The Shareholder Value Triple Play

The Shareholder Value Triple Play

• 1.
  www.strategy-business.com strategy+business ONLINE MARCH 28,2016 The Shareholder Value Triple Play Mature food companies need to use aggressive cost reduction, portfolio simplification, and substantially new approaches to growth to deliver competitive returns. BY TOM HANSSON AND ABHIJEET SHEKDAR
• 2.
  www.strategy-business.com 1 mulas won’t dothe job. The industry needs to develop aggressive plans that will produce discontinuous growth. That sounds like a tall order. But on the basis of our recent analysis of 12 major U.S. packaged food and non-alcoholic beverage companies, we believe manage- ment can drive comparable shareholder returns by de- ploying an alternative formula that has three key com- ponents. The first is cost reduction. Companies must reduce costs sufficiently to offset the margin erosion inherent in their their businesses, create enough savings to allow for reinvestment in the business, and raise op- erating margins by 400 basis points. Second, companies must rationalize their portfolios so that they retain only businesses in which core capabilities create unique ad- vantage. Third, and most significant, they must create new avenues for step-change profitable growth that build upon current capabilities. We believe this ap- proach can increase shareholder value by 50 percent or more over three to four years. Winners and Losers Most major branded food companies have been fighting significant headwinds. Their marketing, sales, and R&D organizations are designed for growth and brand building, and they have mastered the complexities of channel fragmentation, product proliferation, and geo- graphic diversification. But they maintain substantial M any large, well-established companies in the food and beverage and broader consumer goods industries are struggling to deliver compelling shareholder returns. Their core businesses generate healthy gross margins, but top-line growth has been anemic, margins are under pressure, and cost structures remain stubbornly high. In the past, shareholders might have given manage- ment time to make course corrections. But today, capi- tal markets are less patient, and investors are acutely focused on enhancing shareholder returns. Specialized private equity firms have devised models for driving cost reduction and margin expansion far in excess of what leading companies have been able to do on their own — by about 800 to 1,000 basis points in two to three years. And shareholder activists are following suit. Although it is uncertain whether the new investors have the ability to foster growth in the long term, they have delivered outsized near-term shareholder returns. Few management teams will be able to match the new benchmarks solely by cost cutting, and few are posi- tioned to deliver enough growth to meet the challenge without also significantly improving their profit mar- gins. In fact, the industry needs to change its trajectory, transitioning from slow, margin-dilutive growth to fast- er, margin-accretive growth. But simply executing cur- rent plans more effectively or refining traditional for- The Shareholder Value Triple Play Mature food companies need to use aggressive cost reduction, portfolio simplification, and substantially new approaches to growth to deliver competitive returns. by Tom Hansson and Abhijeet Shekdar
• 3.
  www.strategy-business.com 2 The typical shareholderpromise for the major food companies has been to deliver annual sales growth in the low-single to mid-single digits, operating profit growth in the mid-single digits, and high-single-digit earnings-per-share growth. To see how much economic return the companies have actually generated, we ana- lyzed the performance of 12 major U.S. packaged food and nonalcoholic beverage companies from January 2010 to the middle of 2015. We focused on total share- holder return (TSR) minus the contribution of expand- ing multiples and changes in leverage. This measure, which we call operational TSR, reflects the manage- ment actions that lead to superior returns: organic growth, margin expansion, and M&A. Critically, it ex- cludes the across-the-board multiple expansion we saw during the stock market recovery. The companies’ performance falls neatly into two categories (see exhibit). The lower-performing group consists of seven companies that had an average annual operational TSR below 6 percent, and average organic growth rates of about 2 percent per year — just ahead of the rate of inflation. But even this modest growth came at the expense of mar- gins. These companies’ average gross margin fell by 320 basis points over the five-and-a-half-year period, their average operating margin fell 130 basis points before one-time events, and their average annual operational TSR was 3.3 percent. By compari- son, the S&P 500’s operational TSR (excluding banks) for the same cost structures, despite years of incremental cost reduc- tions. And the market environment isn’t particularly favorable. Grocery sales essentially grow with popula- tion in developed economies, and population growth has remained modest. Consumers have become more price-sensitive, and consumer preferences are shifting — away from the kinds of processed foods that the ma- jor food companies have focused on, toward more natu- ral, healthier, and less-processed products. Many of the growth pockets