The Grocer/OC&C Top 150 2016: a fertile landscape post Brexit?

As the saying goes, be careful what you wish for. UK food and drink producers under siege from stagnant growth, falling prices and tightening margins have been desperate for these grim market fundamentals to change. But the shock Brexit decision has shaken up the landscape for these suppliers so profoundly it will be years before the after-effects are fully understood.

To some Brexit can create a newly fertile land primed to generate growth. For others it has irresponsibly scorched the earth and set the fruits of labour back years. What does seem certain is that looking to past trends is no longer a reliable guide to the future.

That recent past is characterised by an ever-intensifying pressure on the UK food industry, with the big four hit by falling sales, and now suppliers following suit.

Across The Grocer/OC&C Top 150 last year revenues declined for the first time since 2001, dropping by 0.1% and ending a four-year period where manufacturers were outpacing retailers on growth.

With margins also close to historic lows even before the disorder unleashed by Brexit, the industry is “a little punch drunk from a number of tough years” according to OC&C head of consumer Will Hayllar.

“It’s a picture of attrition,” adds Premier Foods CEO Gavin Darby. “There has been an awful lot of cost cutting, rationalisation and factory closures, but it frankly hasn’t been enough. It’s not a sustainable environment.”

The culprit is sector-wide deflation. In the early summer The Grocer Price Index found year-on-year grocery prices down by more than 3%, driven by the intense supermarkets price war combined with a slump in commodity and input costs, meaning the Top 150 are having to hike sales volumes just to stay above water.

A cure of sorts may be around the corner. None of us know when Brexit will happen or what it will look like, but the collapse in the value of the pound, losing well over 10% against the euro and dollar since the vote, will mean food prices have to go up because of the higher relative cost of commodities and imported inputs. The Bank of England has forecast a rise in food inflation over the rest of 2016, with OC&C calculating a 15% sterling depreciation should lead to UK food inflation 5% higher than global food inflation. So if nothing else, Brexit changes one of the key underlying dynamics causing such a headache for UK food producers. “The current health of the UK food and drink patient is pretty poor at the moment,” says Hayllar. “In some ways that bit of a jolt that Brexit creates does present an opportunity to try to reset things and benefit through that change.”

”Brexit changes one of the key underlying dynamics causing such a headache for UK food producers”

So the return of inflation is cause for celebration? Not so fast. Inflation is likely to cause as many problems as it cures.

A period of low commodity prices should theoretically have eased the pressure on suppliers’ bottom lines even if top-line growth were hard to come by. But across the Top 150 margins remained flat at 5.3%, well below the 6.4% long-term average, hovering near the low of 5% not seen since the mid-1980s.

With margins already wafer-thin, manufacturers have perilously little slack to absorb higher input costs, meaning they have to pass that inflation on to retailers and consumers. “I don’t think there is any doubt the food industry will see higher costs coming through to manufacturers, which we will need to recover,” says Bakkavor CFO Peter Gates. “We are already in discussions with customers and I would guess some of that will feed through to consumer prices.”

There is no guarantee, though, that consumers and retailers are willing to stump up for these higher costs. A previous period of commodity inflation in 2007/08 saw producers and retailers absorb just £0.1bn each of £5.7bn commodity inflation, but in the second wave, in 2012, producers were taking a £0.3bn hit and retailers a huge £1bn of the £3.3bn inflation.

Given the increased presence of the discounters and with consumers now used to lower prices, the industry may struggle to get consumers to foot the bill.

Hayllar notes that the benefits of deflation have wholly been passed on to consumers because of the aggressive channel environment and retailers may be reluctant to step away from that focus on price even with underlying inflation. “Retailers have seen more margin contraction than producers over recent times, but I think retailers will be trying to go slower in terms of accepting cost increases from their suppliers and holding back the tide as long as they can before passing it on to consumers,” Hayllar says.

Brexit’s effect on the wider economy factors into this calculation too - a booming Britain with GDP growth and wage inflation should take higher prices in its stride, but food inflation married to stagnant wage growth in a weaker economy is a less rosy picture.

“Inflation is not the answer,” says Darby. “If the industry ends up at a status quo after absorbing those input cost increases, that will be a good result.”

