What Qantas, Woolworths, and Transurban have in common (and why it matters to investors)

In episode 28 of Stocks Neat Co-Portfolio Manager Gareth Brown and I discuss the prospect of price gouging in major Australian industries, the role future Competition Policy has to play, and the potential implications for investors.

The topic of competition problems in Australia has garnered increased publicity in recent times, driven by concerns over long-term productivity issues and the more immediate price impact Australian households are experiencing.

We will discuss local oligopolies in the supermarket, airline and toll spaces, and what future Competition Policy shortcomings could mean for consumers and investors.

[00:00:39] SJ: It started with Qantas (ASX: QAN). Then Woolworths (ASX: WOW) came under fire. Now, it's toll road operator Transurban (ASX: TCL)’s turn. They've all been accused of price gouging. The media and the politician pile on has hurt the share prices of all three companies.

Welcome to Stocks Neat episode 28. I'm Steve Johnson, and I'm joined by my co-host, Gareth Brown to talk about the topic du jour at the moment, big companies price gouging in Australia. How are you, Gareth?

[00:01:06] GB: Hi, Steve. Hi, everyone. I'm well. Thanks.

[00:01:08] SJ: That's good to hear. You're better than me at the moment. I'm feeling a bit rough, so the voice comes across a bit funny in this podcast. Apologies upfront, and I'll be skipping the whiskey. I've got a nice green tea and peppermint here. I'm not sure what you've got in your teacup there, Gareth.

[00:01:20] GB: Earl Grey.

[00:01:21] SJ: Earl Grey, very nice.

[00:01:23] GB: Not whiskey.

[00:01:23] SJ: It's freezing cold in this podcast room today as well, so we both needed tea to keep warm. We're going to talk about what people actually mean when they talk about price gouging. Is it happening? What if anything can be done about it? As investors, we’re sometimes on the flip side of this coin. Do we need to worry about it? Let's start at the top, Gareth. What are people actually worried about?

[00:01:46] GB: Well, they're worried about prices going up. We're in an inflationary period that we haven't seen in many years, but the specific charge here, the specific accusation is that companies are using this period of inflation to earn excess profits. They're using it as a guise to increase their take.

[00:02:04] SJ: Yes. We live in a country where oligopoly is the standard. I think that's a function of us having a very geographically spread country.

[00:02:13] GB: Small population.

[00:02:14] SJ: And a small population across it. We've ended up with all of these industries from insurance to banking to groceries where there are typically a very small number of players in it. Is it worse now than it has been?

[00:02:26] GB: I think let's start by looking at those three industries that you mentioned. Maybe start with groceries. The margins are up for worse over the last four or five years. They are higher to begin with than they are in the market like the UK. Woolworths makes an operating profit overall of a touch under five percent. It’s a little bit higher on its Australian food business, closer to six nowadays.

That compares with something like four for Tesco in the UK. Kroger in the US is in the three. So one, two, maybe as much as three percentage points of margin there that is higher versus international peers. So, yes, it's not as competitive as it could be. That's a charge that always applied in Australia and has gotten a little worse recently. Those margins have been elevated for years, and the impacts of that are relatively small in the scheme of things.

Like everyone else, I'm sure my wife and I have been complaining a lot about supermarket pricing. What used to cost us about 300 or high 200s for a weekly shop now is in the sort of low to mid-400s. That's typically probably four dinners, a week's worth of school lunches, and all the bits and bobs that you buy each week at Woolworths or Coles. That's typically split between Aldi and Coles, so we're already trying to save money by utilizing Aldi.

[00:03:50] SJ: What are you doing the other three nights? Kids don't get fed or –

[00:03:53] GB: Well, we might do one short shop that doesn't count in that. We might go to the pub one night. We might get takeout one night. We might go to family or whatever. I'm saying it's not seven meals. It's probably four or five dinners, plus kids’ lunches and whatnot. I think we're spending probably $125 to $150 a week more than we used to. Let's say two or three years ago.

