“Many consumers have returned to some of those pantry staples that we’ve had in our portfolio during this pandemic, and it’s reminding them of their love for a lot of the Kraft Heinz brands,” Christopher Urban, Kraft Heinz’s vice president of global strategic capabilities, said at a virtual licensing conference on Monday. “And we see this in our data. We’ve seen significant increases in household penetration across many of our brands over the past few months. In some cases on some of the brands, we are seeing record high numbers. And I think this increase in household penetration just makes the brands even more relevant to the consumer.”
Urban spoke at the Licensing Week Virtual conference about the opportunities the food company has available and is pursuing, many through the agreement signed last year with Brand Central. Kraft Heinz, which owns scores of well-known and globally beloved brands, entered the Brand Central agreement to transform its megabrands Heinz, Kool-Aid, Planters, Jet-Puffed, Oscar Meyer, Philadelphia, Kraft Macaroni and Cheese and Velveeta into lifestyle brands.
So here’s Kraft’s logic as I see it:
A global pandemic led to record sales for almost every CPG company
Record sales reintroduced old brands to new consumers
They are going to extend the momentum through brand licensing deals
Consider me skeptical. Given the realities of Kraft-Heinz’s business, this seems to be at best an incremental revenue driver.
How Brand Licensing Works
By 1995 M&M’s had lost their mojo. After a generation in the business, sales of the hard-coated candy were flat. The brand was at risk of becoming a commodity. “They’d become just candy.” Susan Credle, a creative director at BBDO, told Business Insider, “An aisle store candy brand versus an icon brand.”
With help from marketing firm BBDO, Mars Inc. transformed the brand into one of the most beloved in America.
BBDO’s idea: Take the colors of the candies in the bag and develop each into a character to make a comedic ensemble.
Credle describes M&M’s as the “court jester” brand — when the king is getting slaughtered, the jester comes in to lift them up.
Along came Red (the sarcastic one,) Yellow (the simple one,) Blue (the cool one,) and Green (the sexy one) — and later, Brown and Orange, too.
The characters debuted at the Super Bowl and were an instant sensation. Today, over twenty years later, M&M’s are still the best-selling chocolate brand in America. Perhaps more importantly, the company leveraged the characters to successfully evolve into a brand licensing platform. People didn’t just want to buy chocolate candies, they wanted to associate with M&M’s themselves. They wanted t-shirts, notebooks, stickers.
Long-term licensing partners include apparel, housewares and plush provider ERE; novelty and candy dispenser maker CandyRific; electronic accessory company Maxell; calendar maker Trends International LLC; travel accessory provider EB Brands and watchmaker MZ Berger. MRG in the past year added apparel maker Mad Engine Inc. and cycling jersey manufacturer Brainstorm Gear to its list of licensees.
This was transformational growth. Apparel, housewares, electronic products–all by a candy company. Kraft-Heinz is betting that it can capture similar enthusiasm with Oscar Meyer, Kool-Aid or any of their legacy brands.
One of the reasons I am skeptical of Kraft-Heinz is that under 3G’s management, the company has effectively no track record of building brands. In fact, they have a strong track record of using zero-based-budgeting to drive efficiencies—which can often destroy a legacy brand’s value. M&M’s transition from a branded candy to a lifestyle brand wasn’t cheap.
In fact, it took one big, bold, and expensive bet—a physical retail store to truly cement the change. A branded retail store is a place where a brand’s image turns into a real experience. Scott Galloway calls it a “temple to the brand.”
Patrick McIntyre, Director of Global Retail at Mars, described the strategy at Insider Trends:
Where brands come to life is advertising either in a TV commercial, in a print ad, or in some interaction that a consumer has with the brand. That’s a snapshot in time. It’s one moment and then it’s over, and then you’re on to the next thing. I think many brands, and us in particular, ealized a long time ago is the impact of being able to amplify those brand attributes in an experience where someone can actually be immersed fully within that brand. That’s what we started 20 years ago with our first M&M’s World Store in Las Vegas – a very famous tourist location. We created a four-floor 28,000-square foot store that was completely and totally dedicated to M&M’s.
