The worst of times? Profitability has recovered to close to 1980s’ levels, say OC&C Strategy Consultants in their analysis of the 1999 Corporate Index compiled exclusively for The Grocer. So why is the sector so out of fashion with investors? Twas the best of times and the worst of times” said no less a figure than Sir Dominic Cadbury at the presentation of his company’s annual results this February. Cadbury was quoting Dickens’ Tale of Two Cities’ in order to express his frustration with what he perceived to be the continued under-valuation of his company relative to the rampant hi-tech sector. Such frustration is understandable when one looks at the track record of a company like Cadbury. Once again confirmed as one of the top performers in the OC&C/Grocer Corporate Index, the company has increased its margin by a percentage point and return on capital by a whopping 50%. This represents the apogee of 14 years of unbroken profit growth. Management has embarked on an ambitious programme of “managing for shareholder value” ­ but were rewarded for their efforts by a 30%+ fall in the share price over the year leading up to the results announcement. A further chastening fact is that the entire quoted UK food industry is now worth less than two thirds of the recently merged Vodafone/Mannesmann group, a reality which speaks volumes for investors’ future expectations. It is sales growth that lies at the root of the dilemma facing Cadbury and their industry peers. Cadbury’s sales fell by 3% last year and those of the industry by 4%, reflecting tight demand conditions and ongoing divestment of non-core businesses. This is in sharp contrast to the dotcoms and other hi-tech companies, where stock market valuations are implying double-digit revenue growth in perpetuity. The result has been a wholesale change in investor preference away from value investing to growth investing, predicated on tolerance of low/negative profitability now but the promise of big pay-offs in the future. We are now living in the world of the revenue multiple rather than the profit multiple as the critical valuation yardstick. Investment styles change of course, and many forecasters are anticipating a flight to value as and when the vogue for racy hi-tech valuations runs it course. However OC&C think that the food industry needs to do more than sit in its bunker waiting for fashions to change. There are real and enduring lessons to be learnt from the new economy. And perhaps it is possible for food companies to appropriate a little dotcom magic. But firstly, what has been happening to the industry’s finances in the past year? Winners and losers Headline trends show a remarkably similar pattern to last year’s Index. Return on Capital Employed is remaining stable at 20% ­ a high figure. Margins are also increasing ­ up from 6.6% to 6.8% for the industry as a whole. However the overall return is being held back by falling sales and hence a lower turnover:asset ratio. Falling sales are being driven by a number of factors: - Market volume growth is effectively capped. Food expenditure now accounts for a steadily declining share of the consumer’s purse. - Prices are being held down by the bargaining power of the multiple grocers and the price war precipitated by Wal-Mart’s entry into the UK. Food prices fell in real terms in 1999. The margin structure of UK food retailing is changing again and manufacturers will yet again have to share this pain. - Divestment of non-core/non-food businesses is artificially depressing the aggregate sales picture. Major players such as Albert Fisher have made significant disposals to overseas buyers, taking these sales out of the scope of the Index. At the same time, other firms such as Dalgety have disposed of non-processed food businesses that were previously counted in to the Index as a result of consolidated reporting. Performance differences between large and small firms are once again reinforcing the message that scale economics in the food industry mean that big is beautiful. The group of firms with annual sales of more than £100m posted increased margins and a high and stable return on capital. By contrast the sixty or so companies in the Index with sales of under £100m posted falling margins and returns on capital. Total return on capital of just over 13% in this group is only two thirds that of the major players. Looking at the performance of individual firms, four recurrent trends are striking: High profitability tends to accrue from: - Either strong leadership positions in specific categories e.g. Van den Berghs (yellow fats, tea and stock cubes); Mars (confectionery); Walkers (savoury snacks); CCSB (soft drinks) and Birds Eye Wall’s (frozen foods)… - …or the occupancy of valuable and defensible niches e.g. Müller (dairy desserts); Wrigley (chewing gum); HP and Colmans of Norwich (condiments). Low profitability tends to arise from: - Presence in low value-added categories heavily exposed to commodity price fluctuations e.g. Acatos & Hutcheson (oils); Del Monte Foods (processed fruit and vegetables); numerous small meat and fish processors. - Heavy exposure to own label supply and hence the bargaining power of the multiples. Major players such as Cott (soft drinks) and Marshalls, Moy Park and Sun Valley (poultry) all delivered low, and in most cases declining, returns this year. ..and the best of times? So what can the beleaguered food industry do and say to an investment community seemingly inured to the real and enduring value that it is creating? While Cadbury CEO John Sunderland may be right in saying that one “cannot eat a portal”, some of the strategies and tactics employed by the dotcoms could benefit the food sector. We counsel the industry to think about the following: - Tell (and sell) the growth story. The technology wave is re-educating the City to value companies more on the present value of their future growth opportunities rather than on multiples of today’s profits. Double digit sales growth opportunities can and do exist within the allegedly mature’ food sector. Nearly 20 firms in this year’s Index were able to demonstrate top line growth of 20% or more (albeit often with reducing short-term profitability, but