What is the cause of that? Well, Woolworths’s gross margin from the Australian food business has actually fallen over the last four years. So they were making – they were keeping 28.7% as gross margin in 2019. It's now down to 28.1. Its cost of doing business has gone down a little.

[00:04:39] SJ: As a percentage of revenues?

[00:04:41] GB: As a percentage of revenues, correct. More than all of it is explained by, I guess, general efficiency and a squeeze specifically on employees and landlords perhaps. I think maybe there's a bounce-back issue from that coming. We'll work on that. But the operating margin's gone to 6% from 4.7.

Yes, Woolworths is more profitable than four years ago, but all that margin of improvement has come from a lower cost of doing business. You can sort of split it out this way. I'm paying 125 more than I used to in dollars. About $92 of that is going to farmers, food companies, and all the supplies that bring it to Woolworths. Again, that's down in percentage but up in dollars.

[00:05:26] SJ: There's actually been a lot of pressure on Woolies to not put as much pressure on its own suppliers. I think there's some genuine issues there with their dominance and their ability to push payment terms and things. But it is also translated into you should be paying the farmers the right price for their milk and their meat and all these sorts of things.

[00:05:44] GB: There’s a lot about where the margin comes from that's probably unfair. But I'm talking about being tight across the entire business. Anyhow, so $125 extra bill, $92 is going to farmers, food suppliers, et cetera. About $22 extra is going to staff and landlords versus the costs four years ago. Only $11 of that $125 is extra profit for Woolworths.

Then I think you can even further break that down and say if they were making the margin they were making back in 2019, half of that 11 is just inflation. The other half is this gouging charge. It’s not insignificant. It's probably five or six bucks a week for my family of five, maybe $250 a year. That's not a small thing, but it's not maybe the huge thing that's being made at the moment.

[00:06:33] SJ: Absolutely. I think when most people are going to the supermarket and seeing these giant increases in their grocery bills, they're not actually aware of the profit margin that Woolies is making. But I think if you ask the average person on the street, they think they were making 30, even 40% of those sales in profits. It's actually not the case. Like you said, if you force them somehow to go back to making the margins some of these overseas companies are making, it would be barely noticeable in terms of people's weekly grocery bills.

[00:06:59] GB: I think like maybe to change the point here a bit, but if the government wants to fix that, I think jawboning and reviews is not the best way to do it. I think I've broken it down as accurately as it needs to be broken down right here in five minutes. It's competition policy. Remove any –

[00:07:16] SJ: Let's come to the competition in a second. You're jumping ahead of yourself here, Gareth. We've got that later in the podcast. We don't want solutions. We don't want solutions. We need to winge before we even contemplate solutions.

[00:07:26] GB: Well, let's move on to toll roads then.

[00:07:27] SJ: Okay. Well, you and I, I’m sure we're far from the biggest toll payers in Sydney. But they are impossible to avoid in this country, and we're probably both – I mean, I know almost exactly what I spend because I get the rebate from the government, about $1,000 a year on tolls. I just punched into a calculator what does it cost to drive from your house on the eastern side of the Harbor Bridge just to get out of the city.

[00:07:51] GB: The eastern side of the harbour.

[00:07:53] SJ: Don't deny it. Which side of Anzac Parade do you live on?

[00:07:56] GB: Southeast of the Harbour Bridge.

[00:07:58] SJ: You go –

[00:07:59] GB: Bunnies territory.

[00:08:00] SJ: Into the eastern distributor. You're trying to get out of Sydney to the north, heading towards Newcastle. You will rack up, what did I calculate, $32 in tolls just getting out of the city. Now, I'm sure everyone living outside Sydney thinks that's a very reasonable price to pay to get out of the place. But it adds up to a lot of money, and this angst seems to have shifted from Woolies now to Transurban, the owner of the toll roads and their price gouging and what should be done about that. Is the charge fair in the case of toll roads?

