Sales are soaring. Up 8.7% on average. But in the boardrooms of the UK's food and drink manufacturers, a case of the jitters has set in.

After a 10-year growth in profit margins, last year they declined from 8.6% to 8.4%. This may sound like a small figure, but with less than half the 150 companies in the OC&C/Grocer 150 index improving margins, and the number of loss makers growing from seven to 12, "these are signs that a broader squeeze is on" says Luke Jensen, head of consumer and retail at OC&C Strategy Consultants.

A number of worrying factors are now at play. The first is interest rates. After a long period of low inflation and low interest rates, the recent hikes have started to hit home. And though food retail has been more resilient than most, supermarkets, led by Asda, and quickly followed by Tesco, Sainsbury's and Morrisons, have promised to do their bit to help. While promising that the cuts will be self-funded, supermarkets are sure to look to food and drink manufacturers for support.

At the same time, after a 10-year decline in the multiples' profit margins, they are starting to close the gap that had opened up (see table far right). With Morrisons and Sainsbury's both promising to return margins to a respectable level, further tough negotiations can be expected.

But the biggest factor in the current squeeze is commodity prices. Prices for grain, wheat, dairy, edible oils and tea have all risen substantially. Bread wheat delivered to the north west this month is trading at £150 per tonne, a 50% increase since last August; while one coffee buyer said the price of coffee had risen 50% in the past four months alone.

This has not prevented sales increasing. Turnover growth was up 11.3% on average. But margins are plummeting. The biggest commodity-based manufacturers - those with turnover greater than £500m - saw operating margins fall from 8.1% to 5% (see p33). And the rising price of raw materials has already hit two of the biggest commodity players, ABF (no2 in the table; p32) and Tate & Lyle (no3). Their profits dropped 22.4% and 61% respectively.

"Both ABF and Tate & Lyle's performances in the past year highlight the risks that commodity companies face," says Jensen. "They were both hit hard by the change in the EU sugar regime, which forced them both to take heavy exceptional charges. This blow more than offset the growth of Splenda for Tate & Lyle. As for ABF, its growth was mainly driven by Primark, its one business outside the food sector."

Smaller commodity-based manufacturers have been even harder hit, with margins falling from 2.8% to 2.4%.

There are many reasons why raw material prices are going up, but essentially they boil down to one of soaring demand coupled with shrinking supply. "Demand has increased because world markets are being stimulated by economic and population growth in India and China," says retail analyst Clive Black at Shore Capital. "That, combined with an Australian drought, poor 2006 harvests in the northern hemisphere and a drive for biofuels in the US has created shorter supply, which means prices have gone up."

The cost of raw material prices is hitting branded and own-label manufacturers too. Nestlé, Northern Foods and Unilever have all spoken publicly about the difficulties higher costs are causing. Coupled with soaring energy costs, input costs have increased by 9.5%, more than twice the 4.2% rate of food prices in the past year (see table, bottom right). The strength of the pound may have softened the blow until now, but the need to shift costs on to consumers is growing. "We expect continued cost pressures," says a Unilever spokesman. "This may result in manufacturers needing to be more aggressive, price-wise, in order to recover these costs in the future."

Of course, whether retailers accept higher prices is another matter. "Multiple retailers are pretty tough on us," says Jonathan Grant-Nicholas, group communications director at own-label specialist Greencore. "It's up to us to be just as decisive and professional with retailers and with our suppliers." Manufacturers have to learn to say no if retailers get too pushy, he says. "We are not prepared to make a product at a loss out of sentiment. If someone else wants to, then fine."

But Jensen believes supermarkets will be reluctant to accept higher prices: "While some costs have been passed on to the consumer via growing retail prices, recent price cuts announced by the supermarkets will result in a further squeeze on manufacturers."

And, if the Competition Commission inquiry into the groceries market results in a slowdown in the store expansion plans of the major chains, that will "inevitably mean increasing pressure to drive profit from suppliers and negotiate even harder with them," Jensen adds.

So who is best placed to survive in the new environment? As our analysis shows, big is definitely better. Sales growth for sub-£500m companies was lower across the board (see table opposite); and while big branded and big own-label manufacturers grew both their operating profit margins (see p33) and their return on capital employed (see p34), smaller branded and smaller own-label companies saw a decline. Significantly, only one company - confectionery manufacturer Dunhills - makes it into our list of the top 10 best operating profit margins (see p37).

Having strong brands is also key. The UK market may have one of the highest levels of own-label penetration and quality in the world, but the best margins are consistently achieved by iconic, quality brands such as Wrigley, Tropicana, HP Foods, Weetabix and Cadbury Schweppes.

The key is to play to your strengths, says Alexandra MacHutchon, UK communications manager at Wrigley, which achieved an operating margin of 29.2% on profits of £62.6m and with a ROCE of 76.3%. She lists those strengths as "historical know-how, understanding of the market, quality of products and trusted brands".

The benefit of being a branded player is bargaining power - the ability to cash in on a particular product's 'must-stock' status. But even Wrigley is being challenged. Cadbury Schweppes has this year launched Trident and has already gained a significant market share.

The own-label sector has less bargaining power, but has nevertheless seen a slight increase in margins, from 4.3% to 4.9%. Best placed, once again, are the bigger own-label companies.

"Big own-label companies seem to be finally getting their house in order," says Jensen, "with significant jumps in profit at Bakkavör and Northern Foods, although Uniq is still in the doldrums."

