouse" Bunnings. Instead of fitting as much as they can into a compact space, these seem set to focus on more premium lines in an airy, spacious layout.

This might also be part of a larger strategy to finally launch a transactional Bunnings website. The first such operation has already launched in the UK, where an ecommerce presence is virtually mandatory for shoppers these days. As HNN has mentioned in the past, the real challenge for Bunnings in ecommerce is delivery logistics. One possibility is that, as Wesfarmers becomes used to the idea that it might be becoming less of a conglomerate and more of a retail specialist, it could merge some operations between Coles and Bunnings. Coles already has a delivery network for home-delivered groceries.

Once Bunnings has ecommerce underway, these new mini-warehouses could become showrooms for goods that are ordered online for delivery or click and collect. This solves the "touch/feel" the product problem, and enables more stock to be handled in a limited space.

In short, even though the end of Masters has released some of the pressure from Bunnings, and it is likely to ease up margins slightly, the retailer will not halt its drive for more innovation. That would seem to be in stark contrast to IHG. While Mitre 10 did launch its Sapphire store program some years ago, this has been not only quite slow to roll-out, but also not very ambitious. It delivers a better store, but the company's initial claims that this was "the store of the future" are somewhat overblown.

In the independent sector, the biggest innovator at the moment is likely Hardware & Building Traders (HBT). With over 600 members this is growing to be one of the more significant forces in independent hardware in Australia. The recent, sad passing of its dynamic leader, Tim Starkey, in late 2016 has been a setback. However, like all good leaders, Mr Starkey had built a solid team, and when it comes to executive power, HBT has something of a very deep bench, consisting of long-term members who operate very successful hardware stores.

In contrast with IHG, HBT has introduced a number of innovative program during 2016, including high quality own-branded products in important categories such as paint. It's also working to expand its "H" branded hardware stores.

If IHG is to meet its expected growth targets, it's likely it will have to learn from some of the management choices HBT has made over the years. The most important lesson is that HBT regards its first aim as making sure its members are happy with it, and with each other. That means providing certainty, and reducing stress wherever possible.

The second lesson from HBT is that it doesn't see suppliers as an opposing force that needs to be browbeaten down to the lowest possible price. Instead, HBT sees suppliers as part of an overall hardware "ecosystem". When that ecosystem is managed well and fairly for all, it will produce good results. Shifting risk from one group to another within the ecosystem might bring short-term gains, but simply destabilises the system in the longer term.
Industry developments

The coming two years, 2017 and 2018, are likely to see some of the most significant changes to the overall Australian retail industry for the past 20 years. While the Australian home improvement retail industry is not central to these changes, it will be one of the more affected retail sectors.

For home improvement, it is likely the full force of these changes will be felt in 2018 rather than 2017. 2017 is important from a strategic perspective, and 2018 will see developed strategies play out in the marketplace.

Broadly, changes will come from two sources: the internal restructuring of the Australian retail industry, and a shift in market power away from retailers and towards suppliers.
Internal restructuring

In terms of the internal restructuring of retail in Australia, 2016 has already given us some clues as to what to expect. The failure of Dick Smith, the inability of Wesfarmers to find a market fit for its Target mid-price department store, the acquisition of The Good Guys by JB Hi-Fi, and the ongoing repositioning of department stores Myer and David Jones are indications of change.
Dick Smith

Much has been written about Dick Smith. There is much to be said about its management, the structure of its IPO and other factors. However, the issue of why, really, it did fail is something that seems to have eluded most commentators.

To HNN, it seems clear there were two movements to its failure. To understand the first, you need only know two datapoints. In 2012 when Anchorage Capital first acquired Dick Smith, smartphones had a penetration rate of 43.7% in Australia. By 2016, when Dick Smith failed, this had grown to over 66%. In 2015 the number of smartphone users in Australia exceeded 15 million.

You can see the significance of this if you consider the stock Dick Smith carried. Cameras, video cameras, alarm clock radios, TVs, voice recorders, landline phones, phone answering systems, DVD players and portable stereos. Every one of those items could be replaced by a smartphone for users in the retailer's core customer demographic.

To counter this rapid change, Dick Smith introduced its Move brand, which was really an attempt to utilise the popularity of the smartphone. This product line consisted of smartphone peripherals, such as charging cables and cases. The product build was standard Chinese commodity, but the items were produced in bright colours, and a considerable margin was added. There was advertising, and Dick Smith leased some of the most expensive commercial space in Australia, at airports, to sell these products.