[00:08:30] GB: Yes. I hate it and I should also state that we use no toll in our commuting to work. When I'm talking about probably similar amounts to you, maybe a little bit more, but probably spending 1,200 bucks a year or so on tolls. This is just not the same argument as someone that has to take a toll road or two every working day to get from their house to an office that's nowhere near public transport. There are many people that have it worse than us.

Yes, I hate it. I drove to the Central Coast a couple of weekends ago to visit some mates the moved up there, $59 in tolls on a day trip to do that. It's really crazy, but it is also contractual. These were contracts that were signed at the time of construction. No one is making a pricing decision year to year. It's all in a formula that's all in the contract. It's very clear the government has got some things very wrong here. I'd personally argue that linking these contracts to inflation was a massive mistake. Most of the cost of a toll road is in its construction.

I don't understand why something like the M2, which was built in mid-1990s is now getting a massive bump in profitability because we're having an inflation period. I don't think that's fair, and it's been a jackpot that's been paying off for the toll road owners at the expense of the consumers.

[00:09:50] SJ: Well, some of the early toll roads were also minimum of, say, three when inflation was higher and people didn't think it was going to go below three percent. They had this minimum of inflation or three percent. Then when inflation was zero, they were still putting the tolls up three percent a year. But it was the contract that the government signed.

[00:10:07] GB: Yes. That's the way I feel about it. If the government feels that's wrong, they probably should be buying these things. I will have a little off-topic rant there. These contracts are two-way. If you get on the M2 of an afternoon, all the patchy repair work every few meters, it creates a couple of significant issues. Your car bounces up and down all the time, and you get this blinding reflection of the sun in your eyes. It's quite unsafe. I think we need to look at these contracts on both sides we are paying. Are we getting the product that we are contractually delivered? I don't know the answer to that.

[00:10:41] SJ: The other thing that I'd have a winge about is they don't tell you anymore what the total cost is. You used to drive through a toll booth, and it said you're paying $4.50. Now, it's all – unless you log on to your account and see what you actually paid, you have no idea what half of these tolls cost.

[00:10:54] GB: It doesn't even clearly say M2, M4. It's sort of there's this code. You ever done that?

[00:10:59] SJ: I actually think that should be a very straightforward ACCC transparency thing that you put a sign up somewhere saying you are paying this toll. Then you make a choice about whether you want to pay it or not. I feel like at the moment that is very difficult. For me, it's a stupid contract that the government has signed. I think there's a very strong case for these assets being government-funded anyway, given they have the lowest cost of capital. Sure, private construction, you can get a lot of efficiencies out of that. But having private ownership of it doesn't seem like a great long-term strategy to me.

[00:11:29] GB: To kick in 500 million to buy land and stuff as well. It's not even – it’s the public-private bit that really confuses me.

[00:11:37] SJ: But it's been done, and I think it is really important in Australia. This is not the only case, I think, of pushing away from this, but we live in a country where the rule of law is very, very important. Especially if you sign a contract with the government, I think you should have every right to think that that contract is going to stand the test of time and that you should get paid what you sign up for. If they want to fix it, it's going to be the government that needs to pay for that, I think, rather than trying to whack Transurban with something. But they do need to think about the future awards of these contracts and that may have an impact on that business's future growth as well.

[00:12:53] SJ: Okay. What about our friends at Qantas?

[00:12:56] GB: Airlines. Look, I might let you deal with the specifics here. However, high airline prices have definitely been a global phenomenon subsequent to the pandemic. Personally, we're paying a lot more to get to Europe to go and see our family once every 18 months or 24 months than we were pre-pandemic, quite a lot more.

Airlines are, in my opinion, they're logically preferencing pricing over increasing route numbers and seating availability. We really need one or two of the big global airlines to blink here and say, “I want to expand.” We need governments to support that when that point comes. At the moment, it's a very global issue, where we're sitting here talking about Qantas. But there's much the same going on around the world.

[00:13:38] SJ: Which is, I think, evidence that it is not specific to Qantas doing something here. There's no doubt. I think they've made some bad strategic mistakes here in terms of maximising the financial opportunity available to them over their customer loyalty over the past few years. 

