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In Packaged Foods, Success Is More Than Just Good Taste

Scale matters, so major players have a competitive edge over smaller peers.

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When we evaluate businesses, Morningstar analysts frequently employ a widely recognized framework known as Porter's Five Forces. Since it was first developed by Harvard business school professor Michael Porter in the 1970s, the Porter's Five Forces model has had a profound impact on the way business leaders assess their markets, and shape their business strategies. Quite simply, the Porter's Five Forces paradigm has evolved into one of the most commonly used analytical tools for assessing the strategic and competitive advantages and challenges of individual companies, as well as entire industries.

Here at Morningstar, we find the Porter's Five Forces model to be especially useful when evaluating companies we cover in the highly competitive packaged foods business. In fact, using Porter's model, we can identify a key industry truism:  Despite its weak supplier power, the packaged food industry's potent combination of intense rivalry, strong buyer power, and substantial number of substitutes make it a challenging one in which to develop a sustainable competitive edge. The packaged food competitors who are best-positioned to reward investors with solid cash flows and long-term excess returns on invested capital tend to have three secrets to success: significant economies of scale, expansive distribution networks, and leading brands.

Supplier Power: LOW
The raw materials used in the packaged food industry vary between manufacturers. In general, key supplies include corn, wheat, dairy, cocoa, sugar, proteins (like beef and pork), and energy (related to distribution and packaging needs). Almost all of these ingredients are commodities that are available from a large number of suppliers, although some--such as  Archer-Daniels Midland (ADM),  Bunge (BG), and Cargill--operate as leading processors in the agribusiness industry, and hold strong negotiating positions relative their customers. That said, manufacturers that possess significant scale tend to garner favorable pricing arrangements, given the significant quantity and frequency of purchases.

However, food manufacturers are not immune to input-cost inflation, which has taken a bite out of their profitability lately. For example, despite attempts to offset cost pressures with price increases, productivity improvements, and product innovation,  Sara Lee's (SLE) gross margin declined more than 200 basis points--to 38% of sales--through the end of fiscal 2010. Although recent supply constraints that have driven commodity prices higher could be temporary, demand in emerging markets could keep raw material prices elevated over the long term.

Buyer Power: MEDIUM/HIGH
Consolidation among retailers as shifted power away from packaged food firms over the past several years--i.e. the rise of  Wal-Mart (WMT) and other discounters like warehouse clubs and dollar stores. In addition, retailers have become more adept marketers to consumers. To expand the distribution of their products, it is essential that packaged food companies adapt their offerings to retailer requests or risk losing distribution through these key outlets--even if this might mean accepting a lower margin in the process.

However, retailers are still dependent on strong, market-leading brands to drive store traffic. Brands capture consumer attention, and build consumer loyalty while typically offering premium pricing and potentially higher gross margins. Theoretically, having more products to offer across more categories puts manufacturers in a stronger position.

Despite a retailer focus to increase the shelf space afforded to lower-priced, private-label offerings over the past year or so, some operators--particularly Wal-Mart--are now singing a different tune. For instance, Wal-Mart has pulled back from pushing private labels in favor of offering national brands at everyday low prices. Further, the retailer recently announced that it will be broadening its product assortment (by about 11% at an average store), bringing back several items and brands that resonate with its consumers. In our view, this strategy illustrates the importance of a strong brand mix.

One firm in the space that possesses significant brand equity is  General Mills (GIS). The firm has announced numerous price increases across its product portfolio (on average mid-single-digit increases impacting about half of its U.S. retail and foodservice business), and according to management, is able to be one of the first in the industry to raise prices, due to its solid brand positioning and strong relationships with retailers.

 

On the other hand,  Dean Foods (DF) has been particularly challenged by retailers flexing their muscles over the past year. More specifically, major retailers have been accepting less than historical levels of profitability on private-label milk offerings to drive traffic in their stores. While this situation is unlikely to persist over the long term, as retailers may seek to garner some profitability from the dairy aisle, we doubt profit will bounce back to historical levels.

We expect consolidation to remain a key theme among packaged food firms in 2011, which could transfer some power back to food firms. With companies like  McCormick (MKC) and  Heinz (HNZ) sitting on sizeable cash positions, the opportunities for small tuck-in deals either at home or abroad could be on the horizon, in our view. We also would not rule out another blockbuster deal like  Kraft's (KFT) acquisition of Cadbury, as credit markets appear to have thawed enough to support larger transactions in the near future.