Today, Mars Inc. has seven full M&M branded retail stores. The London location alone drives 5.3 million visitors a year. The company has an additional store planned at perhaps the most exceptional branded merchandise company in the world—Disney World.
Kraft-Heinz’s approach could drive some incremental revenue
Given that Kraft-Heinz lacks the characters of M&M and it a full-service retail store seems impractical—especially given COVID-19 realities—I think the safest bet is that the brand licensing initiative is used as a supplement to its dwindling research and development arm (Which I’ve covered in detail here).
One of the goals of this website is to illuminate the context surrounding different business strategies throughout history. A lot of what we consider innovation isn’t new, but re-coloring past strategies. That brings me to fake eggs and Coca-Cola bottler distribution strategy.
Eat Just Inc., a plant-based egg substitute company that has sold about 40 million fake eggs—mostly in America. It is looking to aggressively expand into China, where the average person eats 50 eggs a year, compared to just 35 in America.
Tetrick’s plan for international expansion depends on local partners, who will be expected to mix Just’s mung protein with oil, water, and other ingredients, then bottle and ship the products. The CEO cites Coca-Cola Co.’s syrup distribution network as an inspiration and says current board member Jacob Robbins, a former Coke supply chain executive, persuaded him to outsource distribution and the final stages of production.
The rise of the Coca-Cola Bottler
Today, Coca-Cola is arguably the most famous brand in the world. You can go to almost any country on earth and buy a Coke bottle from a convenience store, and it will taste the same in Germany as it does in Brazil. Very few companies have the reach or the consistency. This simple fact is a testament to the power of Coca-Cola’s operations.
It’s even more impressive when you realize that a fateful 1899 decision means that Coca-Cola doesn’t manage its bottling operations. The Coca-Cola Company manufactures and sells soda concentrates to 225 different bottlers—which then produce millions of bottles of Coke. The bottlers are responsible for creating bottled soda and getting the finished goods to individual retail stores.
The below graphic, shows how it works:
Graphic via Coca-Cola’s 2019 Annual Report
Coca-Cola Bottler; part opportunity, part bad business decision.
Why would Coca-Cola give up its bottling operations? After all, vertical integration allows for higher profits—, especially once the business scales.
In 1899, two young lawyers from Chattanooga, Benjamin Franklin Thomas and Joseph Brown Whitehead, arranged an introduction to Asa Candler, traveled to Atlanta, and made a pitch for the rights to put the soft drink in bottles. At first Candler was unenthusiastic. Bottling was still a back-alley business, in his view, and there was a danger that Coca-Cola’s reputation might suffer if he allowed them to go ahead. Still, Candler told his visitors, he had no interest in keeping the bottling rights for himself and his company. “Gentlemen,” he recalled telling the two Chattanoogans, only half in jest, “we have neither the money, nor brains, nor time to embark in the bottling business.”
At the time, Coca-Cola was experiencing exponential growth. It was earning a 50%return on every bag of syrup it sold to a retailer. Asa Candler, the man who enabled this success, agreed to give away the Coca-Cola bottling rights—for free.
Early Coca-Cola Bottlers Struggled
Candler, Coca-Cola’s CEO, had two reasons to be skeptical of bottling.
Household refrigeration wasn’t widely available. The first mass produced domestic refrigerators arrived in the 1920s. It was not until 1945 when 85% of households had a refrigerator. Coke was best served cold and there was no easy way for people to keep it cold.
Bottles themselves were an unproven technology. Early soda used a “Hutchinson” bottle; a bottle “sealed by a rubber gasket haled in place by a long looping wire.” In the summer, Coca-Cola in a Hutchinson bottle was lucky to last two weeks.
From Chandler’s point-of-view, there wasn’t a market, nor the technology required to support bottling.
Initially, it looked as if Thomas and Whitehead would fail to get the project off the ground.
As they looked ahead to 1900 and the challenge of fulfilling their contract, Thomas and Whitehead realized there was no way they could afford the time and money it would take to open plants across the country one by one by themselves. Their only hope, they concluded, was to become “parent” bottlers, recruiting other men and giving them franchises to build the actual facilities and sell Coca-Cola in the surrounding territories.