have been captured by private-label companies (in the price-sensitive category) and by smaller alternative brands (in the healthier, less-pro- cessed category). These competitors are less reliant on scale and quantitative insights, and are more adept at interacting with trendsetting consumers — especially millennials (see “The Big Bite of Small Brands,” by Elis- abeth Hartley, Steffen Lauster, and J. Neely, s+b, Aug. 27, 2013). Tom Hansson thomas.hansson@ strategyand.us.pwc.com focuses on M&A strategy in the retail and consumer sectors at Strategy&, PWC’s strategy consulting business. He is managing director with PwC US in Los Angeles. Abhijeet Shekdar [email protected] is a deals professional based in New York who focuses on the shareholder value proposition of companies as part of PwC’s strategic value consulting business. Exhibit: The Growth Challenge for Mature Food Companies An analysis of 12 major U.S. packaged food and non-alcoholic beverage companies between January 2010 and mid-2015 showed a sharp divergence between low-performing and high-performing companies. Source: Strategy&, PWC 2% per year –320 bps –130 bps 3.3% per year Lower Performers 7.7% per year +40 bps +110 bps 13.6% per year Higher Performers Financial Metric Organic Growth Gross Margin OI Margin Operational TSR Changing the trajectory from margin-diluting, slow growth to margin- accretive, high growth Finding potential for continued above-trend growth, especially without changing strategies Challenge
• 4.
  www.strategy-business.com 3 These more successfulcompanies have succeeded, on average, in boosting growth along with modest mar- gin improvement. However, although this model makes sense in a high-margin environment where returns are already ample, it would not necessarily make sense in the less-branded, lower-margin segments of the food industry. The Cost-Focused Challenge For those that don’t generate profitable growth, another option is available. Eliminate the costs and resources de- voted to that search for growth. Simplify the organiza- tion, eliminate complexity, focus brand investments, cut loss-making lines, and streamline the supply chain. Run the business by the numbers, and reinforce the new di- rection with clear individual objectives. This model will work particularly well in highly branded businesses that have high cost structures, and in which brand equities generate ample margins even if the top line shrinks. Evidence so far suggests that such an aggressive strategy can increase EBITDA margins by approximately 800 to 1,000 basis points. This approach has set a new bench- mark for shareholder value creation. But how can the management teams of the lower- performing major food companies — and companies in other industries with similar profiles — meet this new benchmark? Most management teams lack the skill or experience to raise margins by 800 to 1,000 basis points on the back of cost cutting. Nor is it realistic to expect they can match the shareholder return propositions of the high-performing food and beverage companies by driving 7 to 8 percent sustainable organic growth with- out margin erosion. A Combined Approach The alternative for most companies will be to pursue a three-pronged approach of margin improvement, port- folio rationalization, and revenue growth that will de- liver shareholder returns of the same magnitude as those delivered by the cost-focused formula. Many combina- tions will achieve the same value, but a good starting point might be to split the difference, and aim to com- bine an increase of 400 to 450 basis points in margins period was 10.2 percent per year. The margin erosion can be ascribed to traditional margin pressures, to merger and acquisition activity that diluted margins, and, critically, to a structural port- folio problem. Many of these companies earn their highest returns in areas that either are not growing or are shrinking (often highly processed or “health-chal- lenged” categories). At the same time, they are generat- ing growth in lower-margin businesses — either in less- differentiated product areas (where the margin potential is lower) or in foreign markets where the companies lack scale and their brands have less relevance (and where the impact of currency fluctuations is greatest). Some of these companies face the additional challenge of being, in effect, conglomerates of different businesses with dif- ferent performance characteristics and capabilities re- quirements. As the economic value of pure scale has been diminishing, and as the “best” marketing and sell- ing capabilities become less differentiating, pressures increase to simplify portfolios. Some companies have proactively addressed this challenge by creating pure plays, and some others are moving in this direction by gradually divesting units that can no longer support the cost structure of the parent. The second category in our study, the high per- formers, consists of five companies that had operational TSRs well above 6 percent per year and that achieved an average annual organic growth rate of 7.7 percent. Com- panies in this group were able to eke out an average gross margin expansion of 40 basis points over the five- and-a-half-year period, expanded EBIT margins by an average of 110 basis points, and generated an average annual operational TSR of 13.6 percent — well above the 10.2 percent of the S&P. IllustrationbyMartinLeonBarreto
• 5.
