The current debate of whether inflation is transitionary or structural has a sub-argument that references rising soft commodity prices, food inflation, and struggling consumers – and argues that food producers will be caught in the middle.
This narrative makes some sense: rising input costs cannot be fully passed onto struggling end-consumers and someone is going to have to absorb this.
But is this view correct and what does it mean for our JSE-listed food processors?
The ability for a business to sell a product (or service) for more than it cost to produce is fundamental in business. The better this ability, the higher the margin and, arguably, the safer the business as the stronger its pricing power is. We tend to measure this using the gross profit (GP) margin (what percentage of sales become gross profit).
Logically, we would assume that a GP margin analysis of the different businesses across the food supply chain (primary producer, food processor and end-retailer) should reveal who has the pricing power (i.e. high GP margin) and who has none (i.e. low GP margin).
Gross profit margins across the food supply chain
|Food processor/primary producer/retailer||Last reported GP margin (%)|
|The Spar Group||Retailer||11.9%|
|Pick n Pay Stores||Retailer||19.8%|
|Rhodes Food Group||Processor||34.1%|
Source: Various company reports, author’s own workings and assumptions
If the soft commodity narrative above were to be believed, we would expect to see all the food processor’s GP margins at the bottom.
Interestingly, the GP margins across the supply chain are quite spread out and many of the end-retailers have the lowest of them (relying on volume to generate returns on their capital rather than price).
Ironically, the highest GP margin in this sector is AVI, a food processor (with a fashion arm).
Zooming into two of the largest food processors (Tiger Brands and AVI) and the largest retailer (Shoprite Holdings), we see a more revealing picture of these GP margins over time (per the table above). Shoprite’s GP margins may be lower but they are steady while Tiger Brands and AVI are seeing their GP margins declining across years.
Tiger Brands, AVI & Shoprite Holdings gross profit margin history
Why would this be?
The erosion of branded food processor margins arguably lies in the growing traction of private label/house brands across retailers’ portfolios (i.e. where the retailer sources a near-perfect substitute product, minus the fancy brand name).
While Woolworths has always had strong house brands, Shoprite’s house brands have been gaining traction (in FY17 house brands made up 14% of their sales, rising to 16.5% in FY19 and then 17.1% in FY20).
Spar and most other retailers offer various (and growing) house brand product ranges too.
In essence, these substitute products eat into the brand premiums historically enjoyed by the listed food processors and – rather than short-term soft commodity pressure – I would argue that this is the real threat facing these businesses.
Competing with their customers becomes even messier for the food processors as, to keep their volumes up and their unit costs down, they often manufacture these house brands themselves. (Indeed, Libstar has built an entire – if somewhat low-margin – business based solely on this service.)
In conclusion, while soft commodity pressures may drive some short-term margin contraction in the food processors, the real structural pressure comes from these businesses’ customers, the retailers, and their house brands.
In the longer term, the steady erosion of branded food processors’ pricing power will likely only make these businesses more vulnerable and, broadly, begs the question of how investable this sector is.
Keith McLachlan – Integral Asset Management investment officer.