Food and beverage processors will be fighting it out for an increasingly dwindling supply of grains sourced at ever higher prices, ING Group warned in a new forecast report for the sector. ING's financial analysts predict that agricultural prices will increase further by another 40 per cent by 2020, reflecting a tight supply brought on in part by increased demand for grains, a global water shortage, and changing weather patterns.
The report provides an insight into the adjustments food and beverage managers are going to have to make to their logistics systems, pricing strategies, and product development to cope with the coming crisis. ING's analysts see opportunity for large companies that are better able to adjust and leverage the inflationary environment to their advantage.
"The virtuous inflationary cycle is created as leading consumer goods players translate higher input prices into accelerating sales in premium brands and developing markets," the report stated. Small and mid sized companies overall will have the most problems with input price pressure, while their positioning in regions and categories is focused too closely on western markets and products that depend on a supply of meat or grains.
Adapters to perform well InBev, SABMiller, Heineken and Diageo, and to a lesser extent, Unilever, Pernod and Nestlé have the strategic and financial clout to perform better than their peers in such as situation, the analysts forecast.
Building a 'green and clean' image among consumers will be a big factor in successful growth strategies, they stated. The companies with potentially the strongest difficulties are Cadbury, S&N, Henkel, Beiersdorf, CSM, Grolsch, Nutreco and Wessanen, they stated.
"In particular for CSM, Nutreco and Wessanen, the long-term positioning should be worrying," the analysts stated. "The Grolsch problem has been resolved by the intended takeover by SABMiller." In the food sector, Unilever is the company best positioned for growth among Western Europe's publicly traded companies, followed closely by Nestle.
"Both companies have strong and focused brand portfolios and high exposure to the 'right' emerging markets," the analysts stated. "We expect these two companies also to benefit mostly from the attention to 'greener topics'."
Spirits companies protected Meanwhile spirits companies are "very well" protected against the negative factors from rising input costs on a micro level. "Brewers could feel the negatives from rising input costs, but their activities are positioned in those regions that benefit from rising imbalances in agricultural and energy raw materials," they stated.
The forecast situation will come on top of the the current increased volatility in the availability of input materials and increasing volatility in prices of raw materials. The hit to the bottomline is mainly felt in the higher prices for energy, packaging and agricultural inputs.
Europe's processors are also dealing with increasing volatility in margins related to input prices and their ability to pass this on to customers. Coupled with an increasing volatility in consumer demand, depending on the region, the stage is set for an underground change in the way industry approaches regional markets.
The supply of grain would have to be increased by between 25 to 30 per cent to meet the demand, both for foods, feed and biofuels. Crop yields will not rise enough to meet future demand and could even fall, ING forecasts using scenario modelling.
While grain production has increased in the past 16 years mainly because of a rise in yield, the land used in grain production has in fact declined. All predictions are significantly lower than the average annual 1.1 per cent increase that was experienced from 1990 until 2006.
The annual expected growth rate for grain demand from 2006 until 2020 is between 1.7 to 3.2 per cent, the analysts predict. None of the projections forecasts that yield increase will be able to offset the forecasts for the increased demand.
The low estimate even predicts the yield to be 50 per cent smaller from now until 2020. The low variant incorporates a scenario that a water crisis will occur.
Water shortage a problem In the low estimate water prices will increase significantly and have an effect on grain yield. "The increase in demand and slowdown of growth in yield will cause a shortage of cereal stocks," ING's analysts warn. "This is a serious issue, as the stocks are at a 24-year low."
Recent news flow supports the stand of the International Food Policy Research Institute, which has also predicted a change in grain yield due to a shortage of water. Australia, for example, has recently experienced a 30 per cent reduction in wheat production as a result of drought.
Spirits manufacturers will bear less of an impact as a low percentage of their sales are in energy and agriculture-sensitive cost categories. They will need low sales price increases to compensate for higher costs, the analysts predict.
Brewers will have a higher sensitivity to price rises. Malt and hop prices have already risen strongly recently. "For 2008 this might be even worse than for 2007, but in 2007 most brewers have been able to pass on higher costs quite easily," the forecasters note.
The food companies have a more mixed outlook. The average food company is relatively energy-sensitive, related to their use of packaging and transport. Companies such as CSM and Nutreco are sensitive to such changes, or must have a flexible pricing policy in order to keep their margins intact, the analysts noted.
In the preceding years and quarters, food and beverage processors facing higher input prices tended to announce a rise in sales prices. For example early in 2007, Heineken said that input prices for beer would increase by 8 per cent. Later in the year it became clear that the company
had managed to compensate this impact through higher sales prices. CSM, another hard hit company, had to postpone its operating margin target for one year following the stronger than expected input price increase.
