Food & Drink Round-up Q313: Core Views

The third quarter of 2013 did not have a marquee event of the same magnitude as the first-quarter purchase of Heinz by Warren Buffett's Berkshire Hathaway fund and Brazil's 3G Capital for US$28bn. From a core views perspective, it has very much been business as usual , with notable developments including the ongoing improvement in consumer sentiment in the United States ( notwithstanding the fiscal impasse ) and parts of Western Europe such as the UK. Emerging markets have largely been a mixed bag : W eakened confidence in India, China and Brazil has affected different elements of the food and drink industry , and the threat of the US tapering its quantitative easing programme has led to downward pressure on many emerging market currencies, which has made sales in these markets less valuable to major multinationals.

The run-up in commodity prices on the back of the US's worst drought in about 50 years was among the most important themes seen in 2012. However, the prices of key grains have since fallen sharply, and based on the S&P GSCI Grains index are back to where they were in mid-to-late 2010. This, of course, has been very good for the global food processing industry. Ultimately, what food companies really want is stability, which makes it easier to pursue effective hedging where necessary.

Food Safety Concerns Will Increasingly Affect Consumption

Prices Now Expected To Find A Base
S&P GSCI Grains Index Spot

The third quarter of 2013 did not have a marquee event of the same magnitude as the first-quarter purchase of Heinz by Warren Buffett's Berkshire Hathaway fund and Brazil's 3G Capital for US$28bn. From a core views perspective, it has very much been business as usual , with notable developments including the ongoing improvement in consumer sentiment in the United States ( notwithstanding the fiscal impasse ) and parts of Western Europe such as the UK. Emerging markets have largely been a mixed bag : W eakened confidence in India, China and Brazil has affected different elements of the food and drink industry , and the threat of the US tapering its quantitative easing programme has led to downward pressure on many emerging market currencies, which has made sales in these markets less valuable to major multinationals.

Prices Now Expected To Find A Base
S&P GSCI Grains Index Spot

The run-up in commodity prices on the back of the US's worst drought in about 50 years was among the most important themes seen in 2012. However, the prices of key grains have since fallen sharply, and based on the S&P GSCI Grains index are back to where they were in mid-to-late 2010. This, of course, has been very good for the global food processing industry. Ultimately, what food companies really want is stability, which makes it easier to pursue effective hedging where necessary.

Food Safety Concerns Will Increasingly Affect Consumption

Food safety is a particularly sensitive issue in China , where the 2008 melamine dairy scandal in particular deeply affected the dairy industry and will arguably leave lasting impressions on Chinese consumers for years to come. Yum! Brands , which owns a KFC brand that has been an incredible success story in China over the past 10 years , has been on the receiving end of increased consumer caution and will have a lot of work to do to repair the damage inflicted on its brand following the report in December 2012 that chicken used by KFC was injected with unapproved antibiotics and hormones . This was followed by an outbreak of bird flu in March 2013 . Although KFC has removed offenders from its supply chain , it appears that it will take longer than it might have expected to repair the damage .

Indeed, Yum! Brands reported a 68% year-on-year (y-o-y) decline in global profit for Q313 (to September 2013) to US$152mn , with China , which accounts for about half of the company's sales, a major factor. Chin ese same-store sales declined by 20% y-o-y in Q213 (to July 2013) and had another poor quarter in Q313 . KFC's management ha d been optimistic following the release of Q2 results, publicly stating that the brand was expected to return to growth in Q313. Following the release of these results, however, the company has admitted that growth ma y take somewhat longer to return than originally believed.

A Year To Forget For Yum! Brands
Rebased Share Price With Selected Competitors (10/10/2012 = 100)

Major Category Leaders Pursuing New Business Opportunities

A number of companies are leveraging off powerful positions in their core business areas, such as soft drinks, and using their scale to pursue new avenues of growth . While major soft drinks companies present in emerging markets will very likely see opportunities to grow further regionally, we still believe there will be a time when companies will need to investigate diversification outside their core categories.