Bakkavör, whose profit grew 67.4% to £116.3m on turnover up 68.8% to £1.22bn, has set a gold standard for performance in own-label, achieving nearly double the operating margin of the sector (9.5% vs 4.9% as a sector average), with ROCE reaching nearly 40%. It has achieved this through a combination of scale - with the 2005 acquisition of Geest, and the purchase of Hitchen Foods - successful integration, and focus on growth markets. "We will continue to identify and act on opportunities that will help us grow and add to our portfolio," says Bakkavör CEO Ágúst Gudmundsson. "The fresh prepared foods market in western Europe is expected to grow by 20% in the next four years and by 30% in China and we are well positioned to benefit."

For the first time, acquisitions and restructuring are being led by private equity players, and they are having a significant impact on the market. There were 21 deals worth more than £20m last year - only three more than the previous year - but the value of those deals was up an incredible 277% from £1.8bn to £6.8bn.

As well as bringing cash to the table, private equity companies have renewed focus on efficiency (see p33). And their ruthless approach has coincided with many trade buyers reviewing their portfolios and selling off peripheral assets. There has been plenty of restructuring at large companies such as Unilever and Northern Foods, and more changes are expected across the rest of the sector.

One company well down that track is Premier Foods, which pulled off the biggest deal of the year with the £1.92bn acquisition of RHM. While the two companies still appear separately in the index as the deal was consummated after the year-end, the acquisition will catapult Premier Foods to fourth place in OC&C/Grocer 150 Index. It is effectively the number one food manufacturer in the UK as the top three all include significant sales from international operations.

Scale is only part of the formula that CEO Robert Schofield has employed. As this week's 650 job cuts at RHM proved, restructuring is essential in order to improve ROCE. Against an industry average up from 19.6% to 20.4%, Premier's ROCE increased from 9.5% to 32.3%, which enabled Schofield to achieve his reverse takeover.

But the key is NPD. Schofield knows that in order to make RHM's assets work harder he will need to demonstrate the same levels of innovation that he has achieved in recent years at Premier. The best-known example of this brand extension is Branston, whose sales have increased from £22m in 2002 to £52m in 2006 (see p37). But this innovation has been across a number of brands. Quorn (up 13% year-on-year), Loyd Grosman (up 25%), Hartleys (up 7%) and Ambrosia (up 6%) have all been reinvigorated. "I don't wait for market research," says Schofield. "If the food technicians create a recipe that we all believe in, I support that." He has promised a raft of NPD from Campbell's soups later this summer.

Another company that has modernised an 'old-fashioned' brand is Whitworths. Constrained by £35m of debt, Whitworths was losing over £1m per annum on turnover of £175m. But private equity firm Gresham Trust backed an MBO in 2001 and the team have turned the company through a skilful repositioning of the company: the market for the company's traditional dried fruits and other cooking ingredients had shrivelled up by the late 1990s as customers headed for shop-made products instead. So it switched to marketing its products as healthy snacks and targeted health-conscious consumers with dried fruit and nut, and the children's market in particular. After an initial drop in turnover, sales are now recovering and were up 36.7% to £98.9m last year, although profit margins remain tight. It has since been sold to private equity company European Capital after an £86m deal last October.

Repositioning has worked for many other players, too. "You can't have all your eggs in one basket," says Grant-Nicholas at Greencore, which has bought three Hazlewood businesses in the past year. "You have to move in a different direction to be in the right area. We have moved into chilled, sauces and WeightWatchers, which is paying off, and we ensure not all our products are in areas that are price-sensitive."

Developing a more premium offer has also helped many companies, offsetting the deflationary pricing that has hit categories such as biscuits and bread. OC&C analysis shows that in the biscuit market, for example, price deflation of 2% was offset by a 3% increase thanks to new product development, enabling category average unit pricing to increase by 1% overall. But the most startling transformation has come in the bread category. In 1999, Hovis, Warburton and Kingsmill accounted for 34% of the UK bread market. In 2006, thanks to innovations such as 'Crusty White' and 'White Wholemeal', as well as revitalised packaging (Hovis baked bean wrapper), new bread sizes, and increased ad spend, the three leading brands accounted for 56% of the market.

The biggest trend NPD-wise, however, has been the move towards healthier products. It has led to phenomenal growth for companies with a health ethos, such as Innocent and Yeo Valley.

Innocent makes it into the index for the first time after doubling sales to £75.5m with an operating profit of £9.1m and an impressive ROCE of 115.6%, achieved thanks partly to its outsourcing of manufacturing to third parties (though it retains ownership of the juicing machines), and partly to its continuing innovation. The latest has seen the launch of its range of kids' smoothies, which has widened its demographic appeal. "Previously children's drinks were full of E-numbers and people thought they had to be cheap. They don't," says Jamie Mitchell, MD at Innocent UK. Innocent enjoys a 62% share of the smoothie market.

Organic, too, has proved an important trend for this year's most successful companies. The market, which was last year valued at £1.3bn, is predicted to grow to £2bn by 2010, but as Yeo Valley (see p34), Rachel's Organic, Plum, Alpro and other small manufacturers have profited from the trend, the largest companies are still missing out, says Jensen: "Bigger manufacturers have relied too heavily on purchasing smaller companies where it is difficult to maintain ethical standards. They need to look at increasing their organic ranges if they want to avoid the squeeze over the next 12 months." The only blot on the landscape are supply constraints. With demand in the organic market once again exceeding supply, the commodity squeeze is even being felt here. n