Margins in logistics are falling as contracts with grocery chains mature and one-off cost savings vanish. But the big supermarkets should be useful as a springboard into new areas where profits may be easier to come by.
Logistics companies, normally quite a gentlemanly bunch, started playing dirty last year. Or rather, one of them did. Ask any of the top 10 who the offender was and they all point the finger, off the record, of course, at the same company. Its offence was to be caught out 'low balling', aggressively pitching tenders at unrealistically low prices to buy market share.
Robbie Burns, managing director of Exel, one of the leading logistics companies, dismisses the rogue operator's tactics as short-term and likely to fail. There are a few key players in logistics - the business of managing supply chains - each of which is investing heavily in capital equipment, information systems and people: but just beyond them, says Burns, are others, not committed to logistics as their core business, some of whom are pre-pared to play fast and loose. 'You can do it for a year or so. You can come in and pitch at silly prices, then headhunt existing management from the companies that have trained and developed them for several years and some of that has been happening, but ultimately they'll be sold off or hived off because what they're doing is not sustainable over the long haul.' Burns thinks the underpricers will trip themselves up. Others are not so sure. A research note from brokers S G Warburg earlier this year put it bluntly. 'The low prices that some operators claim they are walking away from today can rapidly become those that they are forced to accept tomorrow.'
The rogue company's actions have been more noticeable on this occasion because of their timing. The predatory pricing put the squeeze on other operators just as the whole business was going through a difficult patch. Until last year the logistics or contract distribution industry had enjoyed a run of success lasting several years, then, about midway through 1994, it seemed to go on the wobble, generally underperforming and ultimately posting disappointing results. Distribution stocks were among the worst performers in the transport sector. Observers believe 1995 will be better, so 1994 was probably just a blip in the progress of an otherwise strongly growing industry. It is worth examining why the hiccough happened in the first place as it reveals some of the dynamics of the industry and the factors which shape the market.
The consensus is that the present problems have more to do with severe difficulties in food retailing than with the distribution industry per se. Logistics grew up on the back of the retail food business when companies such as Sainsbury's, fearful of labour problems, began to contract-out distribution to third parties in the 1970s. The distribution contractors became strong and sophisticated, investing heavily not just in warehouses and vehicles but in the latest information technology.
The relationship with the food retailers has remained very close, so when the retailers do well the logistics companies are buoyant and when they sneeze the logistics companies tend to catch a cold, or at least get the sniffles. That is what happened last year. The food retailers, faced by tough competition from the latest, transatlantic retailing phenomenon of cut-price grocery warehouses, found their margins under intense pressure and did what anyone would - they looked to see who they, in turn, could squeeze.
Food retailers use third-party contractors because they offer reduced costs, says Warburg's transport analyst Wyn Ellis. At times when the retailers themselves are under severe cost pressures they tend to tighten the screw. 'So on contract renewal they've been looking for yet more benefits from outsourcing. They're trying to put pressure on the suppliers of services to them to reduce the cost of supplying those services. What that meant for the logistics companies is that their margins have come under pressure. They've been forced to accept lower prices for doing the same or even an enhanced job. It's very much across the board, a major feature of the industry.' When businesses like the supermarket chains first contract out to third parties there is often a lot of slack in the system which the logistics experts can remove, but it becomes more difficult to find as time goes on. 'What the logistics companies tell us,' says Ellis, 'is that they make very good money in the early stages of a new contract because there are big cost savings to be made. The retailer can benefit quite substantially from those cost savings and the logistics company can take some of the benefit as well. But once you've made those initial gains it becomes progressively more difficult to take costs out. Once you've gone through, say, a five-year contract and the contract is coming up for renewal then the terms are getting tighter. It's a fact of commercial life everywhere nowadays that it's getting very very difficult to pass on your own inflation increases in costs through to the customer who is generally looking for cost reductions. That's certainly been the case in logistics.' According to some observers, a new and subtle twist is being added by some food retailers. They are saying, in effect, 'give us a better deal or we'll take the business back in house'. It certainly could be done. Many of the big customers have comparatively recent experience of operating their distribution systems in house and often retain an in-house capability specifically so that they can use it to benchmark the performance of outside suppliers.
A persuasive counter-argument is that having shifted logistics out of house, and thereby shifted very heavy capital expenditures off their own balance sheet on to that of the service suppliers, the customers would only bring it back in house for major strategic reasons, not tactical ones.
The trouble is nobody in the logistics industry knows for sure how genuine the threats are. Mark Taylor, transport analyst at brokers James Capel and close observer of the distribution market, says that while he does not believe that the food retailers would take logistics back in house, simply threatening to do so may pay dividends. 'In principle, the grocers don't want to take it back in house, but because they wield enormous market power they are prepared to say that they would in order to beat rates down.' The food retailers acknowledge that their business is under tremendous margin pressure and that the pressures flow through to third-party contractors, but some of them believe that it need not be a painful process for the logistics companies. Bob Parle, distribution director of Sainsbury's, says that techniques and information developed by Sainsbury's, which retains 38% of its distribution in house, can be shared with third-party logistics partners. For instance, the supermarket chain has developed a system where the consignment notes of goods on vehicles are transmitted electronically to its stores. 'That's taken a lot of clerical effort out and we've reduced staffing accordingly in our depots. But that system is integral to the distribution network and is used by our third-party contractors, so we expect the same reduction in overhead, clerical and management costs there, and that's reflected through into the rate structures. What we're actually doing is taking cost out of the system but that doesn't necessarily mean that it reduces the profitability of the contractor. If he derives the benefits that we're deriving he can maintain his levels of profitability. If, for whatever reason, the third-party logistics supplier is not astute enough to extract the efficiencies that our methods and service requirements to the stores dictate that he should, then obviously that will impact on his profitability.' Mark Taylor of James Capel believes that pressures like those in the food sector could lead to structural change in the logistics market. The main players will stay in groceries, as that is where they learned their business, and it gives them a critical mass which carries them forward.
'So you can't be successful if you're not in grocery. But the real money is elsewhere. With grocery becoming less attractive what you'll see is the contract distribution market trying to shift away from groceries to other sectors like the industrial and automotive sectors. You're going to see an industry which five years ago was pure grocery effectively become something else.' It is estimated that the entire UK distribution industry is worth about £50 billion a year: the potential market or the logistics providers is about £18 billion. Third-party providers currently take about £5 billion, so around 70% of the potential market for logistics is still untapped. 'While the embryonic state of the industry demands that all statistics be treated with some caution,' says a recent research report by Capel, 'there is no doubt that considerable growth prospects...exist for the UK contract distribution operators.'.