How British retailers “gamed” themselves into a corner

Thu 13 Sep 2018

When my daughter was first born she had trouble sleeping and hated her cradle. So I used to hold her by to the kitchen fan (new parents take note, this works!) for about 10’, until she was fast asleep. It worked magic every time. Until it didn’t. A few weeks later she didn’t like it any more. I kept persisting. If it worked before, it would surely work again. But the more I persisted, the more fussy she became. Why did my method stop working? I thought I was onto something only to discover how fluid things are with fast growing babies.

In recent days, British iconic retailers John Lewis and Debenhams announced earnings below levels expected. How could this have been? The National Institute of Social and Economic Research estimated that British Q3 GDP accelerated significantly to 0.6%, up from 0.2% a quarter ago, on the back of strong retail sales. Yet Debenhams lowered its sales outlook by 15% and John Lewis’ pre-tax profits before one-off items fell to £1.2m in the six months to 28 July, from £83m a year in the same period a year earlier. Both companies pointed to heavy discounting as the culprit.

In comes game theory. According to the famous “prisoner’s dilemma” two prisoners are interrogated separately. If they both confess they will both do heavy time. If one confesses and gives the other up, the one who gives the other one up goes free, but only if the other one hasn’t confessed as well. Only if they both refuse to confess will they both go free. But how will they do that if each doesn’t know what the other has told to the police and the police are not letting them communicate?

Price wars follow the exact same logic. Company A lowers the price and Company B lowers it even more. If company B doesn’t follow it will lose clients. If both lower their prices too much, they will end up with the exact same market share, but with less profits. And, like in the prisoner’s dilemma, they cannot reach an accord to fix prices. However in the past there was still a floor. No one would lower prices beyond the point of their own survival. Then, the world changed. We can now order anything, from 50p books to GBP 10K jewellery from our phones and have it delivered to our house. No need for in-store retailing. Online retailing can afford to sell much cheaper as it employs fewer people, does not need stores and can operate on a more fluid tax regime.

Debenhams and John Lewis played the same game they had played before. They kept lowering prices only to realise that this time the floor had disappeared. Their online competitors could discount much more heavily than they ever could.

Tech is changing the world fast, much like a growing baby. The first iPhone was released on July 29 2007, a mere 11 years ago, forever disrupting how consumers interacted with companies. Brands now start online and it is only after they succeed that they will consider bricks and mortar expansions.

In-store retailing is not dead yet. For all the trillion-dollar-hype, Amazon is still America’s 7^th biggest retailer, behind Wal Mart, Kruger, Costco and Home Depot. But it is catching up fast. Share of online retailing is 10% of the total more than doubling in the last 7 years.

Percentage of e-commerce sales in the US

For Debenhams and John Lewis to avoid the fate of BHS they need to keep up with the times. According to a major survey of 11,000 consumers across nine countries this summer by Mood Media, 50% (and 67% of younger US consumers) would like to receive immediately redeemable discounts pushed to their phones when in-store. So why not start interacting more with clients like that?

What does this all mean for investors? It means they should still trust active funds. Seasoned managers know that a good company is more than cash flows. It’s about a persistent competitive advantage, the ability to weather bad markets and the ability to stay ahead of the pack, while keeping a clean balance sheet and robust growth rates. There are very few fundamental metrics that can quantitatively account for that X-factor which separates future success from future failures. Retailers will eventually adapt (or face perdition). The question is when and at what cost by then.