Overview
The food industry represents a broad category that covers a range of sub-sectors throughout the vertical supply chain, from growers and processors to distributors and retailers. Similar to the overall market, companies operating within the food industry were not immune to the economic downturn and the continuing impact on profits and valuations. However, as providers of consumer staples that generally represent non-discretionary purchases, food and beverage companies as a whole generally navigate through economic downturns in a comparatively stronger position relative to the overall market. Although certain headwinds remain, opportunities exist for those companies that are able to adequately adapt to a dynamic market environment impacted by changing economic factors, consumer trends, regulatory requirements, and technological advancements. As we reflect on past performance, and continue ahead in the current year, food and beverage companies are collectively subject to certain overriding trends that impact the health and stability of the industry as a whole. A market update detailing these various trends and metrics, as well as the resulting impact on transaction activity and equity pricing, is presented below.
Economic Impact
The food and beverage industry does exhibit a certain level of stability given that its products primarily represent consumer staples items. However, the industry remains dependent to some degree on the overall direction of the economy, particularly with respect to its impact on the consumer. In recent periods, as the result of high unemployment, reduced disposable income, and low consumer confidence, consumers have become increasingly price sensitive and altered their purchasing habits accordingly. As an example, over the past two years, consumer trends shifted toward the consumption of more meals at home.1 Additionally, coupon redemption was up 25% in 2010, and redemption rates for Internet coupons represent the fastest growing segment in the business.2 Thus, while food products represent non-discretionary purchases, consumers have altered their buying patterns to focus on more value-oriented offerings and to expand their use of discounts and rebates.
The fallout effects of the economic recession may remain for the foreseeable future, as the recent focus on value likely represents a permanent change in consumer purchasing habits. At the same time, the financial position of the consumer continues to be impacted by existing economic conditions. Despite a declining trend in initial unemployment insurance claims, the unemployment rate remains at historically high levels due to a lack of material payroll gains. Further, economic analysts anticipate that declines in unemployment claims and gains in employment will remain well below the levels required to materially reduce the unemployment rate for at least the next few quarters.3 The disappointing employment situation, combined with rising gasoline prices and a weak housing market, continues to weigh on consumer confidence, as the University of Michigan consumer sentiment index remains at a level historically consistent with a deep recession. However, the index has improved from the lows in the summer of 2010 amid a rising stock market, a steady reversal of declines in disposable income, and the bipartisan Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.4 The future outlook for the food industry is dependent upon a continued improvement in consumer sentiment, which will be essential to spur demand, particularly for higher margin products.
The impact to food and beverage companies of any decline in the financial position of the consumer is further exacerbated by rising commodity costs. Commodity costs increased steadily since mid-2010 and currently represent the primary concern among chief financial officers, according to a survey conducted by Deutsche Asset Management.5 In fact, the monthly food-price index maintained by the United Nations’ Food and Agriculture Organization, which includes commodities such as meat, dairy, cereals, oils, and sugar, increased to a record high level in January 2011 amid supply concerns caused by poor weather conditions, such as droughts in Russia and flooding in Australia, combined with increasing demand from emerging markets in China and India. At the same time, increasing corn prices continue to be driven by heightened demand from corn-based ethanol production, as well as from the population growth, higher per capita income, and increased energy needs of emerging global markets. Overall, analysts expect that corn and oilseed prices will continue to increase as recent signs of a recovery in the global economy increase demand for fuel, industrial metals, and crops.
While input prices have been rising, food processors have not realized a corresponding increase in consumer retail prices, resulting in significant margin pressure. In response, processors are attempting to position themselves for success in this new market environment. For example, opportunities exist to develop new innovative products focused on recent consumer trends, such as restaurant-style products that can be prepared and consumed in the home. Additionally, it appears that there is some opportunity to implement price increases, moderate promotional activity, and/or reduce packaging sizes, given recent announcements to this effect by many of the large manufacturers in the most recent round of earnings results. Finally, industry participants may seek to offset ongoing margin pressures by improving operating efficiencies through the implementation of certain technological advancements, such as self-checkout registers, automated warehouse equipment, electronic shelf labels, and radio frequency identification.
Industry Trends
In addition to the impact of the economy on industry demand and pricing, food and beverage companies must demonstrate an ability to continuously adapt to numerous consumer trends and market influences. The companies that maintain greater probability of long-term success are those that are able to embrace change and that are equipped to respond to such market dynamics. Several of the notable trends prevailing in the industry are summarized below.
Health and Nutrition: Organic and natural products are continuing to gain popularity among the American consumer. In fact, according to a report by the Organic Monitor, the U.S. recently surpassed Europe to become the largest organic market in the world.6 To date, wider adoption of organic foods on the part of the consumer has been limited given the higher price points for such products, caused by more labor intensive operations, smaller scale production, and specific certification standards. Significant opportunities exist for those processors and retailers that are able to partner together to efficiently introduce new organic products at a lower price premium and thereby increase their mass market appeal.
