Food and drink operators struggle to protect margins

A volatile pricing and inflationary environment is hitting margins and diluting profitability across the food and drink sector as companies pass on cost increases to consumers and franchisees, while customers trade down to cheaper alternatives.

The latest food inflation figures from the British Retail Consortium (BRC) and Nielsen Food show the extent of price rises flowing through the sector as companies try to protect profits. In August, food inflation reached 9.3 per cent and fresh food inflation moved up to 10.5 per cent – the highest rates since 2008. Shop price annual inflation grew to 5.1 per cent, a record since the BRC’s index began in 2005.  

The impact of cost pressures is seen in recent updates from food businesses. Manufacturer Bakkavor (BAKK) disclosed this week that its operating margin was down by 100 basis points to 4.1 per cent, “driven by the impact of the significant inflationary pressure on the cost base”, despite pricing action helping it push up revenue by over 10 per cent. The company said that the cost of chicken, its biggest ingredient in the US market, was up by 77 per cent since January.

A range of companies across the sector have cut guidance over the last few months due to soaring costs. These include pub operator J D Wetherspoon (JDW), online food delivery business Deliveroo (ROO), egg-free cake retailer Cake Box (CBOX), and premium mixer supplier Fever-Tree (FEVR).

Some companies are faring better than others with higher costs and margin preservation. Greggs (GRG) has kept its full-year trading expectations unchanged. Franco Manca and The Real Greek operator Fulham Shore (FUL), meanwhile, has maintained full-year margin guidance with profitability being helped by good rental deals and rates reductions on its properties.

Executive chair David Page told Investors’ Chronicle that “we will probably cope with a two to three times increase in utilities because of rent savings”, with most rent reviews for existing sites seeing no increases for the next five years against a budgeted increase of 10 per cent. The biggest pressure on menu prices for Fulham Shore is wage costs, which could lead to increased prices next year, Page said.

Restaurant Group (RTN), which operates brands including Wagamama and Frankie & Benny’s, has interim results out this week after it said in a May update that it expected food and drink inflation of 9 to 10 per cent for its full year. Broker Peel Hunt said that the company’s “equity free cash flow yield is very high, pricing in large downgrades that may not materialise”.

The boozers

The cost pressures on pubs and breweries was highlighted in stark terms in last week’s open letter to the government from six operators and the British Beer and Pub Association. This warned that "a huge number of pubs [would] close their doors for good” without state intervention on energy bills.

Other input costs for alcohol producers are also up significantly. The prices for commodities involved in the “production, packaging and transportation” of beer are up by 62 per cent over the last two years, according to analysis from investment platform eToro. Gas spot prices were the biggest riser, up 138 per cent, with barley and malt prices up 104 per cent and 87 per cent respectively due to the impact of Russia’s invasion of Ukraine.

Dutch brewer Heineken (NL:HEIA) said recently it would push up draught beer prices by 6 per cent – further such announcements from peers are expected.

More power

A material cost pressure for operators more broadly is soaring energy bills. Hospitality is, in general, a low-margin sector meaning that the huge energy price rises forecast from next month would be the latest severe blow for a range of companies without intervention.

Struggling share prices have been helped this week by reports that new Prime Minister Liz Truss will unveil a package to help businesses with energy costs. This could come in at around £40bn, although it is not yet clear how it would be distributed. The policy comes after pleas from a range of industry bodies for significant government support.

Chief executive of UKHospitality, Kate Nicholls, said in a letter to the previous chancellor and business secretary that “without support, the industry will see widespread business failure, leading to tens of thousands of job losses” while the BRC’s chief executive Helen Dickinson said that “the situation is bleak for both consumers and retailers”.

As well as government action on energy, UKHospitality has called for a business rates holiday, the deferral of environmental levies, and a VAT cut to support the sector.  

Franchisees

Many food and drink operators use a franchise model. Franchisees are coming under more pressure as costs are passed on to them – which they can then choose to pass through to customers.

Domino’s (DOM) is a key company in the franchise space. Around two-thirds of the pizza-maker’s revenue comes from sales to franchisees. Average cash profits per franchised store came in at around £94,000 in the latest half, down almost 40 per cent on last year.

The company noted in its interim results that its fall in profits “was largely driven by the timing lag in passing through higher costs to our franchisees”, with the company hit by £3.7mn-worth of food and labour cost inflation. Interim chief financial officer David Surdeau said in the results presentation that more costs would be passed through in the second half.  

Domino’s said that the introduction of a delivery charge in the first quarter of this year, which has a range of 99p to £2.50 and is set at the discretion of the franchisee, was helping franchisees to offset food inflation and higher costs.

Cake Box also uses a franchise model, and looks less well-positioned than Domino’s. Its latest trading update sent its shares plunging as the company said that its full-year margin would be hit despite the passing on “some” cost increases to franchisees. Like-for-like franchisee sales were down 2.8 per cent in the financial year to date, the company said.

Despite weaker trading and passing on higher costs down the chain, Cake Box said it has “a strong pipeline of potential new franchisees”.  Financing for new franchisees may be more difficult to come by, however, as banks tighten lending conditions in an increasingly challenging economic climate.  

Trading down

There is a fine balance between putting through cost increases and protecting volumes. There is growing evidence that consumers are trading down to alternative products as prices rise.

Commenting on the BRC’s retail sales monitor for August, which showed a significant fall in volumes once adjusted for inflation, chief executive of retail analytics firm IGD Susan Barratt said that hip pocket protection had already changed behaviour. 

"Our data shows that shoppers are investing more time in how they can save money by planning more and searching for value with private label options and seeking out discounts," she said. 

Consumer goods giant Unilever (ULVR) flagged in its latest half-year results that there had been “negative impact on volume” as it put through price increases (which reached 11 per cent in its second quarter) and consumers sought out lower-priced options.

There have been indications over recent months of trading down in the drinks sector, with US market analysis by RBC Capital Markets and Deutsche Bank highlighting risks to companies such as Fever-Tree and Diageo (DGE) from declining spirits consumption amidst low-income consumers and slowing spirits growth.

There are winners from consumers changing their habits and plumping for less pricey choices.

On the pub side of things, J D Wetherspoon’s relatively cheap product offering means it could benefit. Chair Tim Martin recently confirmed that the company’s pubs would remain open for their normal hours while other operators have suggested limiting hours. Broker Panmure Gordon said that the company should gain from “taking share from poorly funded smaller operators”. Martin has previously railed against supermarkets' ability to sell cut-price booze, so consumers could go cheaper even than the famously affordable Spoons menu. 

The pizza-makers also look well-placed as consumers trade down from restaurants. Domino’s sales rose during the 2008 financial crisis as shoppers opted to eat in. Franco Manca’s pizzas are significantly cheaper than those offered by rivals, with a range of options under £10. Peel Hunt analysts said that this was "a compelling proposition, which should continue to win mainstream daily custom”.

Bakkavor is bullish on its prospects in an economic downturn. "As we have seen in prior recessionary periods, we expect to benefit as consumers trade down from eating out to purchasing meal equivalents in the supermarket," management said. 

Supermarkets such as Tesco (TSCO) have cheaper own-brand products which cover staples like bread and pasta and also offer pricier ranges such as J Sainsbury's (SBRY) Taste the Difference. But while consumers are increasingly turning to own-brand items, supermarket pledges to not ramp up pricing and price-match battles with discount shops like Aldi and Lidl mean the fight for market share is on, at the risk of margins coming down even further.