Growth in the consumer products industry
The consumer products sector has historically stood strong, but in the wake of the financial crisis, corporates face challenges when it comes to future growth potential.
The consumer products (CP) industry has always been resilient. “No matter how bad the economy is, people still need to eat, drink and wash,” says Jamie Constable, CEO of RCapital, a private equity (PE) firm that invests in distressed companies. “In many [instances], we have built turnaround cases on this consistency.”
However, in the course of the recent downturn, even this most resilient of industries has felt the pinch. During the six months to March 2014, the Consumer Staples Index of the Global S&P 1200 is the worst-performing sector.
Meanwhile, global consumer groups such as Unilever, Procter & Gamble (P&G) and Kimberly-Clark have all seen revenues struggle at some stage during the downturn.
Commodities, customers and challenges
The industry faces many challenges. For instance, commodity prices have soared, eroding margins. Figures from the World Bank show the price of palm oil almost tripled from the end of 2008 to the start of 2011. In the same period, sugar prices almost doubled, as did oil prices.
With consumers hard-pressed, sales volumes fell (P&G estimates that, in 2009, its volume growth halved), limiting the scope for passing on price increases to customers. The emergence of cheaper ‘private-label’ and non-branded products in supermarkets have amplified the trend. Consumers are now happy to trade down — NPD Group, a consumer market researcher, estimates that, in US homes, non-branded goods now account for 29% of the food and drink consumed, compared with a previous level of 20%.
CP companies have also had to negotiate a structural shift from the developed to the emerging world. “As recently as 2005, the CP industry generated around 20% of its revenue in emerging markets (EMs). Now that figure is up to 50% or more, and climbing. It’s a massive change to manage,” EY’s Global Consumer Products Lead Analyst Andrew Cosgrove explains.
Now, after all this adaptation and change, companies are seeing the signs of recovery. EY’s April 2014 Capital Confidence Barometer (CCB) for the CP industry shows that 63% of those surveyed see the economy as recovering, up from 51% a year earlier. However, CP companies are still cautious with their focus, with only 37% saying that the company’s focus is on growth over the next twelve months.
Consumer products M&A
Despite this, recent large consumer M&A deals reflect this returning confidence. Notable transactions from 2013 include the US$28b deal for Heinz by 3G Partners and Berkshire Hathaway in February.
Despite the megadeals, overall deal activity in the CP sector remained flat during 2013. EY’s most recent Consumer Products Deals Quarterly (CPDQ) shows that, for Q4 2013, deal volume decreased by 1%, from 285 deals in Q3 to 281. Deal value also fell, to US$9b from US$15b over the same period.
However, early signs in 2014 are promising. Japanese group Suntory made a US$15.7b move for US drinks brand Jim Beam, and Anheuser-Busch InBev purchased South Korea’s Oriental Brewery from PE firms KKR and Affinity Equity. Gregory Stemler, EY’s Consumer Products Global Transactions Leader, says that, although M&A is back on the agenda, corporates remain cautious.
"Corporates have maintained low levels of leverage and are sitting on lots of cash. They are still assessing the strength of the recovery and waiting to see if inflation comes back,” he says.
Brandon Leigh, CFO of CP maker PZ Cussons (PZC), underscores this point. “We assess opportunities carefully and are very selective about the brands and markets we buy into. When multiples start climbing to 15 and 20 times earnings, we step back. It’s hard to justify paying those numbers and still make the investment payback,” Leigh says. “We’ll only make acquisitions where we see strong brands with a good history in markets that have long-term opportunities for growth.”
PZC’s 2013 acquisition of Rafferty’s Garden, an Australian baby food producer, is one example. Rafferty’s, which holds a 40% share of the wet baby food market in Australia, will allow PZC to expand in the Asia-Pacific food market, where it sees growth potential. The company has established operations in Indonesia and Thailand, and will be able to use existing distribution networks and market knowledge to expand Rafferty’s into these areas.
Private equity moves in
While corporates are cautious, PE firms have returned to consumer deal-making with enthusiasm. The number of PE transactions rose by 19% to 63 deals in Q3 from 53 in Q2, according to EY’s CPDQ.
The reopening of capital market activity has supported this growth. In the US, according to S&P Capital IQ Leveraged Commentary and Data, leveraged loan issuance totaled US$605b in 2013 — the highest sum ever. In Europe, it climbed 136% higher than 2012 to US$67.4b.