Meanwhile Danone said in November 2007 that it has had to raise its yogurt prices by an average 10 per cent in order to compensate for higher milk prices. Companies feeling the pain
Other company announcements related to input costs include:
- Numico had to raise prices earlier because of higher milk prices.
- Grolsch said in 2007 that the 2008 sales price could be raised by 5-6 per cent in order to compensate for the higher costs.
- S&N said in mid 2007 that the rising input costs were hurting its margin, with the combination of declining UK volumes, the structural shift to lower margin
- off-trade, heavy competition between the top four in the UK, and the rising costs worked out negatively for the company.
- Unilever forecast that the third quarter 2007 'gross' impact of increased input costs would be €800m, being offset by price increases.
- Henkel mentioned that the oil price had a negative impact in the 2006 financial year and have also issued a caution for the 2008 financial year at current levels.
- InBev said in its third quarter report that it expects that in 2008 its cost of sales per hectolitre will increase by 3 to 5 per cent.
Diageo, Pernod, Nestlé, SABMiller, Beiersdorf and Reckitt are among those companies that have not mentioned any real concern or have managed to continue with good profit growth and rising margins, the analysts noted.
In addition to increasing prices, many of the big companies in food and beverage production have worked hard to increase their market shares, create premium offerings and increase their emerging market positions, the analysts noted. Between 1980-2005 they tended to divest many weak product positions, low-margin businesses, strengthen market shares and expand in emerging markets.
The process has not yet come to an end and will continue for a long period, the analysts stated.
Future strategies Food companies in particular need to invest further in emerging market positions, while brewers are now investing more aggressively in premium positioning, they noted. "What we observe is that everyone in the chain is gradually becoming convinced that increasing demand from developing countries for food, and the growth of the biofuel industry, is leading to scarcity in wheat, maize, barley and milk, and that the consequence is that prices on the shelf will have to rise," the report concludes.
The premium and global brands will have better protection against margin pressure, because the gross margin is relatively high.
Other strategies What are some of the strategies companies can take to recover the rising costs in addition to increasing prices? ING's analysts counsel against investing down the value chain to secure supplies, as some companies have done.
For example early this decade, Heineken invested in a glass factory specialising in green bottle production. The company divested its stake when its joint venture partner had financial troubles and there was no viable alternative to replace the glass manufacturer.
Nestlé has also taken a step forward to secure sourcing. The company has established five-year contracts with Chinese farmers for the delivery of milk to Nestlé factories. We have seen this kind of activity occurring more often in industries that need large-scale supplies from the local market, because this is much cheaper in transport and labour costs.
Danone did the same in Brazil in the 1990s. "If we were asked to give advice, and if the question was asked whether to go back to raw material production and processing, our response to the manufacturers would be 'no'," ING said.
The analysts instead suggest that purchasers try to secure long term arrangements with suppliers. "They do not want to be told that suppliers are out of stock, and they do not want to be confronted by qualitative bad input material," ING stated. "Therefore, they are increasingly willing to look for longer term contracts with variable prices. Access, availability and traceability are items that are as important as pricing."
The big companies focus increasingly on the branding side and they want input materials that they can trust. Companies like Nutreco, which have full control of the chain, can boost their client base through such relationships. Rising raw material costs have also led to more intensive co-operation
within food and beverage companies. Rising costs were the trigger for best-practice purchasing programmes at Provimi and Nutreco, the analysts noted.
The bigger companies are also in the middle of intensifying their joint purchasing processes. Standardisation is another strategy. Instead of buying 20 different kinds of vanilla flavour, it could be much cheaper to buy only four varieties, the analysts say by way of example.
Companies could also choose to substitute expensive input materials for cheaper ones, the report suggests. "Substitution of raw materials is often a short-term solution," they noted. "A shift in demand from barley to sorghum, for instance, should lead to a rise in sorghum costs if all companies make the same move."
Ingredient substitution one strategy The ingredient substitution is a possibility in the brewing and beverage sector in developing markets, where tastes in beer are not as sophisticated as in developed markets, they stated.
Such substitution could be disastrous for a brand in markets with an ingrained beer culture. In the food sector, active substitution plays an important part in handling commodity developments. Unilever normally uses palm oil in its margarine, but recently has substituted sunflower oil for the ingredient.
Companies could also make targeted product substitutions to meet switches in consumer preferences due to price differences. For example, some brewers sell more soft drinks in certain markets, as beer becomes too expensive for consumers.
InBev is big in soft drinks in Brazil, and SABMiller is big in soft drinks in
South Africa, rest of Africa and Latin America, they point out.