A good example is Mexico's FEMSA , which is the largest beer company in Latin America . I ts Coca-Cola FEMSA unit is the largest Coca-Cola bottler in the world by volume. Given its size and annual sales of about US$18bn, it is not surprising that FEMSA has built up a portfolio of non-core businesses. In addition to operating pharmacies, it was announced in September 2013 that FEMSA was entering the fast - food segment , announcing plans to acquire Gorditas Dona Tota - a Mexican chain that is believed to be particularly strong in Mexico's northern region, according to the Financial Times.

In our view, FEMSA very likely realised that it will need to expand into new segments if it is to continue its strong performance. While rising consumer incomes have in recent years allowed big beer companies to significantly grow their volume and value sales, the highest rates of growth are very likely behind us , and a slowdown in core soft drinks and beer is inevitable. Gorditas is thought to have more than 200 restaurants, including around 10 in the US. The chain's menu is built around convenient Mexican fast food.

Craft Beer To Outperform

After a buoyant first half of 2013 , in which sales rose 13% in volume terms and 15% in value terms, according to the Brewers Association, the US craft beer industry looks set to keep performing strongly over the next few years. While Americans are drinking less mainstream beer on average, the wider beer industry seems to have been re-invigorated by the success of craft beer, which as an industry has arguably done a much better job in capturing the evolution of con sumers' tastes and preferences.

The popularity of craft beer, which first came to prominence in the late 1980s, can to some extent be attributed to brewers' success in finding a receptive audience among US beer drinkers. These consumers had previously been offered a fairly limited choice of mild-tasting lager by many of the mainstream brewers, and beer-drinkers seem to have welcomed the variety offered by craft brewers. We also note that the declining appeal of mainstream beer has benefited the wider spirits and wine industries.

Where The Action Is
Mid-Year Craft Production Volumes (mn barrels), 2009-2013

On a per capita basis, beer consumption in the US has been declining for a number of years. The ability of craft beer to register sales growth despite this trend further reflects its favourable performance. Declines in per capita consumption is also a dynamic in a number of countries in Western Europe, and the trend in the US is even more pronounced given that the population continues to grow at quite a healthy rate (which is unusual for much of the developed Western world).

Fundamental Decline In Mainstream Beer
United States Beer Consumption - Litres Per Capita

Frontier Markets

A number of frontier markets are attracting interest from food and drink companies , particularly as growth in the BRIC countries of Brazil, Russia, India and China slows. Some of the markets drawing investment include Myanmar, Sri Lanka, Indonesia and Colombia.

We highlight in particular Colombia in this round-up . As its political risk profile continues to improve, Colombia is rapidly evolving into one of Latin America's highest-potential consumer markets. From retail to soft drinks, foreign companies are paying more attention to opportunities in Colombia. The latest major food and drink company to take on this opportunity is Krispy Kreme , which signed a franchise agreement with the Colombian company IRCC with the aim of launching 25 stores over the next five years, according to the Financial Times. With a lot of room for Colombian incomes to grow, this could be a good time for Krispy Kreme to get its foot in the door, particularly with its larger rival in the US, Dunkin' Donuts , having led the way in Colombia.

Considering Columbia's population (about 46mn), it is not surprising that an improved economy presents excellent opportunities for companies such as Krispy Kreme. In GDP terms, our Latin America team sees income per capita growing from about US$7,100 in 2007 to about US$10,500 by 2017, which is strong growth when you factor in anticipated population increases.

Colombia Attracting More Interest
Brazil, Chile & Colombia Per Capita GDP (US$)

Consolidation In The Global Alcohol Industry

The new chief executive of drinks firm SABMiller , Alan Clark, said in September 2013 that the consolidation wave that has been a key feature in the global beer market over the past 15 or so years has some legs left in it yet. In our view, there are still opportunities for bolt-on acquisitions in both spirits and alcohol, particularly in China , where there is room for consolidation in both the beer and spirits sectors ( though spirits might be more difficult ) . Companies such as Beijing Yanjing B rewery could be targeted , in our view.

Most of the major alcohol companies have brought down their debt over the past few years , and with relatively cheap financing still available, there is the prospect of more deals in Q413, although major activity is unlikely. We believe there are fewer opportunities for consolidation in Latin America and Africa given that most of this has already taken place. Another avenue for non-organic growth could include companies taking full control of their partnerships, which might involve deals between SABMiller and its privately owned West Africa n affiliate Castel Group , for instance. The real elephant in the room is the potential acquisition of SABMiller by AB InBev - the world's biggest beer company. Any deal would likely cost more than US$100bn ; as things stand , our view is that this is unlikely to occur over the next two- to- three years.