It failed, of course, and Dick Smith's final strategy was a "pivot" into selling home appliances, which also failed, and Dick Smith entered into receivership.
JB Hi-Fi

The inspiration behind that pivot was a similar move by entertainment and technology retailer JB Hi-Fi, though JB had started this pivot much earlier, in late 2012. It began with the opening of four JB stores carrying a new "Home" brand, which sold appliances as well as consumer electronics.

This was one of a series of pivots that JB had put in place since 2005. The first such pivot was a move into gaming, including sales of game consoles and game software. This was accompanied by the introduction of the computer category. By far the best move the company made, however, was to introduce the telecommunications category in 2007.

As sales of what JB refers to as "software" -- which includes music CDs, movie DVDs, games and PC apps -- declined by 9% per year for 2009 through to 2012, telecommunications, particularly the sale of mobile phones and service plans, have filled that gap.

The final part of this pivot has been JB's acquisition of appliance and consumer electronic company The Good Guys. Post acquisition, the retailer now has only 9% revenue exposure to software, where previously it was 14%.

While it is easy to see what the attraction for JB to buy Good Guys was, what was the attraction for Good Guys to sell itself? Why a sale, in fact, instead of a listing on the Australian Stock Exchange?

Again, this was an astute business call by Good Guys. The outcome of a listing would have been uncertain, and the indications are it might not have gone so well. The pro forma operating margin for Good Guys was only 3.6% for FY2015/16 (JB's was 5.6% -- 56% higher than Good Guys). As importantly, it relied on appliances for 66% of its revenue, and which is a highly cyclical business, with serious competitors such as Harvey Norman in the market.

More than that, though, what JB brought to Good Guys was the ability to focus more on customers rather than products, not just in what it sells to them, but also in the information it collects about them.
Suppliers gain more power

The past 15 years have been marked by a retail culture that has become increasingly reliant on the supply of essentially duplicative products. This has been brought about by a combination of technological advances, supply chains built on the availability of low-cost labour, and cultural factors which transformed "copies" from being a "cheap" option to a "smart" option instead.

Whether it is women's fashion, cordless power tools, smartphones, or even bathroom fittings, virtually every "name brand" product today has its shadow, either quasi-legal or outright counterfeit.
Protection against copying - Plumbing Connection

This has created a market paradox. Never before has original design been so valued by the market, and never before has it been quite so difficult to get a full return on the investment put into new product development.

In response, mainline brands have adopted three basic strategies to ensure better returns. Some have opted for more extreme innovation (such as power tool maker DeWalt's 20v/60v FlexVolt cordless system, designed to create a design "safe haven"). Others are relying on "network effects", through producing products that interlink with other products in their range. Another tactic is to make products that connect the manufacturer directly with the end customer. (It's interesting to note that Milwaukee Tool's One-Key feature does all three -- as will, most likely, Bosch's equivalent, launching this quarter.)

The success of these tactics, along with some other factors, has contributed to a shift in retail that is only beginning to show its effects recently. To really understand that shift, it's necessary to first take a look at the retail market models that have existed since the end of World War II. There have been roughly three such models: consumer sovereignty, the revised sequence, and the duplication.

The first of these models is in some ways more theoretical than actual, but provides a baseline for looking at consumer markets. Post World War II, up until the mid-1960s (and beyond), most economists held that in modern, capitalist economies, consumers were "sovereign", in that they created the demand to which retailers and manufacturers would respond.

It was the US economist J.K. Galbraith writing in his landmark work "The New Industrial State" who first popularised a different model. He called it "the revised sequence", and he described it like this:
The mature corporation has readily at hand the means for controlling the prices at which it sells as well as the those at which it buys. Similarly, it has means for managing what the consumer buys at the prices which it controls.

Further, Galbraith follows that up with:
...the producing firm reaches forward to control its markets and on beyond to manage the market behaviour and to shape the social attitudes of those, ostensibly, that it serves.

In the revised sequence, far from being sovereign, the consumer was shaped and moulded by advertising and other means to conform to the requirements of the market. Prices were not set (for the most part) collusively, but there was an understanding that getting into a "price war" would be detrimental to all participants in a market, and this was to be avoided.

The duplication stage emerged from a combination of access to low-cost labour (in China and elsewhere), and new technologies that increased the reliability of products. It began, really, in the late 1990s, but started to have a significant effect in the early 2000s.

