I wrote on the subject of profit margins last year in Margin Call and how we try to normalise them as part of our company evaluation. I referred to The Heinz-Kraft Company (KHC) and how under 3G Capital, a private equity firm, margins were significantly raised at KHC. A consequence of those expanding margins was underinvestment, which subsequently caused earnings to drop. With the toxic mix of falling earnings and massively increased financial leverage the stock price tanked. That stock price remains 60% below its 2017 high. The topic is a bit of an obsession of mine, because it forced many other companies in the fast-moving consumer goods sector (FMCG) to follow the same path, often under enormous pressure from shareholders. It is also one that takes years to play out.
2015 investor letter
Bernstein shows that operating margins for this sector are inversely correlated with organic growth and ultimately returns on invested capital; the higher a company pushes its operating margins, the lower organic growth and lower ROIC (see figures 1 and 2). It sounds somewhat counterintuitive; usually operating leverage results in higher margins accompanying higher sales. In this situation, however, the more that costs are taken out, be that from marketing or innovation, the lower the sales growth rate. How do you offset this top line pressure? If volume growth is under pressure, you can offset it with price increases. This is deeply unhealthy and unsustainable, the further you move from your competitor pricing the more susceptible you are to product switching.
If you cannot get the top line moving organically, an alternative route is to acquire growth through acquisition. Many of the above challenger brands have been acquired, while there have also been the big deals, for example Danone’s purchase of WhiteWave for $12.5bn and Reckitt Benckiser’s purchase of Mead Johnson for $17.8bn, both at premium valuations. This inorganic route, often accompanied by share buy backs, funded by leveraging the balance sheet, can keep the music going for a while. Since 2013 Danone and Reckitt Benckiser have doubled and tripled their respective leverage levels. Both companies are now in significant trouble, have suffered significant share price declines and face margin resets. And it doesn’t end there for the FMCG companies, Bernstein flags another challenge currently accelerating; the growth of e-commerce and the power it gives to the gatekeepers such as Ocado or the likes of Wal-Mart and Tesco with their online platforms. This puts additional pressure on sector margins and sales growth. Covid-19 has given such e-commerce a big boost. All this comes at a point when valuations for the sector have been driven higher by low interest rates and in the form of the bond proxy trade, adding valuation risk to the earnings and financial risks described above. While it is difficult to precisely attribute causation for the rise of the challenger and local brands, Bruno Monteyne at Bernstein says, “Margin targets provided oxygen for fragmentation”. You could also argue strongly that 3G, and their cheerleader Warren Buffett, bear much responsibility for what has happened. It was the example they set on “eliminating many unnecessary costs” and their very public touting of this business model, which has led the sector and underlying shareholders on this very merry dance…
Figure 1 European Food & HPC - EBIT Margin V Organic Growth
Figure 2 European Food & HPC Sector – ROIC v EBIT Margin
Source: Company reports, Euromonitor, Bernstein analysis.
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