By Claire Bisseker

Business is adapting to a new environment where the battle against inflation, though not entirely won, has been successful to the point that inflation is expected to stay low and stable for the next two to three years.  The challenge of growing profits in a low-inflation and even deflationary environment is a new experience in SA, even for seasoned retailers . 

Though falling inflation is great for consumers, especially since wage increases are still running slightly ahead of general inflation, it makes life a lot tougher for retailers.  High inflation is easier for them because they don't have to worry as much about managing stock and consumers don't hold back in the hopes that prices will fall further.

The situation is now reversed. 

In an environment where prices are rising slowly or are falling, retailers have to avoid being heavily stocked with items whose prices are falling. And expenses, especially labour costs, lag behind selling prices.

There are only two ways to counter that - by cutting costs in other areas and by being more productive. 

"It is easy to make money out of retailing in a high-inflation environment," says Pick 'n Pay group financial director Dennis Cope, "but it's not sustainable and it's not good for the country. It's good that things are cheaper because then we can sell more and that's got to be more sustainable." 

The Reserve Bank says low inflation is good for business in that it is easier to respond accurately to price signals in the market (reducing resource misallocation) and because it brings about less interest rate variability and lower nominal rates, both of which contribute to growth. 

Conversely, a bit of inflation is handy for retailers since it gives them growth in the top line without having to raise the bottom line.  New Clicks CE Trevor Honneysett contends that while a low-inflation environment will weed out players of poor quality, the transition will force many companies to cut staff numbers to remain competitive. 

"This is a real negative for the country at a time when we need to be stimulating job creation and reducing unemployment levels," he says.  Cope says food retailers are definitely experiencing a new environment.

Up to mid-2003, they were experiencing average annual inflation above 10% but last year Pick 'n Pay branded stores experienced inflation of just below 2%. Across a basket of staple foods, including maize , prices fell by 4% because of the strength of the rand. 

Pick 'n Pay's strategy was to go for turnover growth by reducing margins to get huge benefits of scale. "The strategy worked," says Cope. "Our recent results were good and showed that turnover growth averaged about 13% across the African businesses."

Cope expects price inflation for branded Pick 'n Pay stores to be 3%-5% this year, but points out that were the rand to strengthen further and oil prices to decline, consumer prices could rise at a lower rate.  "We've lived through so many years with high inflation that we just can't get used to the new low-inflation environment," he says. 

Deflation is hardest to manage at the low end of the retail game, where consumers are in survival mode and can' t take advantage of lower prices to buy more. 

Mark Lamberti, CE of wholesale and retail group Massmart, says it is wholesaling basic commodity staples like maize meal at 10% less than at this time last year.

Wholesalers in this market reacted initially by promoting aggressively, in an attempt to offset the loss of value with higher volumes, but found that this strategy didn't work at the bottom end of the market as retailers held back in anticipation of yet lower prices. 

They were also forced to become fanatical about containing costs, but with more than 60% of the average retailers' costs dominated by wages and rentals, costs are slow to change. 

Lamberti says retailers in this market will have little choice other than to raise their mark-ups to obtain the same rand gross margin as before. 

Masscash, part of the Massmart group, caters for this market and profits have taken a knock over the past year, he says.  At the upper end of the market, consumers have tended to take advantage of the lower prices of things like DVD players, computers, software and digital cameras (some of which are half the price they were a year ago) by buying better quality or more goods, neutralising the negative impact on retailers. 

"Over the past 12 months, the deflationary pressure was accommodated by a rise in volumes," says Lamberti, "but I believe retail sales growth peaked in October last year, so retailers are going to be under greater pressure to contain costs .  "In the new, low-inflation environment, managing costs and productivity becomes much more crucial, as does innovative merchandising, so that you can present the consumer with a better and different product selection that may command better prices ." 

Not all retailers have been affected equally. Selling clothes is a lot easier than retailing fridges, where one retailer's product is virtually identical to the competitors'.  Foschini Group financial director Ronnie Steyn says: "We have our own designs, so we can manufacture our own price points. If you don't want the price of your garment to fall by 10%, then you can add some new details to the design."  Over the past year, inflation across the group averaged 3%, though there was deflation in some basic lines.

Steyn predicts that price rises will stay at this level for 2005. 

For decades there has been an ingrained mind-set in business that held that input costs and prices would rise each year, but that higher prices could be passed on to consumers.  Retailers argued that consumers wouldn't resist price hikes because they expected yearly increases and got related wage increases .  Honneysett says the real challenge lies on the expenditure side. 

"We need a mind-set change in staff expectations of salary increases, and also from landlords who can no longer expect to see the level of annual, pre determined rental increases that we have had in the past," he says.  "Staff and rental costs are generally two of the highest costs of any retailer, and these need to reduce to more realistic levels in an environment where we are seeing little or no increase in the selling price of goods."  Over the past two years, wage settlements have not fallen as fast as inflation, so disposable incomes have risen, fuelling the consumer spending boom. But the gap is starting to close. 

Between late 2002 and early 2005, CPIX inflation fell from a peak of 10,5% to a recent low of 3,1%. Wage growth eased much more slowly, averaging 8,5% in 2003, 7,5% in 2004 and 6% for the first quarter of 2005.  Wages tend to be set on the basis of past inflation and, therefore, settlements tend to lag behind the downward trend in actual inflation.  "Wage settlements are starting to align with inflation as employees grow in confidence that the economy is being responsibly managed and are starting to believe that low inflation is sustainable," says Lamberti. "This year we're talking about executive salary increases of no more than 4%." 

First National Bank economist Cees Bruggemans predicts that with CPIX expected to move in a 3,5%-4,5% range in the coming months, average wage increases are likely to drop more severely than they did in 2003/2004. Instead of a one percentage point erosion, there could be at least a 1,5 point easing and possibly more, suggesting average wage growth this year of 5%-6%. 

According to the Reserve Bank's latest monetary policy review , the Bank feels that with CPIX having hit a record low of 3,1% year on year in March, it will peak at around 5,2% in the first quarter of 2006 before declining to 4,5% by the end of that year.  The Reuters consensus forecast is that CPIX will remain within the target band of 3%-6% right up to the end of 2007.  The Bank's bullish inflation outlook is anchored in the fact that inflation expectations have improved considerably, indicating that there is an acceptance by business, consumers and trade unions that low inflation can be sustained. 

According to a Bureau of Economic Research quarterly survey, business's inflation expectations for 2005 fell by 1,6 percentage points between the last quarter 2004 and the first quarter 2005, labour's expectations fell by 0,8 and analysts' by 0,7 .  This change in perception among all groups resulted in the average expectation for CPIX declining by a full percentage point to 4,5% for 2005 - the lowest level since the survey's inception in 2000. For the first time, all respondents expect inflation to be below the upper end of the target and to remain so for the next three years. 

Despite the bullish inflation outlook, it is always subject to risks and uncertainties. On the international front, the Bank highlights the threat of crude oil spikes, as well as the uncertain outlook for the US dollar, which has important implications for the rand.  Domestically, monetary policy will continue to be alert to continued high levels of expenditure, high growth in asset-backed credit extension and wage settlement trends.