To summarize the chain of events:
Coca-Cola outsourced bottling and distribution to a middleman
Unable to scale, the middleman outsourced bottling and distribution to established bottlers—essentially becoming a “service manager” for Coca-Cola
New Bottling Technology Fuels Growth
Running Parallel to all of this was William Painter, an Irish born, Baltimore based inventor. In 1892 he patented an early version of the modern bottle cap: his design standardized glass bottle necks and the corresponding topper. Standardization allowed mass sterilization. Manufacturers could quickly and systematically sterilize bottles—drastically increasing the shelf life of products.
With the technical shortcomings addressed, bottles exploded.
In most cities, a franchise to bottle Coca-Cola was now considered a license to make money. (Expressing the point explicitly, the bottler in San Antonio printed up a letterhead that depicted a Coke bottle spurting dollar signs, over the slogan, “There is money in it.”) Many bottlers found demand so heavy they divided their territories and assigned their rights to a new genus of sub-bottlers who built smaller, more efficient plants. There was no need to recruit new bottlers, because applicants were beating down the company’s door and begging for the opportunity.
Coca-Cola Bottler: Money for Nothing
Bottling opened up a whole new channel for Coke. Within decades syrup sales to bottlers would account for 40 percent of Coca-Cola’s overall revenue. Thomas and Whitehead’s ‘parent’ bottling company found itself in perhaps the best position.
The parent companies were left without a clearly defined role. Syrup was shipped from the Coca-Cola Company’s factories directly to the actual bottlers, so the parents were not even acting as genuine middlemen. They simply sat back and took a royalty on every gallon, even though they never handled a drop. The parents paid the Coca-Cola Company 92 cents a gallon for syrup, then turned around and “resold” it to the actual bottlers at a generous markup, usually $1.20 a gallon. It was all done on paper.
So to recap: Asa Candler, the man who enabled Coca-Cola’s massive rise, agreed to not only give away the Coca-Cola bottling rights but structured the deal in a way where Coke ended up paying a middleman (parent bottlers) for the privilege.
Eat Just’s Rationale
The primary benefit of the Coca-Cola bottler strategy is that instead of building out a physical production and distribution footprint, a company can tap into an established network and scale quickly. The downside is that you lose margin once successful. Plus, they’re going to be at the whim of their partners. Assuming Eat Just operates the “parent bottler” strategy, and has reasonable controls around the operation, it could make phenomenal sense for a company expanding into new markets.
Part of strategy isn’t just understanding the past, it’s learning from the mistakes of the past.
General Electric announced it would sell its lighting business to Savant Systems in a deal valued at $250 million. The agreement itself was long rumored but still comes as a surprise. In a way, the transaction signifies the death of an era–almost as if Coca-Cola sold of its sugary beverage line. General Electric didn’t invent the light bulb, but it did invent consumer light bulbs—the first affordable and mass-produced version. This spring boarded General Electric into the pantheon of history’s great companies. In the mid-2000s, G.E. was in everything from consumer goods to entertainment, and it boasted annual revenues on par with a middle-income country. Then, mismanagement forced the company to rethink the conglomerate strategy. “It has shifted its focus to making heavy equipment,” the WSJ wrote in its coverage, “like power turbines, aircraft engines, and hospital machines.” In 2019 G.E.’s revenue dropped to around $30 billion.
Sometimes significant shifts beg simple questions. If G.E. was one of history’s best companies and it was a conglomerate, what is a conglomerate? Is there a standard conglomerate definition? What was the rationale for becoming one? Did the conglomerate strategy lead to General Electrics’ decline?
A conglomerate is simply a holding company or corporation that operates in multiple industries, usually owning individual divisions that could stand apart as separate businesses on their own. Early conglomerates were initially focused on a suite of related activities, like G.E. and electrical system in the 1900s or branded food conglomerates of the 1920s.
Like all aspects of business, the conglomerate structure evolved as American politics evolved. Founded in 1892 by five titans, including J.P. Morgan and Thomas Edison, General Electric combined a variety of small electrical component companies under one umbrella.