[00:13:55] GB: Even the service, selling tickets on flights that were never going to take off.

[00:14:00] SJ: They're not tickets, Gareth. They're rights, rights to travel. I think they have made some mistakes there. But overall, this is a very, very competitive industry, and Qantas has not been a great business over a long period of time. In fact, even in this past COVID period, they lost more money during COVID than they have made in this period of elevated earning. So it is, in my opinion, a bit of a scapegoat.

I do think you need to distinguish between the domestic business and the international business, though. You're already seeing competition come back into that international space rapidly. I have a friend who works at Qantas. I won't mention any names, but they flew one of their aircraft up to Singapore last week. It's a very old aircraft. They've ordered a lot of new planes, but they've been late in ordering those new planes, and they're flying a lot of old aircraft. The inflight entertainment system was down, so they had Generation One iPads that you could hang on the seat in front of you. The same day, Singapore Airlines had three new Dreamliners flying up to Singapore. That competition is coming back, and you're already seeing it in prices. I think it's just a matter of time until Qantas is a price taker, not a price maker there.

Domestically is a different story. I mean, they have 65% market share here domestically. They've historically priced at a level that means they make money, but their main competitor does not. I think that's a very difficult one to fix. As an investor, I'm much more confident about the value of that domestic business than I am about the international one. I think one thing that the government could do specifically there is force more competition for slots at airports. One of the challenges with competing with them is you can't take off and land at the times that everyone wants to fly. They have locked up a lot of those slots fairly effectively and apparently don't use a chunk of them as much as they should. I think that's one little thing that could be done.

[00:15:53] GB: Also, on the international front, the Qatar Airways thing was a disgrace. They wanted to fly. I can't remember. It was 17 or 21 or something more flights a week into Sydney and Melbourne. They basically got knocked back. We can't do that. That's cronyism at its finest, right? It's screwing the consumer for the benefit of your mates or your donors or whatever it is.

[00:16:15] SJ: Or your Chairman's Club access.

[00:16:17] GB: Yes.

[00:16:18] SJ: You better be careful, Gareth. You don't want to say too much here or you might actually lose your Chairman's Club membership.

[00:16:24] GB: Good on you, man.

[00:16:26] SJ: All right. I mean, the conclusion, it's more of a beat-up than it is a specific problem going on at the moment. But I don't think that takes away from the fact that we do have competition problems in the country. People do need to think about answers to that because in my view, it is causing long-term productivity problems in Australia. It might be overstated at the moment, but I think oligopolies are a problem and what do you do about it.

One thing I just wanted to have a laugh about before we kick that off is some of the lobby group arguments that come out here. You get the Woolies is price gouging, and they've got to do something about it. Then I saw one push from the lobby group saying, “Well, if you curb Woolies’ profitability, then that's going to affect every single Australian that owns super in the country.”

Okay. That may actually be true, but I did some really quick numbers. The average super fund allocation is about 30% Australian equities. Woolies is about two percent of the index. The average allocation to Woolies is about 0.6%. Roughly, there's $360 of Woolies’ revenue for every super fund member in Australia. There are a couple of calculations to get to there, but 360 bucks of revenue per super fund member. 

They're spending on average five grand per year shopping there. So it's more than 10 times. If you took a dollar out of Woolies’ pocket and put in the consumer's pocket, the result is more than 10 times. It's massively, massively skewed towards people who don't have superannuation or much. The super system skewed the other way.

[00:17:58] GB: Maybe the income inequality impacts of a failure in competition policy. I think it's really important. It's not that everyone owns the same number of Woolworths shares.

[00:18:06] SJ: That's right. Putting the laughable arguments to one side, how do you solve the problem? Directing government involvement, in my experience, does not typically end well.

[00:18:16] GB: Often makes things worse, doesn't it? I think very often that typical government involvement is redistributing the proceeds of the reduction in competition policy, rather than actually tightening up the competition policy. I think that is one of the most important things we as a country and we as the West can do is to beef up that competition policy for the benefit of the consumer.