In mid-2015 the then managing director of the Wesfarmers-owned Bunnings big box home improvement chain, John Gillam, summarised the strategic changes this brought to the retail industry by stating that "The margin is the outcome".

A lot can be read into that one pithy statement. One aspect of modern retail it highlights is the difference in the way new products are developed. Under the revised sequence, a new product would be designed, production costs estimated, and pricing determined by modelling volume versus margin to deliver the greatest overall profit -- at the least risk.

In the duplication sequence, the goal was to introduce products that duplicated existing products, though they might not have all the features, at a price that was irresistible. The cheaper product might not have the same quality as the original, but it had a known degree of quality.
Suppliers strike back

If "the margin is the outcome" is a good signpost for the recent retail economy, there is another, quite chilling, signpost for the retail economy that is to come. This originates with one of retail's all-time greatest strategists, the head of US online retailer Amazon, Jeff Bezos. It is something of a personal motto of his: "Your margin is our opportunity".

"The margin is the outcome" is a product-based strategy. "Your margin is our opportunity" is a sales-based strategy. The first is based on disrupting markets by offering products with fewer features, but also "just enough" features, at an attractive price-point. The latter is based on direct competition through efficiencies gained post-supply chain, in the sales process itself.

To give that some context, Bunnings (as an example) is adept at knowing which features its customers want in a particular product. For example it might suggest a cordless brushless hammer drill kit with two batteries and a charger at a price point under $160.

Amazon is adept at knowing exactly which customers are likely to want a particular product, and what will trigger a purchase for them. For example, the purchase of a mitre saw, and a book on how to build decks might trigger a suggested purchase of a cordless impact driver, of the same brand as the mitre saw.

The first models general purchasing behaviour, and it could be likened to casting a net into waters where you are fairly sure the fish will be. The second models specific customer buying patterns, and is more like dangling a hook with just the right kind of bait in front of a small school of fish.

At the moment, Amazon is close to being the only retailer in the world that can utilise this post supply chain model. That's because it has a very rich set of longitudinal (taking place over time) data to work with.

However, there is a midway point to this kind of modelling, and that is represented by the approach Kingfisher is using for its home improvement businesses. By engaging in what is likely to become a longitudinal study of customer behaviour around projects such as bathroom renovation, it can closely predict choices and needs for the associated range of product lines.

Outside of retailers, however, there are other companies that are now collecting data that can be used in this modelling. One of the aspects of Milwaukee Tool's One-Key Bluetooth-enabled tool networking is that it means the company is now collecting very precise data about tool use by clearly identified customers.

Milwaukee will be able to tell, for example, when a tool is close to wearing out, and will need to be replaced, or if a tool is being over-stressed, meaning its owner really needs to upgrade to something better. This means that, in a sense, Milwaukee now "owns" these customers more closely than the retailer which sold the tool ever could.

What develops from this, and from a similar system being developed by Bosch Power Tools, is not known at this time. It does, however, seem likely that this is a sign that the role of the retailer will be further changing in the near future.

If there remains a single mystery about the development of home improvement retail in Australia, it has to do with the role that the internet and ecommerce will eventually play in its success.

Bunnings does not have an ecommerce website in Australia (except for gift cards), but it has built out its web presence to be quite considerable, with very high site traffic. Aside from offering a comprehensive catalogue of its stock, the site also offers guides to a wide variety of maintenance, renovation and woodwork activities.

Its attempt at a social media style site, "Workshop", seems either not to have worked too well, or simply not received much backing. While it continues to be run, its membership and posts are quite low.
Bunnings goes social with Workshop website - HI News, page 6

The Mitre 10 website is functional, but it's evident that not much has been spent on its development. That is really not a criticism: the question of how you would go about developing a web presence that will work for independents is a major one.

It's likely that the answer will lay in not directly pursuing so much a hardware/home improvement angle on this, as looking at a more general "home ownership" angle. Two of the most successful websites in this area, Houzz and the US-only (which has Lowe's as a major investor) have taken that approach with a great deal of success.

Houzz has become an "idea book" for home design, with access both to products, professionals such as architects, and tradies as well. Porch began life as site that aspired to be a kind of "log book" for houses, providing owners (and prospective buyers) with a record of what work has been done on a house and by whom.

It seems likely that this is one area where real development will not take place for another two years or so, and that the answer will emerge from new technological developments that are not as yet evident.

Will Sapphire save Mitre 10? - HI News, page 3
Powerhouse independents: Hume & Iser HTH, page 44
HNN Sources

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