As both businesses expanded, it had become increasingly difficult for either company to produce complete electrical installations relying solely on their own patents and technologies. In 1892, the two companies combined. They called the new organization the General Electric Company.
Several of Edison’s early business offerings are still part of G.E. today, including lighting, transportation, industrial products, power transmission, and medical equipment. The first G.E. Appliances electric fans were produced at the Ft. Wayne electric works as early as the 1890s, while a full line of heating and cooking devices were developed in 1907. G.E. Aircraft Engines, the division’s name only since 1987, actually began its story in 1917 when the U.S. government began its search for a company to develop the first airplane engine “booster” for the fledgling U.S. aviation industry. Thomas Edison’s experiments with plastic filaments for light bulbs in 1893 led to the first G.E. Plastics department, created in 1930.
Basically, through a variety of mergers and acquisitions, General Electric was able to monopolize all aspects of the early American electrical system—from the technical standards and power generation by industry—to the light bulbs screwed into sockets by consumers.
Throughout the Great Depression, America’s attitudes toward corporate concentration changed. The consensus view was that monopoly power, like General Electric held, was bad for society. The result was a variety of New Deal regulations designed to stop conglomerates from rolling up entire industries.
Stoller explains what happened next:
But in the early 1960s a new type of conglomerate emerged, although this time these corporations were shaped by strict antitrust laws. In this instance, cash-rich corporations like RCA and LTV invested in entirely unrelated lines of business—Hertz or Wilson Sporting Goods,say—the argument being that an excellent executive team could manage any line of business well. One of the highest-flying conglomerates at the time, LTV, bought business lines in missiles, electronics, electrical cable, sporting goods, meat and food processing, and pharmaceuticals.
Essentially, General Electric was generating enormous amounts of cash and could no longer use that money to acquire businesses within its core industry.
General Electric, like many monopoly-based conglomerates, decided to expand outward.
The benefits of a conglomerate
The following image lists every industry General Electric operated in 2000. That year it had revenues of about $130 billion. Adjusted for inflation, that’s about $190 billion of revenue in modern times. To put things in perspective, in 2019 the IMF estimated the New Zealand had a total GDP of about $204 billion.
General Electric was incredibly diverse. It had its hands in everything from entertainment production (NBC) to Lighting and Medical systems.
Here’s the revenue break down by business unit:
Business Unit
Revenue (millions)
Percentage of total Revenue
Margin
Aircraft Engine
$10,770
8%
23%
Appliances
$5,887
5%
12%
Industrial Products and Systems
$11,848
9%
19%
NBC
$6,797
5
26%
Plastics
$7,776
6%
25%
Power Systems
$14,861
11%
19%
Technical Products and Services
7,915
6%
22%
GECS (Financial Services)
$66,177
51%
28%
The smallest business unit had revenues of over $5 billion; larger than many best-of-breed companies. It was the definition of a conglomerate.
So we know what conglomerates are and why they became diversified across a variety of industries. Any definition of a conglomerate needs to explain the benefits of the structure. There are three major pieces.
Rise of Management
G.E. viewed businesses as interchangeable. In the eyes of leadership, a great manager could manage a microwave division just as successfully as they could manage a production company. If there was an opportunity, even if it was completely unrelated to their core competency, the company would jump headfirst. General Electric was proved right during expansionary economic conditions and was dead wrong the minute things went south.
Reduced Short Term Risk
Appliances and Industrial Products don’t have high margins like entertainment or finance, but they involve less risk and generate large amounts of cash flow—that the company can use to fund other deals and reduce risky ones.
Writing in The Master Switch, Tim Wu describes how this enabled G.E. to purchase Universal, a film production company.
Universal would enjoy as much of a hedge as any entertainment firm could hope for. By 2008, G.E. had annual revenues of over $183 billion, while Universal had income of $5 billion, less than 3 percent of the total. With a holding company of that size, the prospect of losing millions on a single film, while not pleasant, is no existential threat. Here was the ultimate defense against even the biggest movie bomb: a corporate structure so titanic that the fate of a $200 million film can be a relatively minor concern.