It's very clear to me that there's been pretty significant failures not just in Australia. Australia has been a high-margin market for a long time. US is the one that really comes to mind here. It's hard to reverse, but at least step one is to stop it getting worse. Look, I'm not just talking about Google search monopolies or Facebook buying Instagram back in 10 years ago or whenever that was. As important as those things are, there are so many plain boring vanilla businesses that have been impacted by this.

We look at insulation businesses, plumbing supplies, HVAC, waste management, auto parts retailing, all sorts of businesses in the US. If you asked me 25 years ago about the quality of those businesses, I would have said they're tough, they're competitive, and they have limited pricing power. All those Industries have consolidated over the last 25 years down to, I don't know, four to five large players. Margins have marched up and up and up.

We've been a massive beneficiary of that. We own some of those businesses that have been impacted, and we try to invest in the world the way it is, rather than how we think it should be. But I view much of that issue as a failure of competition policy. There's an argument that some will make, and there's maybe some slight validity to it that economies have scale more than offset that. It's going through to the consumer. I'm skeptical, and the main reason I'm skeptical is you're seeing in the margin just up and up and up. I do believe that these failings have a massive knock-on effect on things like income inequality.

[00:20:14] SJ: Yes. I think it is now very, very difficult to reverse some of those problems, right? I mean, how do you introduce more competition into the banking sector in Australia? It's going to be very difficult for a new entrant to come in. But I think at the very least, you need to think about what's happened and how do we stop this continuing on the trend that it's been continuing on of late.

For me, the ACCC in Australia comes in grief. But they actually try and stop a lot of these mergers. You look at the recent Westpac (ASX: WBC)’s purchase of Suncorp’s banking business. The ACCC has tried to stop that, and it's been turned over in the courts. I think a lot of people don't realise the ACCC is a regulator, not an enforcer of the laws. It doesn't make the laws, and you have every right. These companies have a big enough chequebook to actually take the ACCC to court and say, “You’ve made the decision. We don't agree with it.” They win more often than they lose fighting against the ACCC. It’s quite clearly a problem of legislation, rather than one of the ACCC not having enough teeth because I think it has actually tried.

For me, the really key issue here is the criteria that is set in law about whether you're allowed to buy another company or not. Here in Australia, it's substantially lessen competition. Is this transaction going to substantially lessen competition?

[00:21:37] GB: Can you as the regulator prove that it's going to substantially lessen competition, right?

[00:21:41] SJ: I think it's too low a bar to jump over. It needs to be flipped on its head and say, “Is this going to impact the ability to introduce future competition as well?” Okay, you take Suncorp (ASX: SUN) away. The reality is it was a pretty small bank. There are still four big banks competing with each other. It's probably not going to change the dynamic of the banking market in Australia dramatically. Certainly, significantly as the law says. Does it stop Bendigo and Adelaide Bank (ASX: BEN) from merging with Suncorp?

You could have put a whole heap of these smaller banks together over time and ended up with a fifth player in the Australian market. That would have made a positive difference. It needs to be a negative threshold here that you need to prove that your acquisition is not going to impact future competition, as well as current. I think that would help a lot. Once you get a 20% market share, I think largely the answer should be no, unless we think there's a really strong case here for economies of scale delivering consumers better outcomes. The experience has been you get better outcomes maybe for four or five years. You get a lot of cost out of these businesses. Then you get the margin increase over time. Consumers over the long term end up being worse off.

All right, moving on to the last section, implications for investors. I mean, the reality is, and we're not apologetic about this, we actually spend a big chunk of our lives walking around looking for businesses that are in strong competitive positions and have pricing power. They can be wonderful investments, and I think a lot of investors are doing the same thing. There is quite, obviously, more societal pressure on these businesses than there has been, I think.

[00:23:17] GB: Very recently, yes. It's been a tailwind for the businesses for 20 years and possibly a bit of a head in the last two, as we're running into this inflationary issue, I think.

[00:23:26] SJ: Has it changed anything for you when it comes to investing? Do we need to worry about it as investors?