  www.strategy-business.com 4 es for gettingit wrong can be significant. Underinvest- ment may erode a massive profit pool, and overreliance on a turnaround may simply leave the company without growth — with excessive time, resources, and focus spent on the old core at the expense of new growth avenues. Expand existing profit pools. Many companies un- derestimate the growth potential in their existing core, either because they are distracted by what they see as more attractive opportunities in other markets or be- cause they fail to see opportunities to use their own dis- tinctive capabilities to gain share in their competitors’ profit pools. Companies should identify and surgically invest in the company’s most attractive profit pools to maximize profitable growth from existing businesses — those where distinctive capabilities provide superior re- turns and allow the company to gain share or tap into growth pockets. These investments may take many dif- ferent forms, including focusing product innovations on specific channels, boosting promotional spending for specific customers, or devoting more R&D resources to specific product categories (see “Secrets of the Activist Manager,” by Larry Jones and Joseph Duerr, s+b, Dec. 16, 2015). Pursue step-out growth. Most companies don’t have enough attractive investment opportunities in their portfolios to create sustainable, profitable growth at an annual rate of 4 to 6 percent. Thus, creating new profit pools — which can be done through a combination of organic means and M&A — is an imperative. The key is to focus on a few material initiatives that leverage and strengthen what the company does best, and to extend those by category or geography. These step-out plays can take a variety of forms, including: “Big bang” innovation. In most instances, innova- tion will be a component of any winning strategy. But in some cases a big, successful initiative may be the key — hitting home runs rather than singles. An obvious example in the food and beverage category has been single-serve coffee systems. The companies that devel- oped them successfully redefined their businesses around these products (at least for a period of time). through cost cutting with sustainable, profitable top- line growth of 4 to 6 percent per year (or M&A to add the equivalent value). Although this is a big challenge, it is achievable. Here’s how to do it. Cut costs. Most companies will need to raise mar- gins by 400 to 450 basis points over two to three years through cost reductions and rationalization. This ap- pears consistent with the targets that at least some com- panies in the food industry are setting themselves, and with the “bigger and faster” cost reduction that’s been gaining traction in response to the activist challenge (see “Be Your Own Activist Investor,” by Deniz Caglar, Vinay Couto, and Gary L. Neilson, s+b, Oct. 19, 2015). But rather than mandating across-the-board cost reduc- tion, this shareholder value formula calls for an ap- proach that both cuts costs and preserves and enhances the distinctive capabilities that are critical to growth (see “Is Your Company Fit for Growth?” by Deniz Caglar, Jaya Pandrangi, and John Plansky, s+b, May 29, 2012). Rationalize the portfolio. Managers need to be very selective in deciding which horses to bet on among their businesses. For each business unit they decide to keep, they should be able to answer “yes” to three questions: • Can we create more value from the business unit than it is worth to someone else? • Can the business unit benefit from our capabili- ties enough to support our new, slimmed-down cost structure? • Does the business unit fit with our new share- holder return proposition to investors? Stabilize the old core. Portfolio rationalization is not always a simple prospect. Given the economic realities of highly branded mature categories, management teams may not always be able to get adequate returns by divesting (or spinning off) some of these businesses. As a result, some will remain in the portfolio. Food compa- nies are responding in a variety of ways to this chal- lenge. Some run these businesses purely for profit, rais- ing margins and accepting sales declines. Some are investing “just enough” to stabilize them. And some are doubling down, betting that material innovation and marketing initiatives will reverse the decline. The right answer will not be the same for all, but the consequenc-
• 6.