Although SABMilller's CEO did allude to the potential for increased mergers and acquisition activity in beer, he also stated that the main focus for his company would be growing sales and earnings organically. We expect that for the big four brewers at least, this will be the focus for the next few years. While Carlsberg could arguably benefit from more non-Europe exposure, its three larger rivals have extensive exposure to nearly all of the emerging regions. There is a huge opportunity given the relatively low consumption of beer per capita in the emerging world, and this is where the real opportunity lies, in our view. Making beer more affordable and accessible will be key in these emerging markets .

Major Western European Food Retailers Trying To Fix Business At Home

If the era leading up to the global financial crisis in 2008 was characterised by international expansion - with Tesco playing a particularly prominent role under former CEO Sir Terry Leahy - the past two or three years in particular have necessitated a major shift in strategy for both Tesco and France's Carrefour , the second and third biggest food retailers globally.

Tesco has been under pressure from shareholders to address structural shortcomings that were exposed by the landmark profit warning it announced in January 2012. This was the moment it became clear that the retailer had to focus a lot more attention on its domestic operations. T he inevitable fall guy would be parts of the international business, with the failed US Fresh & Easy business the obvious target.

Resurrecting its UK business and ultimately clawing back some of the market share that it has ceded to rivals in the ultra-competitive UK retailing landscape is going to take longer for Tesco than some observers might have hoped. According to Kantar Wo r ldpanel, Tesco was the slowest growing major UK food retailer over the four - week period to September 16 2013 . A ccording to Barclays, Tesco has lost market share for five consecutive periods.

Carrefour has been faring better with its turnaround strategy in France . Its first - half results reported in August 2013 point to further gains made by the firm in its bid to reverse the losses that saw its share price plummet in 2011. With CEO Georges Plassat's leadership continuing to effect meaningful progress, significant improvements across the retailer's domestic operations reflect our long-term view that France must remain at the core of the retailer's strategy in the pursuit of long-term, stable growth.

Despite French net sales slipping by 0.3% y-o-y , a key takeaway from the H1 13 results is a 75.4% jump in operating profit in France, to EUR482mn. Net income also rose to EUR902mn (compared with the EUR3mn recorded in H112) , with the company's bottom line boosted by fewer losses from disposed assets abroad . These impressive indicators point to the retailer's continued recovery.

Food & Drink Core Views
Short-term Outlook
Source: Bloomberg, BMI
Having declined considerably since mid-to-late 2012 following the US drought, grain prices are expected to find a base over Q413, with moderate increases anticipated.
Consumer sentiment in Western Europe is improving, and the US continues to look resilient despite the ongoing fiscal impasse.
Provenance is increasingly important, particularly in Western Europe following the horsemeat scandal.
Major Western European food retailers will focus on revitalising domestic businesses at the expense of international expansion.
Long-term Outlook
Companies with strong emerging market exposure will continue to outperform in terms of sales growth, although the best opportunities may now be beyond the BRIC countries.
Multinationals will increasingly seek opportunities in frontier markets.
Emerging market-based firms will increasingly pursue developed market investments for the purposes of diversification and access to stellar brands.
Food safety concerns will increasingly affect food and drink spending.
Hypermarkets will underperform in developed markets, where convenience and discount retailing are the strongest opportunities.
Conversely, hypermarkets remain a great opportunity in less developed retail markets, particularly adjacent to shopping centres/malls.
Investment in innovation will increase as producers seek differentiation; emphasis will be placed on protecting innovations.
Government legislation will play an increasing role in marginalising unhealthy food and beverage products.
Governments will increasingly pursue alcohol as an effective means of raising revenue through higher taxes.
Functional foods and energy drinks will provide considerable opportunities globally.
Major category leaders will pursue new business opportunities as they diversify in search of long-term growth.
Craft beer will outperform mainstream beer in many mature beer markets.
Consolidation will continue to take place in the global alcohol industry, particularly in Asia.

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