Developed market consumers are increasingly trading down, delaying purchases, renting rather than owning and powerful intermediaries like Amazon are shifting loyalties away from producers.
Retailers have responded with a lower spend on marketing or a shift to private label goods (a term usually referring to a retailer’s own-branded goods) and discounting to protect the bottom line. These responses may prove effective in the short term but could prove to be dilutive to the pricing power of brands over time.
Giffen goods (goods which increase in demand as prices increase) with status appeal and where consumers perceive meaningful risk from opting for a cheaper brand may continue to be immune. Well-known deep discounters such as Ryanair should also continue to stand out but companies with goods in the middle ground with rising private label penetration are more likely to struggle with pricing power.
The current drive in private label household products is being led by the invasion of Lidl and Aldi. Lidl has only recently opened in the US to assault the historically loyal brand consumer there and it will be fascinating to observe. Private label represents nearly 50% of fast-moving consumer goods in the UK versus just 20% in the US. Walmart and Kroger have responded by investing in private label and price pressure on branded food and HPC (home and personal care) manufacturers, who happen to be operating at peak margins, is increasing.
Private label tends to generate up to 10% higher gross margin for retailers, providing an opportunity for an industry that normally operates on razor-thin profitability to extract an economic rent for their own brand. Private label is also clearly deflationary. Kroger noted recently that they expect the prices on a basket of goods to be lower in five years, excluding material increases in commodities.
Private label is not just limited to low-cost groceries. Boots’ No. 7 products and John Lewis’ household appliance range are both testament to how sizeable retailers have been able to extend their brand to their own products. The advent of dominant online platforms has only aggravated this shift. Consider ASOS’s own clothing range, Netflix’s own content and, of course, Amazon’s extensive private-label portfolio. Brands need to go where the traffic is going and, in key areas, the new retailer is outweighing the brand.
Against a backdrop of weakening volume growth, many consumer product groups have cut marketing to protect the bottom line. Henkel, Danone, Kellogg, Colgate and Unilever all beat on margins recently despite demand trends staying weak, but they are now questioning whether their brands are strong enough to withstand a sustained drop in advertising spend.
Producers who cut price to maintain share have experienced significant difficultly in reverting to full price, particularly in high end fashion, leaving the producer few options to capture the trend by consumers to 'trade down' their basket of goods. Cheaper derivative lines have been a common solution that is now at or near saturation point. Consumers are also choosing more often to break down a package and pay only for the service they consume, assisted by increasing regulatory transparency and sacrificing the ‘branded’ bundle of the past.
Brands can respond by controlling distribution, often going direct to consumers and Inditex and Adidas are good examples of this. They can also consolidate to retain pricing power and economies of scale, with Anheuser-Busch InBev being the classic operator in this regard.
I am a big fan of relatively simple economic theories. Hayek’s intertemporal equilibrium, Keynesian economics, Friedman’s monetarism and Schumpeter’s creative destruction to name a few are, as Geoff Boycott would say, ‘just common sense.’ For example, Schumpeter’s principle is that a metaphoric ‘gale’ of excess capital tends to destroy returns on capital employed, while areas of the economy left short of capital tend to see returns improve.
In the current environment, with interest rates so low, the capital excess or ‘gale’ is in the form of corporate leverage and the global brand captains are quite exposed. Companies such as Anheuser-Busch InBev and British American Tobacco are responding to the price pressures in the market with leveraged acquisitions to consolidate their respective industry and maintain pricing power. Investors have seen these free cashflow engines deleverage in the past and are complacently pricing the stock of Anheuser-Busch Inbev in the region of 27x 2017 earnings.
By sacrificing valuation protection, assuming a continuation of historic returns and a reduction of leverage to normalised levels, despite the growth in private label and shifts evolving in retailing, investors are unquestionably taking a higher risk trade than in the past. British American Tobacco has similarly raised leverage to record levels in the acquisition of Reynolds Tobacco, leaving a slim margin for error in a structurally challenged industry. In his recent letter, the famed high-yield investor Howard Marks of Oaktree Capital noted that investors can either take higher risk for a higher return or accept a lower return for the same level of risk and in the current market, he prefers the latter. Investors in leveraged brands however, may have chosen the former.
By contrast, the traditionally cyclical areas of mining and banking have had capital discipline thrust upon them in spades through regulation and recession. In mining in particular, the severe cyclical downturn resulted in marginal production being shut down and peripheral assets being sold by the likes of Glencore, BHP and Rio Tinto to repair dangerously overstretched balance sheets. Capital destruction is complete and is now driving higher returns as supply and demand balances have improved. Product prices are rising and so is the cashflow. There is not a brand in sight.
The charts below show that the forecast free cashflow yield of Glencore is approximately 2.6x that of Anheuser-Busch Inbev with a leverage ratio that has fallen by about 75% from the peak. Rio Tinto’s leverage has dropped by 50% relative to EBITDA and the free cashflow is 2.2x that of British American Tobacco, leading one to question where the risks in this market are. Developed economies remain over-burdened with debt and excess capital creates excess supply, low interest rates and deflation. Deflation remains the ultimate risk to leverage.
While the staple stalwarts are core holdings in many highly respected funds, the capital short sectors are under-owned. Our exposure to staples is not inconsiderable. We have become used to their steady outperformance and the opportunities for growth in emerging markets may well be enough to offset the price in the developed world. However, they are still just an equity, a financial instrument that more often than not is often highly leveraged, expensive and over-owned.
Paying some attention to the Schumpeter model suggests that we should focus on balancing portfolios in a way that reflects the structural shifts in sectors effectively. It is not a call on the economic cycle and blindly buying ‘value’ but constantly recognising the change in relative risk and returns that present themselves. It may mean buying managers who may have been out of favour for a while and being a little patient. Old habits die hard and people love brands, don’t they?
*Goldman Sachs - Fortnightly Thoughts; Sumana Moanohar, Hugo Scott-Gall and Navreen Sandhu