“The capital markets have been open to finance CP deals, which has allowed PE firms to come back with interest to the market and compete strongly again with corporate deals,” says EY Spain Transactions Partner Mar Ares Martin. “We’ve also seen appetite from EMs such as China and Mexico for financing big consumer deals. This has pushed banks to finance deals in the sector.”
However, for Charles Ind, Partner at PE firm Bowmark Capital, the return of leverage is only part of the story.
“The big issue for consumer deals was visibility on the economic recovery. Nobody could predict what was going to happen to consumer spending, so it was difficult to arrive at a valuation,” says Ind. “After this uncertainty, you can now build a clearer picture of how a consumer-facing company will perform. You can see how it has traded through a deep downturn. With greater visibility, it is easier to develop financial forecasts and get comfortable with pricing.”
This trend has wider implications. “The sheer size of some of these CP buyouts will impact other companies significantly,” says EY’s Cosgrove. “PE firms have bought these assets with plans to make substantial improvements to margin. Consumer businesses will be watching closely because if buyout firms can deliver, the pressure will fall on them to achieve similar results.”
Emerging market earnings
When it comes to CP, corporate and PE strategies share a focus on EMs. “EMs remain crucial for growth. The shift from West to East is a long-term trend,” says Tom Salmon, a director at PE firm 3i.
According to the IMF, EMs will account for around 60% of global GDP as early as 2015. Meanwhile, Euromonitor, a market intelligence firm, forecasts that more than 60% of retail growth will lie in EMs.
But breaking into EMs is challenging. Consumer habits vary, distribution networks differ from the retailer-focused model that Western groups are used to, and there are already strong local and regional competitors in place. Regulations also pose significant barriers to entry.
“Establishing a presence in a market such as China, for example, is not easy,” says Salmon. “There are controls on labeling, restrictions on moving products in and out of the country, and regulations around how a business is domiciled. The opportunity is undeniable, but execution is difficult.”
These markets can be volatile, too. Drinks group Diageo reported a 22% decline in sales in China for the six months to December 2013. A series of anti-extravagance measures were introduced by the Government, leading to a fall in sales of baijiu, a white spirit drunk to seal business deals. Weakening currencies, high inflation and rising interest rates in EMs have also put pressure on consumer spending.
But these challenges must be met. “The big test for CP companies is that growth in developed markets has flattened out. They can’t rely on 2% growth from these markets anymore. Companies are going to have to become much more aggressive in EMs,” says Stemler.
Big corporates are already reshaping their businesses accordingly. In 2000, EMs accounted for 20% of profits at P&G. In 2013, they brought in 39% of the group’s profits and 45% of sales volume. In 2013, Unilever was generating revenues of €28.3b (US$38.5b) in EMs compared with just €21.5b (US$29.8b) in developed ones. As businesses pursue growth, the EM share of earnings is bound to increase.
Consumer risks and regulations
In addition to negotiating the shift toward EMs, CP businesses have also continued managing the day-to-day risks of doing business. According to respondents to the CP CCB, continued slower growth in EMs is seen as the biggest economic risk by companies (chosen by 31% of respondents), while increased global political instability was seen as a major factor by more than a quarter (27%). Elsewhere, corporates also saw inability to effectively manage the tapering of quantitative easing (15%) and the pace of structural reforms in the Eurozone (14%) as risks.
Chances of another spike in commodity and energy prices, and the long-term challenge posed by cheaper private-label brands, are of particular concern, prompting companies to emphasize efficiency to protect margins.
“All CP companies have been faced with the rising cost of doing business,” says EY’s Cosgrove. “Consumer spending is volatile and businesses are still dealing with huge increases in commodity prices. Taxation and regulatory costs continue to move upward. Companies are having to make significant changes to their business models just to maintain margins.”
According to EYs Margin unlocked report, the world’s largest CP companies have only achieved margin growth of 0.6% during the last decade. A poll of executives for the report showed that 75% found it harder to sustain operating margins during the last three years; 60% expect it to be harder to maintain margins in developed markets; and 67% expect it to be tougher to sustain or grow margins in EMs.
Companies have responded by streamlining supply chains and cutting costs. PZC has invested £9m (US$15m) in a supply chain optimization program; Reckitt Benckiser has managed to push up gross margins by 50 basis points through cost optimization plans; and Unilever has cut its overheads by reducing CO2 emissions by one million tons.
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