Opportunities and Threats in a Consolidating Retail Environment

Article from April 2010

The

Journal Opportunities and Threats in a Consolidating Retail Environment

By Greg Pearlman BMO Capital Markets A recent equity research report suggests that Wal-Mart is again “lacing up the gloves in the fight to win the modern day price war in food retail in 2010.”

Investors responded to the report favorably, bidding shares of the world’s largest retailer up 3% in a single day of trading. For mid-sized consumer packaged goods (“CPG”) manufacturers, many of which are still reeling from a protracted downturn in consumer spending, the message is a shot across the bow. Wal-Mart and other national retailers will continue their demands for price cuts and other concessions unfavorable to suppliers as the battle over U.S. retail market share intensifies.

In the last five years alone, the market share of the top 10 U.S. food retailers has grown from 53% in 2005 to an estimated 59% today, with discounters Wal-Mart and Supervalu gaining 4% and 3% respectively. While retail consolidation is not a new trend, the challenges it presents to CPG manufacturers continue to evolve.

In this increasingly competitive environment, mid-market CPG manufacturers must be mindful of risks arising from these rapidly changing consolidation trends so that they can adapt and become stronger. In this article, we will describe a number of themes germane to mid-sized manufacturers that serve this consolidating retail environment, and explore the threats and opportunities inherent to each.

Theme 1: Retailers Continue to Stay Lean Despite an Improving Economic Outlook

During the latest recession, discount retailers saw their pricing advantage

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diminish as most retailers adapted by slashing prices to drive value-oriented consumer to stores. As Wal-Mart’s actions suggest, price competition remains fierce in the U.S. retail environment, and several major chains seek to re-focus their message on every day low pricing. Recent improvements in the economic outlook aside, Wal-Mart, Target and other national retailers have been explicit about their commitment to continue price reductions in key product categories.

SKU rationalization remains a major worry to mid-sized CPG companies, many of which already struggle under retailer pressure to bring down costs. Over the last several years, retailer initiatives such as Wal-Mart’s Project Impact have been focused on accelerating SKU rationalization in order to make shelf space available for broadened private label programs and high velocity national brands.

In part due to these SKU rationalization efforts, private label share of U.S. grocery sales has risen to 17% in 2009 from 12.5% in 2004. Further, Kroger recently eliminated 30% of its cereal varieties; CVS eliminated Energizer batteries (leaving only Duracell and private label); Walgreens cut its superglue varieties from 25 to 11; and Supervalu reduced the number of SKUs it carried by 25% per store. If global standards are a benchmark, U.S. food retailers still stock a relatively high number of SKUs. For example, a 2008 study revealed that a typical U.S. supermarket carried 47,000 SKUs, nearly three times that of its average counterpart in the UK. Wal-Mart, one of the leaders of SKU reduction, admitted it may have alienated some customers through its SKU reduction initiative and will likely bring back approximately 300 of the 1,000 SKUs that were eliminated in its WIN-PLAYSHOW initiative. Irrespective of Wal-Mart’s SKU reduction backtracking, mid-sized suppliers should still expect to see greater share consolidation among top brands in many CPG categories. Moreover, formerly popular “green” and other niche products are at significant risk of reduction or all out elimination at certain national retailers.

Technology changes, such as scan-based trading, pay-on-scan, pay-by-scan, and radio-frequency identification (RFID), continue to attract the attention of midmarket suppliers that worry about the costs and risks of these inventory management methods. While adoption of these systems has slowed considerably since the last recession began, CPG companies selling through major retailers should continue to monitor this trend and be prepared for the organizational changes required if adoption of these or other technology is mandated.

Theme 2: Retailers Are Becoming More Active Marketers

Retail chains are becoming more aware of the needs of their core consumer, and are more aggressively pushing for targeted solutions from suppliers. Even global CPG suppliers are losing the latitude to push standard products through multiple retail channels. Their mid-market competitors have long had to differentiate in order to gain acceptance at larger retailers, and should anticipate this requirement to intensify. The growth of loyalty card programs has provided a wealth of information regarding consumer demographics and spending patterns. Kroger and other chains have partnered with data analytic firms to improve the efficiency and effectiveness of marketing programs, and to better manage inventory. Middle market CPG companies should develop the means to both w ww.ACGChicago.com

qualitatively and quantitatively measure consumer buying habits and needs, in order to better align with programs of their retail partners.

This trend is also reflected in the growth of the private label category. Attracted to private label’s higher margins and the ability to position store brands as a point of differentiation, retailers have invested heavily to market and develop the category.

In partnership with private label manufacturers, retailers have elevated the category and now offer private label products that are often equivalent and sometimes exceed the quality of national brands. As a result of retailer focus on the category, share of private label goods increased substantially since the start of the economic downturn, accounting for over 30% of total sales in a number of categories.

Theme 3: Retailers Search for Means to Differentiate from Wal-Mart

Alternative retail channels, such as convenience and dollar stores, are positioning themselves as challengers to Wal-Mart and other national retailers based on location and convenience. The convenience store channel has evolved as an important retail channel with recently expanded food offerings, including more sophisticated and expanded prepared and private label food. As a result, convenience store sales grew 50% between 2003 and 2008 to an estimated $174 billion. Dollar stores have also exhibited compelling growth as the category emerges as a viable competitor to Wal-Mart and other national retailers. Large dollar store chains have reported significant same store sales growth driven by the appeal of the smaller, less cluttered store format and expanded offerings of groceries and other consumable goods. In 2009, Dollar Tree increased the number of stores equipped with freezers to accommodate frozen food by 16% while Dollar General is undertaking extensive store remodels to retain higher income customers as the economy improves. In 2010, the dollar store channel is on pace to add more square footage in the U.S. than Wal-Mart for the first time ever. Given their attractive growth profiles, these and other alternative retail channels represent complementary, and possibly alternative, customer bases for mid-sized CPG manufacturers.

