The specter of private label

Once dubbed ‘The Inevitables’, there once was, and perhaps still is, an expectation that branded food companies will remain defensive stalwarts that will grow for years to come. As is the case in investing, change is guaranteed, and branded food manufacturers have not been immune to disruption. Perhaps this was put most poignantly by Jorge Paulo Lemann, the co-founder of 3G Capital, which is one of the largest shareholders of Kraft Heinz (Nasdaq: KHC):

“I’m a terrified dinosaur…I’ve been living in this cozy world of old brands and big volumes…you could just focus on being very efficient and you’d be okay…we bought brands that we thought could last forever… and all of a sudden we are being disrupted in all ways.”

The landscape for branded packaged food companies has markedly shifted in recent years, with a growing number of challenges these companies will need to navigate going forward. One of the darkest storm clouds brewing for branded food players is that of private label products, and the risk that the loss of branded market share to private label worsens. Below are some observations that should give pause to investors who hold a sanguine view on branded food companies.

1) Increasing retailer consolidation

In the U.S., the top five largest grocers have increased their market share from 38% in 2012, to 46% in 2017, according to Euromonitor data. It is possible that we see a continuation of this trend of retailer consolidation in the U.S, as large grocers try to defend share against smaller retailers as well as e-commerce grocery disrupters such as Amazon.

Source: Euromonitor; via Morgan Stanley Research

If U.S. grocer consolidation were to continue, it could support the current trend of increasing private label penetration in packaged food. If we observe the private label penetration of packaged food by geography, it is clear that more consolidated grocery markets such as the UK show trends of higher private label penetration of the packaged food category. In the UK (where food retailers are more consolidated), the penetration of private label products is around 2,000 bps higher than in the U.S. What this means is that there’s potentially a long runway for private label penetration to increase, a scenario that would pressure the market shares of branded incumbents.

Source: Euromonitor; via Morgan Stanley Research

Some retailers have publicly stated their desire to pivot their SKUs more substantially to private label products. Kroger, the number two grocery store in the U.S., launched its “Restock Kroger” program in late 2017, aiming to reconfigure 20-30% of its space allocation with a desire to increase the presence of its private label products.

During a 2018 investor conference, Kroger’s CFO stated “Make no mistake, our brands [referring to private label] in every store will be – will have a bigger presence and will be a more important aspect of it. We are, as we reset stores, bringing all the Kroger product in that category together in the center of the shelf.” Notably the margin differential between food manufacturers and food retailers has expanded to ~4x in 2017, compared to 3.3x in 2010. We would expect that in a time where this differential has expanded, and the branded to private label price gap has also increased, grocers will look at doubling down on private label as an opportunity to drive foot traffic and capture margin. This is unequivocally negative for branded food players.

2) Branded to private label price gaps have increased

The price gap between branded food products and private label has increased materially in recent years. As an offset to stagnating volumes, branded food companies have been increasing pricing on their products, or employing other subtler means to boost unit prices such as using smaller packet sizes. Similar to boiling a frog, the competitive impacts from the price increases might not be dramatic in the short term, but the price premium of branded food products over private label products has increased to a point where consumers might be incentivized to make the switch from branded to private label.

Source: Nielsen xAOC + C; via Morgan Stanley Research

While we’ve seen this price premium increase for the industry, the ratio has blown out dramatically for some companies. Take Kraft Heinz, for example. KHC saw its price premium relative to private label increase by 57% for the period of 2018 to-date, compared to 2014.

Source: Nielsen xAOC + C; via Morgan Stanley Research

What’s happening should be obvious: companies such as Kraft Heinz are using price increases as a tool to drive revenue growth, and offset declining volumes. You might be able to get away with putting through price increases and getting them to stick with consumers in the short run, but an overreliance on pricing as a revenue driver can be calamitous. There is a point where the branded price differential with private label becomes too severe, volume losses worsen, and there becomes an increased risk of the need to enact a downward pricing reset to remain competitive. This would lead to significant margin pressure, which we believe that market is simply not factoring in at current share prices.

3) Grocery dollar growth has mostly come from private label

What we have seen in recent times is that two-thirds of total U.S. grocery dollar growth is being driven by private label. This is rather incredible, considering that private label represents less than 20% of the total 2017 U.S. grocery sales mix. It is difficult to see these trends abating, and with retailers increasing their focusing on private label, it is likely that private label will remain an important driver of U.S. grocery sales.

Source: Nielsen xAOC + C; via Morgan Stanley Research

 

The above factors are likely to combine to create headwinds for branded food manufacturers. Storm clouds continue to brew over the packaged food sector, and we believe that some of these challenges will continue for branded food companies over at least the next few years.

Montaka is short Kraft Heinz (KHC), Kellogg (K), Campbell Soup (CPB), and General Mills (GIS)

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George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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