Barriers to Entry: MEDIUM
Although there is little to stop a new entrant from encroaching on the packaged food industry, we contend that barriers to successful entry are high. Significant time and resources need to be invested to achieve the economies of scale that dominant packaged food firms hold, including building a manufacturing and distribution network, and developing brand strength and relationships with big-box retailers.

Further, there are no meaningful switching costs between the products sold by food manufacturers. Consumers have a choice of multiple brands in almost every packaged food category. That said, leading packaged food firms heavily invest behind the marketing support of their core brands in an effort to convey to consumers the value and quality in their brand. For instance,  Kellogg (K) spent over $1 billion, (about 9% of consolidated sales) on advertising to enhance the strength of its brands.

Building brands today is a much more expensive proposition than it was even 10 years ago, as is developing the distribution networks and retail relationships needed to reach consumers. Furthermore, creating and maintaining the consumer connection is a significant challenge. It requires time, money, and marketing savvy. In addition, media is increasingly fragmented, particularly in digital channels, which can make it more difficult to reach a group of consumers without significant financial resources.

Threat of Substitutes: HIGH
Even though there is not a substitute for the industry, we believe the threat of substitutes is high within the industry. Packaged food firms compete with other branded offerings and lower-priced private-label products. Sales volumes within the industry come under pressure since the recent recession, as fragile consumers have shown a willingness to trade down to lower-priced private-label alternatives.

The quality of private-label products has improved dramatically as supermarket chains have invested heavily in their brands (like  Safeway's (SWY) O Organics brands), many of which rival branded offerings in terms of quality. Although private-label offerings have gained share, it remains to be seen whether consumers that traded down to lower-priced, value offerings will ultimately trade up in a more robust economic environment.

However, if a packaged food firm's product assortment consists of items in competitive categories and offerings that possess little to no brand equity, consumers are more likely to make purchase decisions strictly based on price--rather than brand--which limits a firm's profitability. This is especially true in "commodified" categories, like meat and dairy. For instance,  Tyson's (TSN) low- to mid-single digit operating margins pale in comparison to  Campbell Soup (CPB), which tends to generate operating margins in the mid- to high teens.

Despite numerous substitutes, some packaged food firms dominate the category in which they compete. For example,  Hershey (HSY) is the leading player in the domestic chocolate segment, with 43% share--far in excess of any of its competitors and private label offerings (which maintain just 1% share of the U.S. chocolate market). As a result of its strong brand equity and leading share, Hershey's sales momentum has continued unabated in spite of reduced promotions, which is especially noteworthy in this soft consumer spending environment.

Degree of Rivalry: HIGH
Rivalry is intense in this highly competitive industry, particularly given that packaged food categories tend to exhibit modest growth, and are dominated by a few large players. In general, packaged food firms will battle for share by investing in product innovation and marketing support of its core brands. The high degree of rivalry leads to competition on price, and manufacturers were fairly aggressive with price promotions in 2010.

Soft consumer spending has magnified the degree of rivalry among packaged firms, in our opinion, especially among branded and private-label offerings. While companies throughout the packaged food space have utilized promotional spending in an effort to propel volume growth, numerous firms have conceded that these lower prices aren't driving the incremental volumes necessary to support them. As a result, we expect increased investments behind product innovation that resonates with consumers. However, in our view, this spending is unlikely to yield measurable improvements overnight.

So Where Do We Stand Now?
It's no secret that competitive pressures remain intense in the packaged food industry. While we are fans of the recent rhetoric that promotional spending is taking a backseat to increased brand investments, food manufacturers must tread lightly, in our opinion, as consumers are not in a position to pay up for new offerings if the added value is not apparent. As a result, we continue to believe firms that maintain strong brands (like wide-moat manufacturers Hershey and McCormick) are better suited than those with lackluster brand portfolios (such as  ConAgra (CAG) and Sara Lee) to operate in the current environment of fragile consumer spending and rising input costs.

While the packaged food space tends to be fairly valued at this point in time, we think that long-term investors seeking exposure to the consumer staples industry should still keep an eye on the moaty names in this space. Stellar growth is unlikely, but solid cash flow generation and a history of enhancing shareholder returns (with increased dividends and additional share repurchases) should appeal to income-seeking investors. If stocks within the packaged food industry trade down on concerns surrounding rising input costs or competitive pressures, we may go a step further, and recommend the shares.

Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.