Quorn CEO Kevin Brennan agrees: “It’s very disruptive for a business to have to continually put prices up. If there is modest inflation, we try and find ways to deal with it or absorb it.”

Where there seems more agreement is in believing that growth is more likely to be achieved outside the UK than domestically. The previously strong pound hit export growth last year - across the Top 150 international sales edged down by 0.1%, but that was considerably better than the 3.3% dip in UK revenues. The share of revenues from outside the UK also rose from 13.7% in 2014 to 14.4% in 2015 as suppliers continued the long-term trend of internationalising their businesses.

The Brexit collapse in the pound could be a boon for exporters, whether building business outside the EU or selling comparatively cheaper goods into EU markets.

But the falling pound will only be giving a shove to what is already a rolling bandwagon when it comes to UK suppliers broadening their horizons. That trend is particularly obvious when looking at recent M&A activity. In 2015 Top 150 M&A rose to the highest level since 2009 at £3.9bn, largely driven by Nomad’s £1.9bn purchase of Iglo Group.

M&A recovery driven from overseas

This long-term M&A recovery has been primarily driven by overseas investment, with UK buyers only accounting for 4% of deal value in 2015 and 18% in 2014. A host of deals follow the pattern of a foreign trade buyer snapping up a UK asset, usually with an eye to expand it into other international markets - Monde Nissin’s swoop for Quorn, Lotus Bakeries buying Urban Fresh Foods and Natural Balance Foods, and more recently Amplify’s deal for Tyrrells all prime examples.

“There’s a challenge for UK-based corporates here,” Hayllar says. “For all those interesting growth brands the successful bidder has been an overseas buyer, perhaps because they have more ability to drive international growth, or stronger balance sheets.”

What top-line growth there has been among the Top 150 has largely been driven by M&A from expanding into areas of growth. “We have been careful to invest in pockets of bakery products that are in growth, like artisan breads, free-from products and out-of-home eating,” says John Duffy, CEO of Finsbury Foods, which led the Top 150 with 45.8% growth.

But M&A activity ground to a halt in the first half of 2016, just £0.8bn across five deals. “There are not many accessible scale opportunities in the UK at the moment and the overall trading environment means a lot of companies don’t regard it as a good moment to acquire in the UK,” says Rothschild global head of consumer Akeel Sachak.

However, the currency devaluation has clearly led to cheaper valuations and the UK remains one of the best jurisdictions in the world to foster small, innovative brands. Once again the Top 150’s smaller brands (under £500m sales) outstripped growth rates of larger brands by 1.2% against -2.5%.

Brands bubbling under the Top 150 are likely to remain attractive to foreign buyers and are often adept at finding growth in niche areas.

The post-Brexit fall in sterling could also be a trigger for growth closer to home. UK food only accounts for 55% of total food consumed and the higher prices of imports could provide opportunities for UK suppliers to win share from overseas manufacturers.

OC&C highlights the pork industry, where Aldi, Tesco and Lidl all import over 40% of facings and Asda imports over 60% because of cheaper imports. The falling pound should wipe out that differential and throw up opportunities to dislodge overseas suppliers.

The impact of Brexit

The elephant in the room in terms of cross-border trade is just how the UK will operate outside the EU, but these issues will take so long to play through that the impacts remain theoretical rather than material. Rothschild’s Sachak notes the EU itself could look very different by the time the Brexit actually takes effect. “We have no idea what kind of EU we will be confronted with in a couple of years with upcoming French and German elections. It’s far from clear whether we will or won’t be part of a single market.”

“It would be helpful for all of us to have more certainly, but in the short term nothing is really going to change for the next couple of years,” surmises Finsbury’s Duffy.

When Brexit does come, the food supply chain will inevitably be a crucial battleground given the reliance of UK farming on EU subsidies. Average farm profits were driven 56% by subsidies in 2014/15, compared with 41% in 2011/12, and if these subsidies are continued in some form the impact on the supply chain could be stark. “Subsidies help make those farms viable,” says Hayllar. “If agricultural subsidies weren’t continued at a similar level, that implies pushing out input prices in the UK.”

Another major - though currently still theoretical - impact of Brexit is on the supply and cost of labour.

Food production is the UK industry most dependent on migrant workers, with a 31% share of the workforce and the vote to leave the EU clearly puts that supply under future threat.

