Sunday, August 17, 2008

squeezing Big Food

in an earlier post, I mentioned that the "integrated corporate" model will face increasing pressures in the coming years. more news has come out on this theme....

first, to define the "integrated corporation".. this is something like Campbells Soup or Coca-Cola (which I own). it's called "integrated" or "vertically integrated" because, unlike earlier kinds of businesses, everything from production to sales and marketing is organized under one roof.

just 150 years ago, there were no food brands. farmers harvested vegatables and raised livestock. either they sold it themselves or some kind of middle man would buy it to sell in urban markets. while there were differences in quality, people had to make these distinctions and decisions on their own. the key thing is that each stage of the economic activity is done on its own, by separate parties, each following their own interests.

this lasted until James Buchanan Duke created what became the American Tobacco Company in the 1880s. why did this happen when and where it did? the answer: technological change made production easier and opened up completely new realities.

in the case of Duke, it was the automatic cigarette-rolling machine. this device suddenly made it possible to churn out butts on a greater scale than anyone previous had imagined. facing a potential glut of his own product, Duke built a network of sales and marketing offices whose personnel visited local stores on a regular basis, making sure they sold Duke's products such as Lucky Strikes. they took charge of who sold what and tracked rival products to undersell the competion. they also maintained consistent quality by taking back unsold items after a certain amount of time.

this is how brands were built. by the early 20th century this management structure was spreading rapidly throughout the country and the world. (others included Kellogg, Coca-Cola, Standard Oil, etc.. in fact, this kind of company played a big role in the 1920s stock-market run-up).

one important thing many people don't realize about this structure is that it is utterly interconnected with the mass-production model. if you're going to sink millions -- or billions -- of dollars into factories, you better make sure someone is going to buy what gets churned out. that means a constant stream of orders, aided by a fleet of trucks, to keep paying the bills.

in essence, the brands we all know and love are designed to pay for the machines of corporate executives and their investors.

this was a wonderful arrangement because mass production let companies make Corn Flakes, Mac & Cheese and Fritos cheap enough for the average person to see value in them. inexpensive fuel and a road-building government also allowed trucks to reach retailers spread across the increasingly sprawled suburban landscape.

it's obvious these factors are changing. fuel and commodity costs are up 40-100% in the past year. even though they have pulled back recently, prices will continue to rise as millions of indians and chinese enter the middle class. for instance, in kellogg's latest earnings release, the company's profit rose a mere 4%, despite an 11% growth in sales.
(management tried to exaggerate profit by borrowing money to repurchase their own stock... they have added about $350mln of debt this year, leaving them with a smaller book value than they had in december. don't be fooled.)

but something deeper is happening in addition to the food-and-fuel price squeeze. this is from a recent press release by Unilever:

The top five categories where shoppers would reduce their expenditure if the economy continues to struggle include: air fresheners; cookies; beer/wine; frozen dinners; and soda/pop.

this might not come as much of a surprise. but if you look more closely, you realize these are the kind of high-margin items that allow the classic integrated food company to profit. things like frozen dinners and air fresheners... now, it might not sound like a big category.. but I think it means something more than just these two items. when people are struggling to make ends meet, they will avoid the more expensive items that come in fancy packaging. they're also more inclined to buy in bulk, seek items on sale, and use more coupons.

Unilever continues:
Consumers would like manufacturers and retailers to be creative in product packaging and sales approaches. There were several shopper preferences including introducing larger pack sizes, smaller package sizes at lower price points, and modestly reduced package sizes with the same price point. ... [ shoppers ] are taking a new approach to shopping as our study found that quick trips to the grocery store are declining and major stock-up trips that allow consumers to replenish their cupboards for a long period of time are on the upswing.”

I might be jumping to conclusions here, but when I read that people are buying more stuff at once, seeking bargains and bigger containers, while avoiding quick trips and convenience foods, I see that consumers themselves are shifting to lower-margin items. not only are the food-company margins being squeezed by food and fuel .. they're also being squeezed by people's choices.

this is from Fitch Ratings most recent Leveraged Finance Weekly (aug. 15, 2008):
"Until recently, the larger packaged food companies have been able to cover their commodity cost increases through higher prices and efficiency measures while maintaining volume growth," says Philip Zahn, senior director with Fitch’s retail and consumer team. "However, it is becoming increasingly clear that, for most companies, this is not sustainable."
while Fitch was referring to European food companies, I believe the situation will be roughly the same in the U.S.

finally, underlying all of this is the revolution in information.

on one hand, the big integrated industrial companies I discussed above benefitted from their ability to feed cash into their mass-producing factories. but here's another way of understanding this: big, vertically integrated companies enjoyed a huge advantage in terms of access to information. a network of sales and marketing people tracked many different geographic areas and market segments: they reported back to the big suits where new grocery stores were opening and who was buying what. these same executives recieved information from procurement people who tracked agricultural trends and commodity prices, production people who could apply cost-saving techniques to the entire enterprise, and finance people who could find the cheapest ways to pay for everything. because it united all this under a single roof, the real advantage of the integrated corporation was its consolidated base of knowledge. (another way to understand the importance of information is to consider the proliferation of white-collar jobs in the 1950s and 1960s -- armies of workers who wielded numbers and reports rather than hammers or ploughs.)

the internet is already chipping away at this advantage for many industries. the record and newspaper industries seem to be the first victims. (both made huge profits by monopolizing access to information in the analog world, when the transmission of knowledge was finite and restricted to physical media.)

while it might seem that big integrated companies in industries such as food are immune to this, don't count on it. executives at these companies would tell you their market knowledge and sales networks are some of their biggest competitive advantages. (these are essentially assets... now that there are more information assets in general, theirs by definition would be worth less.)

I know people who are now buying beef and poultry directly from farmers, and the "buy local" movement is in its earliest stages. farmers' markets are also growing increasingly common.

while some big companies like wal-mart will find ways to piggyback on this trend, it's inherently negative for the big integrated food companies that rely on buying from far away, expending lots of energy to process and ship food, only to then spend more money on advertising trying to convince you to buy it. ordinary people are getting more access to the same kinds of information the big companies have and will cut out Big Food, which is essentially a middle man between farmer and consumer.

if any lesson is clear from the last 10-15 years, it is that access to information drives middle-men out of business. this has happened in financial markets and online with things like eBay.

I am not saying any of these companies will go out of business... my point is that large consumer-products companies are starting a long process it will be a long and slow process of experiencing this squeeze. and, I suspect it will happen more in categories such as food than items such as cleaning supplies.

it's a secular trend that is only now beginning.

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