A merry dance…

March 3, 2021

2:26 pm

I wrote on the subject of profit margins last year in Margin Call and how we try to normalise them as part of our company evaluation. I referred to The Heinz-Kraft Company (KHC) and how under 3G Capital, a private equity firm, margins were significantly raised at KHC. A consequence of those expanding margins was underinvestment, which subsequently caused earnings to drop. With the toxic mix of falling earnings and massively increased financial leverage the stock price tanked. That stock price remains 60% below its 2017 high. The topic is a bit of an obsession of mine, because it forced many other companies in the fast-moving consumer goods sector (FMCG) to follow the same path, often under enormous pressure from shareholders. It is also one that takes years to play out.

Back in early 2016 Warren Buffet could not have been higher in his praise for 3G and their approach:
Jorge Paulo and his associates could not be better partners… Their method, at which they have been extraordinarily successful, is to buy companies that offer an opportunity for eliminating many unnecessary costs and then – very promptly – to make the moves that will get the job done. Their actions significantly boost productivity, the all-important factor in America’s economic growth over the past 240 years. Without more output of desired goods and services per working hour – that’s the measure of productivity gains – an economy inevitably stagnates. At much of corporate America, truly major gains in productivity are possible, a fact offering opportunities to Jorge Paulo and his associates

2015 investor letter

In the last decade we have seen challenger and local brands really make an impression in consumer markets. Illustrating the point are trends towards challenger personal care products (Harry’s and Dollar Shave Club for razors, Rodan + Fields for skincare), baby care such as nappies (ECO by Naty) and baby food (Ella’s Kitchen), alcoholic drinks (craft beers such as BrewDog and countless gins like Sipsmith), tonic (Fever-Tree), ice cream (Halo Top) and local breweries, artisan coffee and artisan breads (Gail’s Bakery in London). This has put pressure on the large branded players. It has meant slower organic growth and market share losses. The question is whether this trend was a function of a changing marketplace in terms of customer tastes and behaviour or if it was a massive own goal by the big brands themselves that allowed this to happen. Bernstein Research gives a very interesting take on these changes.

Bernstein shows that operating margins for this sector are inversely correlated with organic growth and ultimately returns on invested capital; the higher a company pushes its operating margins, the lower organic growth and lower ROIC (see figures 1 and 2). It sounds somewhat counterintuitive; usually operating leverage results in higher margins accompanying higher sales. In this situation, however, the more that costs are taken out, be that from marketing or innovation, the lower the sales growth rate. How do you offset this top line pressure? If volume growth is under pressure, you can offset it with price increases. This is deeply unhealthy and unsustainable, the further you move from your competitor pricing the more susceptible you are to product switching.

If you cannot get the top line moving organically, an alternative route is to acquire growth through acquisition. Many of the above challenger brands have been acquired, while there have also been the big deals, for example Danone’s purchase of WhiteWave for $12.5bn and Reckitt Benckiser’s purchase of Mead Johnson for $17.8bn, both at premium valuations. This inorganic route, often accompanied by share buy backs, funded by leveraging the balance sheet, can keep the music going for a while. Since 2013 Danone and Reckitt Benckiser have doubled and tripled their respective leverage levels. Both companies are now in significant trouble, have suffered significant share price declines and face margin resets.And it doesn’t end there for the FMCG companies, Bernstein flags another challenge currently accelerating; the growth of e-commerce and the power it gives to the gatekeepers such as Ocado or the likes of Wal-Mart and Tesco with their online platforms. This puts additional pressure on sector margins and sales growth. Covid-19 has given such e-commerce a big boost.All this comes at a point when valuations for the sector have been driven higher by low interest rates and in the form of the bond proxy trade, adding valuation risk to the earnings and financial risks described above. While it is difficult to precisely attribute causation for the rise of the challenger and local brands, Bruno Monteyne at Bernstein says, “Margin targets provided oxygen for fragmentation”. You could also argue strongly that 3G, and their cheerleader Warren Buffett, bear much responsibility for what has happened. It was the example they set on “eliminating many unnecessary costs” and their very public touting of this business model, which has led the sector and underlying shareholders on this very merry dance…

Figure 1 European Food & HPC - EBIT Margin V Organic Growth

Graph

Figure 2 European Food & HPC Sector – ROIC v EBIT Margin

Graph

Source: Company reports, Euromonitor, Bernstein analysis.

Sector averages based aggregating all Invested capital, across companies (in Euros), and aggregating all NOPATs and EBITs across companies.

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
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