Even before any impact from curtailing EU freedom of movement and the introduction of the national living wage, labour costs are coming under pressure in the Top 150. Total headcount remained static at 320k (own label up 2%, branded down 3%), but manufacturers saw a 3% rise in average per-head staff costs in 2015.

Flat overall revenues have meant labour productivity only improved in large branded suppliers on a revenue per head basis, deteriorating slightly in the three other segments. Some 68 companies saw improvements in productivity, but 81 saw it drop during the year.

Recent FDF figures suggested a more positive current picture for labour productivity compared with other UK industries, but labour has the potential to become a ticking time bomb for food producers.

“Sometimes it is more efficient in a factory to have higher labour content because it’s more flexible, quicker, and you have less downtime”

“Labour is really important as an outcome for Brexit negotiations,” says Faccenda CEO Andy Dawkins. “Our average length of employment is over six years, even though our workforce is 50% migrant labour, and we’re very keen these people get looked after.”

“It’s important to us what the outcome is in relation to EU passport holder labour, but that’s clearly going to take several years to come through and we’re not taking particular short-term actions at this stage,” adds Bakkavor’s Gates.

Longer-term it seems unlikely labour will become cheaper and Hayllar believes the issue should lead to a “significant uplift” in investment in automation to prioritise efficiency and protect margin. Finsbury’s Duffy agrees labour challenges will “require all of us - food businesses in particular - to look for ways to automate and create efficiency products”. Gates concurs, but stresses automation should not impede manufacturing flexibility, which is crucial in enabling production lines to respond to changing consumer and retailer demand. “Automation is great, but it’s not always possible because sometimes it is more efficient in a factory to have higher labour content because it’s more flexible, quicker, and you have less downtime,” he says.

Pressure on capex

“I don’t think we’ll see labour shed from the industry,” adds Faccenda’s Dawkins. “We will all look to grow it more efficiently but we have to treat people fairly, look after them and properly reward work that’s put in.”

Whether it’s efficiency led or consumer based the business case for manufacturing investment is complicated by market conditions, with UK producers already struggling to justify large-scale capital projects.

Overall capex from the 138 companies that detail investment fell 0.8% last year and slipped back to 2.8% of revenues from 3% the previous year. Only smaller own-label businesses grew capex investment in 2015, with large branded players cutting investment by 8.8%. OC&C suggests the collapse in business and consumer confidence since Brexit could lead to a further short-term slowdown in investment.

Most starkly the lack of capex growth is married with return on capital employed falling to its lowest level for 30 years at 12.4% amid the market deflation and flat profit margins. So what capex is happening simply isn’t feeding through to the bottom line.

Premier’s Darby sees this ROCE slump as an immediate priority. “You can only invest in capital to drive out costs if you get a return on that capital,” he says. “If your revenues keep falling, it is tough to make even individual capital decisions make sense.”

Bakkavor’s Gates says every business is balancing payback on capital spend against longer-term strategic aims. But he adds: “Because capital spend is disruptive to the business, while it’s taking place you have to be comfortable with when you’re going to get a return on your spend [so] the bulk of our investment goes into relatively short payback projects to put in more capacity and support growth.”

As for the regulatory reset in the wake of Brexit, an optimistic view could see the UK build on its existing reputation as a global leader in incubating innovative, creative, disruptive and insurgent brands to inspire structures and trade agreements that increase the sector’s global competitiveness. But Brexit should not distract suppliers from controlling their own controllables - the chief of which is working harder to find and fund growth.

“Future growth is going to have to come via innovation,” says Sachak. “Historically big companies have not been great places for generating innovation, but they are much better at taking somebody else’s innovation to a much broader range of consumers.”

“The industry needs to move from cost-cutting to innovation,” agrees Premier’s Darby, pointing to examples of smaller companies growing chiefly because they’re the ones innovating.

Suppliers may have become risk-averse when it comes to investment because of the chaotic grocery retail environment, low margins and poor return on capital spend. But the Top 150 figures suggest focussing on efficiencies isn’t enough to solve tightening margins - companies need to take calculated risks, pursue the pockets of growth still out there, and commit capital to growth.

Darby sums up: “You’ve got to have top-line growth, or you’re just running faster and faster to at best stand still.” Brexit - with its inflationary push and export opportunities - could be the jolt to finally get it moving again