Synergy!
Being a conglomerate in a variety of disparate industries allows the company to augment itself across a variety of transactions. Synergy is a terrible word, but it’s the best one I can think of.
The relationship is symbiotic. G.E. Capital helps G.E. by financing the customers that buy G.E. power turbines, jet engines, windmills, locomotives, and other products, offering low interest rates that competitors can’t match. In the other direction, G.E. helps G.E. Capital by furnishing the reliable earnings and tangible assets that enable the whole company to maintain that triple-A credit rating, which is overwhelmingly important to G.E.’s success. Company managers call it “sacred” and the “gold standard.” Immelt says it’s “incredibly important.”
That rating lets G.E. Capital borrow funds in world markets at lower cost than any pure financial company. For example, Morgan Stanley’s cost of capital is about 10.6% (as calculated by the EVA Advisers consulting firm). Citigroup’s is about 8.4%. Even Buffett’s Berkshire Hathaway has a capital cost of about 8%. But G.E.’s cost is only 7.3%, and in businesses where hundredths of a percentage point make a big difference, that’s an enormously valuable advantage. And thanks to the earnings strength of G.E.’s industrial side, G.E. Capital can maintain its rating without holding much capital on its balance sheet.
Combined with a rising stock market, in the mid-2000s, G.E.’s conglomerate strategy looked like a great deal.
Until it wasn’t.
The Weakness of a Conglomerate
No definition of a conglomerate would be complete without the structures weaknesses. If you look at G.E.’s 2000 income statement, something should stick out. It was ostensibly an industrial conglomerate that made everything from MRI machines, power turbines, and microwaves. However, around 50 percent of its revenues came from financial services—most of them intertwined with the industrial business. Again, management looked great during boom times, but it became clear how incompetent management was in bad times.
As entangled as it was in the mortgage bubble and the shadow banking sector, G.E. Capital toppled over. At the height of the 2008 crisis, literally no one would lend to it in the overnight markets. G.E. Capital was only saved by an emergency injection of $12 billion from Warren Buffet and other investors. It turned out that the good reputation and credit rating of G.E.’s traditional businesses had essentially been used to gamble wildly in the financial markets.
General Electric said Wednesday that the federal government had agreed to insure as much as $139 billion in debt for its lending subsidiary, G.E. Capital. This is the second time in a month that G.E. has turned to a federal program aimed at helping companies during the global credit crisis.
G.E. Capital is not a bank, but granting it access to a new program from the Federal Deposit Insurance Corporation may reassure investors and help the lender compete with banks that already have government-protected debt, a G.E. spokesman, Russell Wilkerson, told Bloomberg News.
“Inclusion in this program will allow us to source our debt competitively with other participating financial institutions,” Mr. Wilkerson said.
Essentially, all three of the benefits of a conglomerate were so grossly mismanaged that laws had to be shifted to classify G.E. as a bank. If it wasn’t reclassified, it could of brought down large portions of the world’s economy.
Compounding matters, G.E. followed up the financial crisis with a series of bad acquisitions across its’ entire portfolio—including, the largest industrial purchase in the company’s history.
Turns out it’s only easy to manage a large corporation when the stock market is rising.
Conclusion
Rephrasing Matt Stoller’s definition of a conglomerate:
General Electric was simply a corporation that operated in eight different industries, including medical devices, light bulbs, and power generation. At its’ peak, each division generated over $5 billion a year. In boom years, the structure reduced short-term risk, created synergies, and allowed managers to shine. In bad years, the inefficiencies and mismanagement, often masked by its size, brought the firm down.
Three months into the coronavirus lockdown and results have been mixed for major CPG companies. Companies that have diversified product offerings and sell through a variety of channels are doing moderately well. P&G, the Ohio based conglomerate, saw consumers stock up on paper goods and cleaning products. Fear of stock-outs led to panic buying and fear of the virus meant people washed their clothes more—and P&G owns Tide and Charmin. The result was a rise in revenue of 10 percent. Companies whose products decline in value during quarantine–beauty, luxury, travel–were not as lucky. Unilever saw flat sales, but with $58 billion in annual revenue, they will be fine. But what about small CPG companies?