perhaps for sound investment reasons: after all did that ever worry a dot com?). - Pursue innovative financing strategies. A major attraction of a mature, cash-generative industry is the potential to unlock value from financing. A major trend this year has been for private equity houses such as Hicks, Muse, Tate & Furst to purchase UK food businesses in leveraged buy-outs. This has the twin benefit of releasing cash to shareholders and reducing the cost of capital. - Manage with passion. An unfortunate side effect of the last 20 or so years of retrenchment in the food industry has been to instil a highly conservative mindset, making managers relatively unwilling to talk up the possibilities afforded by the sector. While transient dotcom fizz is probably not appropriate, the impact on investors of visionary food industry statesmen’ like the late Roberto Goizueta at Coke and Antoine Riboud at Danone is not to be under-estimated. - Back to branding. Much of the capital flows from dotcom flotations have been directed towards brand-building expenditures. By contrast the food sector has been chary of selling the brand story and has preferred to dwell on cost reduction and shareholder value management. Twelve years’ data from the Grocer Index and other authoritative sources has demonstrated again and again the value inherent in strong branded positions, usually ones with more defensibility than the latest dotcom franchise. Again a programme of enthusing and educating investors needs to be pursued. - Harness the possibilities of the internet. Food manufacturers can directly harness the value-creating possibilities of the internet in a number of ways, for example: * B2B’ supplier exchanges on the model currently being implemented by Ford and GM in the car industry have the potential to radically reduce costs. This will be particularly attractive to players with a high proportion of raw material costs and the need to deal with a fragmented, commodity supply base. * B2C’ transaction-based websites for high priced/high value density items. Distribution economics will mean that, from the manufacturers’ perspective, the opportunity to sell low-ticket food items direct over the web will be limited. However, high ticket items such as alcoholic drink and premium foods (e.g. French cheese, caviar, smoked salmon) are being successfully retailed on-line. There is enormous potential to expand this in areas such as the gift market, where players such as the confectionery manufacturers are particularly well-placed to compete. How the Index is Compiled Compiling and interpreting a financial index is a difficult and complex task, especially when the aim is to represent the whole industry. Setting aside the problems of having to depend on the published accounts at Companies House, there are difficulties in deciding which companies to include and which financial measures to use. The objective of The OC&C Corporate Index is to provide a fair representation of the overall financial trends within the industry. While the performance of individual companies is undoubtedly interesting, OC&C urges those analysing individual companies to refer to the set of individual accounts in order to understand the accounting policies being used and the underlying reason for any performance trends. The following definitions and criteria have been used in compiling this index. OC&C has attempted to include those major food manufacturers and processors who filed accounts and a representative sample of smaller companies. The resulting group encompasses a wide variety of food industry sectors from, for example, chicken processing to breakfast cereals. For large diversified food companies comprising a few major subsidiaries, such as Unilever, OC&C has listed where possible their major operating companies, such as Birds Eye Wall’s. A number of companies listed in the index have activities outside mainstream food manufacturing and processing. Major firms which have recently been acquired have been retained as a separate listing when separate accounts are filed. Owing to acquisitions, there is the possibility of double-counting when preparing the overall industry composite. Depending on the date of the acquisition and year-end of the acquirer, the latest set of financial accounts may include some of the acquired company’s results. Financial year-ends and speed of filing differ between companies. Rather than attempting to match up accounting periods, the two most recent years have been selected. Caution therefore needs to be exercised in comparing companies whose returns and trends span different time periods. In the few cases where companies have changed their year ends, lengthening or shortening their financial year, the sales and profit values have been annualised. This is shown by an asterisk. Definitions Operating profit equals profit before interest and tax, including income from associated companies where relevant. It excludes amortisation of goodwill and exceptional items relating to profit/loss on sale of fixed and intangible assets, reorganisation costs, losses on disposal of operations, cash received and release of provisions from discontinued operations. Operating profit margin (%) equals operating profit divided by sales. Capital employed equals total assets (excluding intangibles) less current liabilities (excluding borrowings). Inter-company balances described as “loans” are classified as borrowings. Return on capital (%) equals operating profit divided by the average of the year-end and previous year-end capital employed. In the few cases where a previous year end capital employed figure is not available, or is not comparable, the year-end capital employed is used.In the few cases where meaningful capital employed numbers are not available for subsidiaries, the return on capital is indicated as “not applicable”. The totals exclude data for such companies. Historical cost accounting conventions have been used, unless only current cost accounts have been filed. While reasonable care has been taken to ensure that stated facts are accurate and opinions fair, OC&C shall not be responsible for any errors or omissions. n © OC&C Strategy Consultants 2000 {{COVER FEATURE }}