Similarly, according to the “What’s Hot” chef survey conducted by the National Restaurant Association, several of the top trends for restaurants in the current year include locally sourced meats and seafood, locally grown produce, sustainability, children’s nutrition, and farm and estate-branded ingredients.7 The challenge for food companies will be to 1) determine which products to offer to the consumer in order to achieve a level of differentiation in their product line-up, and 2) develop a process for efficiently bringing such products to market.
Finally, consumers often respond en masse to certain health trends highlighted in the media. Thus, in order to remain competitive, food and beverage companies are often required to adapt their business models in response to these trends. For example, the recent negative perception of high fructose corn syrup has caused many manufacturers to reformulate their products to utilize sugar or other sweeteners, which may materially increase production costs and require extensive capital investments.
Private Label: The negative effects of an economic recession on employment levels, disposable income, and consumer confidence cause consumers to migrate from branded to private label products in search for more value-oriented offerings. At the same time, the quality of private label offerings continues to improve, further enhancing their attractiveness to the consumer. Retailers have responded by introducing and expanding their private label product lines, which tend to produce greater margin potential at the retail level (although not necessarily at the manufacturer level). According to a Product and Branding Trends survey conducted by Grant Thornton, approximately 74% of food and beverage manufacturers reported that at least some percentage of production encompassed products that carry private label/store branding in 2010, which represents an increase from the 71% reported in 2009.8 Similarly, the research firm Booz & Company reports that private label product sales increased from 15% of total food sales before the recession to 18% in 2010.9 The challenge for manufacturers in this changing landscape will be to demonstrate an ability to consistently differentiate their traditionally branded products in a manner justifying a pricing premium. Additionally, manufacturers are increasingly partnering with their retail customers to produce both a branded and private label alternative within certain categories for purposes of assisting the retailers in developing a tiered product offering across multiple price points.
Regulatory Reform: Food and beverage companies are subject to a number of regulatory requirements focused on food safety and consumer protection. These requirements, which are enacted and enforced by government bodies and agencies at the federal, state, and local levels, require continuous monitoring and compliance. In particular, one of the more significant developments in this regard is the $1.4 billion Food Safety Modernization Act recently signed by President Obama on January 4, 2011. As a result of this legislation, food processors will be required to prepare detailed written plans that evaluate the hazards in their operations, implement and monitor effective measures to prevent contamination, and establish any necessary corrective measures. Additionally, importers will be required to verify the safety of food from their suppliers. The legislation also increases the role of the Food and Drug Administration, which will for the first time have a congressional mandate for risk-based inspections and mandatory recall authority. It will also work more closely with foreign governments and increase its inspection of foreign food facilities. Although many large producers already maintain many of the protective systems mandated by the law, smaller producers and importers may incur higher costs of compliance in the form of new tracking equipment and higher insurance expenses.
The current administration is also focused on promoting health and nutrition, particularly for children. Notably, the $4.5 billion Healthy, Hunger-Free Kids Act of 2010 recently signed into law by President Obama on December 13, 2010, mandates certain nutritional improvements for all food served in schools. In addition, food and beverage companies must also voluntarily or involuntarily adapt to numerous other safety, nutrition, and anti-obesity initiatives advanced by various authorities or consumer advocate groups, including menu labeling laws, state soda taxes, fast food children’s menus, etc.
Valuation Metrics
The M&A market has recently undergone a period of increased activity, as both strategic and financial buyers remain active in the market. The level of activity partially reflects the fact that the industry in general is relatively stable and in the mature stage of its economic life cycle. As a result, acquisitions often provide more viable growth alternatives than those available organically. Additionally, smaller and medium-sized companies may not be able to effectively compete as independent entities due to increased commodity costs, transportation expenses, and regulatory requirements. Thus, the economies of scale afforded by larger competitors allow for new product innovation and technological investments. The corresponding table includes select transaction activity involving acquisitions that have recently closed or have been announced and are pending.
As shown on the following page, public trading multiples generally stabilized and began a modest recovery over the past year. This trend is anticipated to continue amid a gradual economic recovery, particularly for those companies that maintain the financial wherewithal to withstand and react to the near-term challenges provided by existing economic and consumer trends. Over the long term, we maintain confidence in the industry as an opportunity for stable returns and healthy dividends given its solid fundamentals amid an improving economic situation and a return of consumer confidence.
1 Kopylovsky, Dmitry, “Supermarkets & Grocery Stores in the US,” IBISWorld, November 2010, 4.