For the time being, consumers are buying more coffee to get their fix at home, aiding producers like Nestle. In the 13 weeks ended May 17, U.S. retail sales at supermarkets and other outlets rose 15% from a year earlier, according to data from Chicago-based market researcher IRI.
But “at-home increases for coffee will never compensate for food-service loss,” according to Judy Ganes, the president of J. Ganes Consulting, which follows the industry. “Recovery won’t be quick.”
Before the virus hit, Chris Nolte and Paul Massard sold about 2,000 pounds a week of their Per’La Specialty Roaster to Miami-area hotels, restaurants and in the single coffee ship they ran. They started the roaster operation in late 2015, mostly focusing on hotels, and added the coffee shop two years ago.
Once the closures began, bringing the city’s tourist season to a brutal halt, that number dropped by 85%, according to Nolte.
It is hard to comprehend how any business can survive a spontaneous collapse. General Mills, the $17 billion food giant, stemmed the impact by transitioning supply and distribution lines to focus only on retail. They were able to accomplish this because it had a generation of time to diversify its offerings. Today, food service accounts for about 12% of the company’s revenue, retail accounts for sixty. For Per’La Specialty Roaster it is 85%.
How is the small CPG brand able to compete?
“We are using mostly Instagram and Facebook,” Nolte said in a phone interview from their roasting plants just outside Coral Gables.
Initially, the company had nine employees, but Nolte and Massard are the only two left working.
Now the two men, who met during their first semester in business school back in 2001, have pivoted to social media and online sales to overcome at least some of the sales dearth.
Internet or direct-to-consumers is always trotted out as the silver bullet for struggling companies in the coronavirus era. It’s basically the business version of telling unemployed people to ‘learn to code.’ It’s an unserious idea for a structural issue.
Food service involves selling and delivering one fifty-pound bag of coffee to one customer, retail involves selling fifty one pound bags to fifty customers. They have entirely different cost structures and operations.
Let’s take customer acquisition. A quick test reveals that it cost about $4.00 to run a targeted Google add for ‘Coffee’. If a pound of specialty coffee cost $5 to produce and sells for $16, that’s already 36% of the margin on customer acquisition—and that’s assuming every single person who views the add purchases the product—which is an asininely optimistic assumption. It also fails to factor in that every small coffee manufacturer is faced with the same dilemma—driving the advertising cost as demand for eyeballs increases.
The end result here isn’t good for anyone but large coffee producers—who already have a large retail business to offset the food service. I am not sure what the solution is, but it is going to be painful.
Sales of the company’s hygiene and cleaning brands, including Cif surface cleaners and Domestos bleach surged by double digits as consumers stocked up to clean their homes to fend off coronavirus. In-home food product sales also rose as shoppers loaded their trolleys.
But ice cream sales and the company’s food service business, which sells ingredients to chefs and restaurants in 180 countries, were hit hard by the pandemic. The company, which also owns the Magnum brand, said it missed out on the start of the ice cream season in Europe, with outlets closed and distributors reluctant to buy stock with an “uncertain holiday and tourism season” ahead.
All of this is understandable. As the table below shows, 79% of Unilever’s revenue comes from two categories: Beauty & Personal Care and Foods & Refreshment. Under COVID-19 quarantine people are spending less time doing their hair and make-up. They’re also eating out less. Packaged foods are flying off shelves, but unfortunately for Unilever, the bulk of its Foods & Refreshment margin comes from Ice Cream and Food Service—two categories crushed by social distancing.
Its last category, Home Care, which includes cleaning solutions, is doing fairly well—but it’s also it’s smallest and least profitable. In 2019, it accounted for about 21% of Unilever’s overall business—but just 16% of operating profit. Meanwhile, Beauty and Personal Care accounted for 42% of sales and 52% of operating profit.