Theme 4: America’s Changing Demographic Makeup Can Be a Once in a Lifetime Growth Opportunity

America is rapidly becoming older and more ethnically diverse. The number of Americans aged 55 and over is expected to increase by over 30 million, to 97.3 million, between 2005 and 2020. By 2020, 29% of Americans will be over 55 years old, up from 20% today. In the 1990s, the population of Hispanics and Asians grew four times faster than the population as a whole, while the African American population grew 20% faster. By 2008, the minority population in the U.S. reached 34% of the total population, which is expected to increase to nearly 40% by 2020.

The well-established U.S. ethnic foods market is an estimated $75 billion business, representing approximately $1 out of every $7 spent on food. However, the growth opportunities come not only from ethnic groups, but also from broader consumer groups increasingly drawn to the perceived health benefits and variety offered by ethnic foods.

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The aging and diversification of the U.S. population offer substantial growth opportunities for middle market CPG companies that have innovative products serving an increasing number of potential customers.

Theme 5: Sustainability Is NOT a Fad

Sustainability is no longer a theme of niche consumer groups. With intense media attention focused on the environment, the “green” movement has attracted widespread interest. In response, a large and growing number of companies are taking up the banner of sustainability, which benefits a broad set of stakeholders and increases profitability for shareholders in many circumstances. In this light, Safeway and Best Buy have joined Wal-Mart as charter members of the Sustainability Consortium, an organization of companies seeking to make products and supply chains more sustainable.

In July 2009, Wal-Mart announced plans to develop a worldwide sustainable product index to evaluate its global suppliers on a number of metrics, including energy and climate impact, natural resource utilization and material efficiency. The assessment, which top-tier suppliers are already required to complete, will consist of 15 questions that give insight into a supplier’s impact on the environment and society. The final usage of this assessment is still to be determined. At minimum, Wal-Mart will use the assessment as one metric in choosing how to allocate shelf space to suppliers. In the future, the score may be communicated to consumers, who will be able to make purchasing decisions in part based on a particular product’s sustainability rating.

Theme 6: Growing Cash Balances and Credit Availability Whet Appetite for Acquisitions

Over the course of the latest recession, large CPG companies practiced conservative financial management, reducing acquisition activity to a virtual standstill while significantly paring back capital expenditures. As a result, a number of these large CPG companies have accumulated significant levels of cash with the aggregate cash balance of the 10 largest U.S. food and consumer companies increasing 76% to $11 billion since the latest recession started in December 2007.

Recent increases in strategic activity by these cash-rich companies and other anecdotal evidence suggests that many large CPG companies are feeling more secure in their economic outlook and are actively scouting for acquisition opportunities among strong middle-market companies. Moreover, private equity firms that raised capital before the credit crisis still have significant capital that needs to be deployed over the next several years. These factors increase the likelihood of more robust M&A markets and opportunities for owners of wellpositioned middle market CPG companies to realize significant value.

The Bottom Line – How Mid-Market Companies Can Compete and Win • Find your sustainable niche within the consolidating retail environment. Align

all of your business operations around whichever strategy best fits your company’s strengths. One size does not fit all. This may lead you to become a low-cost private label manufacturer or a niche-oriented innovator focused on high quality products. The key is simply to compete where you can win. w ww.ACGChicago.com

• Help alternative channels compete and win against major national chains.

Smaller scale retailers are also engaged in fierce competition. Being on the right side of market share gains will allow your company to grow with new retail partners.

• Innovate across the organization, not just in product development.

• Become highly customer focused by offering customized products to different

customers and channels. Adaptability will be a necessity in these changing market environments.

• Embrace technology as an investment that will drive growth within evolving

retail channels. Make these investments proactively with a clear strategy for the near, medium, and long term.

• Be mindful of your company’s sustainability. Many companies have found

that sustainability is not only good PR but can increase profitability.

About the Author

Greg Pearlman Managing Director and Head of Food and Consumer Group Greg is a Managing Director and Head of the Food & Consumer Group for BMO Capital Markets. He is a veteran investment banker, with 25 years of deal experience in M&A, as well as equity and fixed income underwriting. Greg holds an MM in Finance and Management Policy from Northwestern University’s Kellogg Graduate School of Management and a B.A. from the University of Michigan.

This article is one in a series of contributions by ACG Chicago’s Sponsors and was taken from ACG Chicago’s publication, The Journal, April 2010 issue. We appreciate BMO Capital Market’s support.

BMO Capital Markets is a leading, full-service North American financial services provider offering equity and debt underwriting, corporate lending and project financing, merger and acquisitions advisory services, merchant banking, securitization, treasury management, market risk management, debt and equity research and institutional sales and trading. BMO Capital Markets has over 2,200 employees operating in 28 locations around the world, including 15 in North America.

BMO Capital Markets is a member of BMO Financial Group (NYSE, TSX: BMO), one of the largest diversified financial services providers in North America with US$373 billion total assets and more than 36,000 employees as at January 31, 2010.

In the U.S., retail and commercial banking services are provided through Harris, also a member of BMO Financial Group. www.bmocm.com

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