If it turns out to be the case – and we won’t be certain for some while – the catalyst won’t be within the industry for fast-moving consumer goods (FMCG) itself, but at the point where the likes of Unilever’s Magnum ice cream or Nestlé’s Shredded Wheat change hands between retailers and consumers.
In other words, it is dynamics in the retailing industry that will prompt the change of heart, the latest example of which is this week’s proposed tie-up between the UK’s Tesco (TSCO) and Carrefour (ENXTPA:CA) of France. Sure, the details are so sketchy as not even to be vague. Some sort of arrangement – quite likely hastened by the prospective merger of Asda and J Sainsbury (SBRY) – is dignified by the “intention to enter into a long-term strategic alliance”, say the two companies (although if it were just a short-term tactical fix, their bosses could hardly own up to that). Whatever transpires, the Alliance – the companies are keen to emphasise its importance with the capital ‘A’ – will be agreed within two months, implying that the hard work of defining the details, screwing the suppliers, soothing the regulatory agencies will begin after that.
Sure, it does not do to be too flippant about the proposal, rushed though it seems. After all, combined, Tesco and Carrefour still have a stock market value of £35bn and – more important – generate annual sales of approaching £140bn. So a serious attempt to unify their global buying operations will have important ramifications; more so because it rapidly follows the intended Sainsbury-Asda merger and is just four months after Tesco completed its £3.7bn acquisition of UK groceries wholesaler Booker. Factor in other developments, such as Amazon’s groceries store and the would-be dominance of delivery infrastructure by Ocado (OCDO), and the whole creative-destruction thing is mashing up the UK’s groceries industry in a way not seen since supermarkets throttled corner shops from the mid-1960s onwards.
It is within this context that investors should rethink their attachment to FMCG companies. Recall that this affection is based on the idea that the FMCG business model can barely go wrong because it is so simple and effective (and, as such, reminiscent of a Peter Lynch truism that you should only invest in ideas that you can illustrate with a crayon) – the companies make products that are a frequent but necessary cash purchase, that do the job so well they become trusted and are never so expensive that consumers query buying them or are much tempted by a rival’s cheaper version.
The success of this model – combined with growing demand from a new middle class in the developing world who crave brands that can be trusted – has done wonderful things for the profitability of the likes of Unilever and Nestlé. Data for these two, plus Associated British Foods (ABF) and Kerry Group (KYGA), is shown in an online table (click on link below), which emphasises its point by showing profitability ratios and growth rates at 12-year intervals between 1993 and 2017. All four groups currently generate profit margins and return on capital higher than in the early 1990s, with the exception of Nestlé’s return on capital. No matter, the Swiss giant’s profit margins are 50 per cent higher while, in the case of Kerry and Unilever, margins have doubled.
Simultaneously, the supermarket operators struggled. While their sales and operating profits were still growing at a decent lick in the early 1990s, for most of this century they have been stagnant and declining.
This reversal has had much to do with the hubris of the people who ran supermarkets up until a few years ago. Too many of them imagined their companies’ success owed everything to the skills of UK retailers (ie, themselves) whereas it depended on the idiosyncrasies of the UK’s planning laws, which effectively awarded local monopolies to supermarkets, especially the big ones out of town.
Eventually, however, the urge to grow undermined that business model and, as just one part of a multi-pronged and long-running effort to restore food retailers to acceptable profitability, supermarkets’ bosses are busy merging bits of their operations, or all of them.
That must threaten the FMCG suppliers. True, the threat is hardly likely to be existential, but it may be easily enough to erode the ratings on which their shares trade. Why, for example, should shares in solid low-growth companies such as Nestlé or Associated British Foods trade on earnings multiples in the high 20s?
It wasn’t always so. For decades, such companies were regarded as leaden-footed beasts and their shares were rated accordingly. True, they had the protection of brands, but such fortresses came at the price of heavy capital and marketing spending to stay ahead of their rivals. For all but the market leaders, that game usually proved too expensive in the long run. When more muscular retailers start to pressurise their selling prices, it is easy to imagine that a similar scenario will play out again for FMGC suppliers. In which case, their shareholders may have little but sub-par investment performance to look forward to. How attractive is that?
