Cutting prices for the future

In this post-National Credit Act world, it's a lonely place. The words “sale” are plastered haphazardly across the elbow to-elbow shop windows of Price 'n Pride, Morkels, Bradlows, Ellerines, and Geen & Richards, all seeking to wring out whatever buying power remains in the already-stretched consumer.

“It was a sobering experience,” says African Bank MD Dave Woollam. “Many of those we took had no idea just how difficult it is for these shops to make a living now.”

Abil took over Ellerines in March, and soon realised they had bought a bruised peach. First, Abil had to “revise” Ellerines' dicey accounting practices as its earlier reporting policies overstated its net asset value.

Second, a scary number of bad debts emerged, a legacy of the fact that Ellerines had earlier signed up a glut of customers who shouldn't have got credit.

Abil is now taking its biggest gamble yet. Toni Fourie, CEO of Ellerines, explains how he plans to boost business by slashing prices, both on interest rates and add-ons like insurance.

“The situation can't persist. At some point, the credit regulator will see what's going on here, and get stuck in. Charging insurance of R20/month on R1000 credit is unreasonable. That's money we just shouldn't be making,” says Fourie.

Previously, Ellerines' gross yield (the overall margin of financial services revenue against its loans) was 50%, in line with JD Group and Lewis. Now, the bank aims to cut this between 35% and 40%. For credit life insurance Ellerines, for example, used to charge more than R15 for every R1000 insured. Eventually, it plans to cut this to R5/R1000.

These price cuts are already taking effect: the FM's shopping exercise revealed that on R9000 credit, Ellerines' high-end subsidiary charged R4207 in insurance while Lewis charged R6652. Also, Ellerines' interest rate was 24%, as opposed to Lewis's 32%.

While such an exercise may be socially beneficial for the poor, why do this if the largest competitors aren't following suit?

Nedcor Securities analyst Syd Vianello says Abil is taking an unwarranted gamble with its investors' cash. “Lewis hasn't brought its insurance rates down. They've always been slightly more expensive than JD Group and Ellerines, yet it hasn't hurt their customer numbers,” he says.

At Lewis's AGM last month, CEO Alan Smart told the FM he believed Lewis's prices were “in line with our competitors”. So nothing is likely to change.

Says Vianello: “If the market will bear those rates, there is no incentive for Lewis to charge lower prices. As a shareholder, you'd stick with the guys who are making a bigger margin”.

Shamil Ismail, an analyst for Cadiz Securities, agrees. “Ellerines has broken ranks with the other credit retailers on a decades-old pricing model. They've got good intentions. It'll cost them in the short term.”

Ismail says that besides picking a punishing time in the credit cycle to reinvent itself, African Bank may have underestimated the task of absorbing Ellerines.

But Fourie argues that the market (or regulators) will see to it that prices drop anyway. By pre-empting this change, Abil is ahead of the curve. “In general, retail businesses are lazy. Ellerines' cost base is R3,6bn, but an appropriate cost base is R2,5bn. There will always be a financial services income, but we need to get to a point where we rely on it less,” says Fourie.

Analysts agree that costs need to be cut, pointing to JD Group in particular. JD Group executive chairman David Sussman believes Ellerines is taking the right approach by cutting fees.

“Remember, we started doing this in 2006. The first element was to separate our consumer finance business from our retail business, and that's no mean feat,” he says. Sussman says this divorce should bring down costs for JD and its clients.

But separating the financing business from the retail operation has revealed a painful truth: more often than not, sluggish retail operations were being carried by the huge margins that retailers charged for insurance and finance costs.

Ellerines' results for the three months to March showed that while the retail business made a R73m loss, the financial services business posted a R226m profit.

Fixing this implies a world of pain. For Ellerines, it means cutting back on its 1200 stores to about 1000 stores.

But it's necessary. A report last year by Avior, an independent equity research firm, showed that in 102 locations Ellerines has four stores competing for the business of one customer.

But will Ellerines' grand plan of cutting prices work, and will its customer base grow? Avior's report concluded that “we are sceptical Ellerines' cost reduction will be a big driver for increased volume”.

For example, on a R292 monthly instalment for a R3000 72cm television, cutting insurance by half and slashing the interest rate from 26% to 21% made a difference of only R25 (8,6%).

Says Avior: “We believe customers may ‘trade-up' in product quality, to reach their affordable level.”

Consumers may benefit, but will this result in more business for Ellerines? As an investor, Vianello rates Lewis as a hotter prospect than either Abil's Ellerines or JD Group, mainly because it isn't cutting prices.

“Toni Fourie may be able to get the pricing right over the longer term by cutting prices, but the real trick is to increase sales per square metre,” he says.

Ellerines is well aware that its trading density, the money it makes per square metre, is lower than its rivals. At year end, Lewis was making R4225 in operating profit per square metre. JD Group was making half that (R2226) while Ellerines was making R995/m² (if you annualise its first quarter figures).

The comparison is skewed as Ellerines' first quarter includes its three worst trading months, but it shows why it is closing stores and axing seven of 13 brands.

Vianello says the risk here is that when a brand closes, those customers may go to a rival. “Those lost sales don't just default to your brand. In the short term, I see many Ellerines customers going to Lewis and JD Group,” he says.

Lewis is in the pound seats. It has fewer brands, and more clients in the lowest income bracket, people who are less affected by the interest-rate pinch.

The bottom line is that for the quarter to June, Lewis's revenue climbed 7,4%. By contrast, JD Group's revenue for the six months to February fell 3% and Ellerines' sales fell 4% for its first quarter.

But if Fourie is right about the changing credit zeitgeist, his pre-emptive strike could work to Ellerines' advantage.

First, as credit regulator Gabriel Davel says, the better price disclosure under the National Credit Act could help customers realise which shops charge less.

Second, regulators may get involved. This week, the Financial Services Board (FSB) told the FM it had investigated JD Group's conduct. Further complaints could spur authorities to act.

But Vianello says: “There are so many subjective issues in this little game called affordability, and how do you make an objective finding? Sure, in some cases, things are done that shouldn't be, but many instances aren't very clear-cut.”

But the FSB probe could mean more share-price punishment. Of the three, JD Group's investors have bled the most. Its share price of R33,10 is less than a third of its March 2007 peak of R101,45. Lewis's price of R41,75 has taken less of a knock from its high of R72,70 in April 2007.

But if nothing changes, Lewis looks the best pure-play retailer. Of nine analysts who cover it, five rate it a buy, expecting its share price to climb nearly 20% to hit R47,27 within one year.

For JD Group, only two of eight analysts rate it a buy. Cautious investors would pick Abil. Not only does this still give exposure to Ellerines, but it also exposes shareholders to the bank's growing loan book (up 40% in the first half), and a dividend yield of 8,5%.

The biggest risk here is that Abil will either uncover yet more skeletons, or it mishandles the cost-cutting and loses customers to its rivals.

So is Abil playing fast and loose? Or is there a need to change?

Absolutely, says Cadiz's Ismail. “The furniture model used in the 1970s doesn't work now. Now, more people can access bank finance, so they go into stores and pay cash. And they're finding it cheaper to buy from cash retailers.”

Ismail says credit retailers are all chasing a shrinking pool of credit-dependent customers. So companies willing to break the mould to rely less on credit will gain the most. Abil may have unwittingly triggered the process.

The contrasting strategies have set up the game for a fascinating few months. At this stage, there's no clear victor.

Source: Financial Mail

Published courtesy of