[00:23:31] GB: I think we do. Most of that worry is in the risk section of our framework, rather than the rule-it-out kind of section. I mean, something like an Alphabet (NASDAQ: GOOGL). I think you do have to worry about regulators around the world coming along and saying this is unacceptable. You can't suck the marrow out of every bloody industrial ecosystem on Earth. I think it's better for the consumer if there is some action on that front. We have to recognise that as a risk if we want to be shareholders in it, which we're not at the moment.

Maybe further down, something like a Ferguson (NYSE: FERG) or an IBP (NYSE: IBP) that we own as distributor businesses. What we love there is you come into the situation where it's consolidating. So you have three or four large players with not very large market share and then a really long tail of independence. You can just see that going for another 20 years. That's the upside case. The downside case is someone comes along and says, “Actually, this is hurting the consumer.” Again, for us, it's more weighing up the probability of that happening and what are the consequences and really reflecting on that in the risk section of our business and in the downside case.

[00:24:42] SJ: Yes. I think the companies should also be careful how they go about it not just from a regulatory perspective. I think even from a business perspective. They have been really good examples of companies pushing the dominant market position and the pricing power too far to the point where they create enough of an incentive for someone to actually enter an industry and become a significant competitor.

Maybe the best example on that front is Gillette/Procter and Gamble (NYSE: PG) putting up the prices of its raises year after year and being a much, much-loved investment for a lot of investors around the world for a long time. It got to the point where it became absurd. I guess the Internet helped as well, came along. But you had Dollar Shave Club and a bunch of competitors come into the market that Gillette had enough scale to sell cheaper than all of those competitors.

[00:25:32] GB: It took it as margin.

[00:25:33] SJ: It took as much margin as it possibly could, and it ended up creating competitors. I think industry dynamics do change. I think here in the supermarket industry in Australia, we are – Aldi get to a market share where it's making a difference. More about this than me but we saw in the UK, that Tesco (LON: TSCO) was making margins like Woolies is making now 20 years ago and –

[00:25:55] GB: Maybe less, yes. Really came to a head about 10 years ago with the German interlopers, Aldi and Lidl particularly. Tesco had to have an awakening there and had to recognize that it was time to cut margin, get very, very efficient, and pass a lot of those savings back to the consumer, to not see market share. I think –

[00:26:17] SJ: It happened surprisingly quickly there as well. You think this is going to be a slow unwind of the increase that often –

[00:26:23] GB: Because the way they get into these situations is slow. They just take a little bit more and a bit more. They get to report higher dividends. Then all of a sudden, they recognise they've lost five points of market share, and they have to fix it. I think when you talked about that, sort of maybe abusing your competitive position, the great models are when they share those economics or give most of those economics back to the consumer, right?

Costco (NASDAQ: COST) is probably the best example I can think of right now. Just working on efficiency all the time, but then taking those dollars and putting it back into the offering so that you gain share and rather than putting it all into shareholders’ pockets. That way, you are protected against competitors because you are ruthlessly efficient and sharing it or giving most of it to the consumer. That's the kind of model that's harder to fight against.

[00:27:12] SJ: JB Hi-Fi (ASX: JBH) has been a great example of that here in Australia. I'm actually a bit worried about their strategy right now. They had this uplift because COVID margins jumped.

[00:27:22] GB: They're used to it now.

[00:27:23] SJ: Well, they're used to it. They've probably got incentives around EPS growth and all of these things internally that incentivise them to keep it there. They're really fighting hard. Margins have come off a little bit, but they're still way above where they were. I'm not actually sure that that's the right long-term strategy for them that they should actually go back to what we're really trying to keep taking market share as our primary objective. That was a really clear strategy of theirs for a long time. Now, they're a bit hooked on recent profitability. It seems to be less aggressive in terms of that.

I agree with you. I think it's a much more sustainable competitive advantage, the scale equals cost. We're going to share that with the consumer, rather than we're going to keep taking price. I think, ultimately, those price takers find a way of catching up with them eventually.

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