  www.strategy-business.com 5 New approach toforeign markets. Many large food companies have struggled abroad. They earn lower re- turns where their brands are less well-known. As a re- sult, attempts to grow in all geographies result in mar- gin erosion. An alternative is to focus resources in a couple of countries at a time to move from a follower position to a leadership position, raising margins while driving growth. This strategy may involve acquiring lo- cal competitors or focusing innovation in the country, and will likely include upgrading in-country capabili- ties. Returns follow the ability to add value. Nuanced approach to on-trend businesses. Many large companies have struggled to reach consumers who seek healthier, less-processed products. As a result, many established firms have purchased smaller entrepreneur- ial businesses. The challenge is to derive enough value from these acquisitions to move the needle, especially given their small size and the high prices usually paid for them. Buying and holding upstarts separately doesn’t create enough value, and absorbing them in a “billion- dollar brand” organization stifles them by imposing the parent’s institutional methodology on the acquired companies’ more flexible take on innovation and brand building. Part of the trick is to find a happy medium that enables acquired companies to grow by providing sales access and distribution resources to boost the tar- gets’ sales, while allowing them to remain entrepreneur- ial. But critically, the parent also must apply the insights that make the target company successful to its tradi- tional core business in order to change the parent com- pany’s growth trajectory and experience a step change in value. Roll up your sector. The more focused a company becomes on a narrow range of products, the more it is able to develop advantaged capabilities in that category — through insights, innovation, category management, commercial processes, and operational expertise. Global or regional consolidation will be the attractive play where these capabilities are sufficiently differentiating (see “Grow from Your Strengths,” by Gerald Adolph and Kim David Greenwood, s+b, Aug. 18, 2015). Adjacent M&A. Mergers and acquisitions are a prov- en inorganic growth strategy, but one fraught with risk. Most acquisitions fail — particularly those that are made outside the existing core. “Near-in” adjacencies are the most promising. Companies that can identify where their distinctive capabilities will provide advan- tages outside their existing business, or identify how they can jointly build advantage with an adjacent target, will have the best chance to add value. Thinking Big Executives in food and beverage companies are facing a truly challenging situation. Capital markets have be- come much more demanding, and outside investors have shown how much value can be created. Most com- panies will need to pursue a triple play of cost reduction, portfolio rationalization, and growth of a magnitude not often seen before. But before picking and choosing tactics, executives have to change their mind-set. The industry may be fo- cusing on cost reduction, but many players will still fall short of the targets necessary to establish a competitive shareholder value proposition, and only some compa- nies have taken significant steps to simplify their portfo- lios. And there is certainly nothing incremental about the growth challenge most companies face. As a result, companies need to adopt a far-reaching top-down approach that maps out the potential growth avenues over a five-year time frame. They must identify a portfolio of big ideas to make the kinds of step chang- es that will likely double or triple the value of their most advantaged units — while ensuring that the resulting corporation will be strategically coherent and competi- tively advantaged. Executing this strategic triple play won’t be easy. But the rewards will be significant for companies that succeed. They will be positioned to achieve consistent, profitable growth and future value creation. And they might even fall off the activists’ radar. +
• 7.
  strategy+business magazine is publishedby certain member firms of the PwC network. To subscribe, visit strategy-business.com or call 1-855-869-4862. • strategy-business.com • facebook.com/strategybusiness • linkedin.com/company/strategy-business • twitter.com/stratandbiz Articles published in strategy+business do not necessarily represent the views of the member firms of the PwC network. Reviews and mentions of publications, products, or services do not constitute endorsement or recommendation for purchase. © 2016 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. Mentions of Strategy& refer to the global team of practical strategists that is integrated within the PwC network of firms. For more about Strategy&, see www.strategyand.pwc.com. No reproduction is permitted in whole or part without written permission of PwC. “strategy+business” is a trademark of PwC.