Category
Revenue
% of Revenue
% of Operating Profit
Beauty & Personal Care
21.9 billion Euros
42%
52%
Foods & Refreshment
19.3 billion Euros
37%
32%
Homecare
10.8 billion Euros
21%
16%
Unilever accelerates an agile supply chain to meet COVID-19 demands
In my opinion, the most interesting tidbit from the earnings call had nothing to do with coronavirus. It had to do with an agile supply chain. When asked about how the pandemic changed the company’s operations, CEO Alan Jope responded:
Earlier in the pandemic we changed our monthly operational forecasting cycle to a weekly basis so we can reflect the rapid changes in consumer demand. And we have been using people data centres to pick up the changing consumer sentiment early.
Forecasting is a huge component on any CPG company’s supply chain. A company needs to not only know how much it plans to sell, but how much it needs to produce and accrue. A large CPG company will produce multiple forecasts, here’s just a small sample:
Forecast
Description
Accrual
Every CPG manufacturer pays retailers trade dollars—essentially a percentage of sales to ensure prime locations and promotional activity. Companies need to forecast this to ensure the end of month financials are correct.
Demand
A combination of Production, Sales and Supply Forecasts.
Production
How much the company will need to manufacture to meet consumer demand.
Sales
How much product retailers are going to buy.
Supply
How much raw material they’ll need to buy to make production goals.
Most CPG products have relatively predictable demand. Forecasting is centralized at a corporate level and done at a monthly basis. Demand Planners and Forecasters will run through a handful of different business scenarios and develop a forecast. Given the mass uncertainty caused by covid-19, Unilever is increasing forecasting frequency. This gives them more information and enables quicker decisions—reducing stock-outs. This is interesting, but not particularly unique. Most CPG companies are doing so.
We’re actually moving away from scenario planning and trying to focus on building agility and responsiveness into the company. And I don’t know that we should all be spending too much time locking in particular views or scenarios for the future, but rather unleashing the trapped capacity that most big organizations have by letting go and letting people close to the markets, close to the front line, exercise their judgment and their decision-making. We’ve discovered a new responsiveness in Unilever that I wish we had unlocked years ago, but it’s taken this crisis to do that.
This is almost the definition of an agile, resilient supply chain. What does this mean in practice?
Unilever is moving away from mass centralized forecasting and into a decentralized model—putting decision making power in the hands of the front line. Centralized planners won’t spend their time modeling various scenarios—the front-line worker will drive opportunities. It’s potentially a revolutionary change that requires flawless execution of technology and business process.
Writing on the Andreessen Horowitz blog, influential tech entrepreneur Marc Andreessen published It’s time to build. The essay laments Western civilization’s response to the coronavirus. To Andreessen, who the New Yorker labeled a “farsighted theorist” and sits alongside Bill Gates and Peter Thiel in the pantheon of serious Silicon Valley thinkers, the issue is desire.
He writes:
The problem is desire. We need to want these things. The problem is inertia. We need to want these things more than we want to prevent these things. The problem is regulatory capture. We need to want new companies to build these things, even if incumbents don’t like it, even if only to force the incumbents to build these things. And the problem is will. We need to build these things.
With respect to Andreessen, the problem isn’t desire. The problem isn’t inertia. The problem isn’t will. Those are vague passive buzzwords that help distribute blame evenly across society rather than at the specific, powerful groups whose actions created the situation.
Let’s take this specific passage of It’s time to build:
We see this today with the things we urgently need but don’t have. We don’t have enough coronavirus tests, or test materials — including, amazingly, cotton swabs and common reagents. We don’t have enough ventilators, negative pressure rooms, and ICU beds. And we don’t have enough surgical masks, eye shields, and medical gowns — as I write this, New York City has put out a desperate call for rain ponchos to be used as medical gowns.
1. We don’t have enough coronavirus tests, or test materials — including, amazingly, cotton swabs and common reagents.
We do not have enough coronavirus test because of mismanagement from the Trump administration—full stop. According to reporting by ProPublica, one of the finest news organizations in the world, the CDC “shunned the World Health Organization test guidelines used by other countries and set out to create a more complicated test of its own that could identify a range of similar viruses.” When that test was sent out to labs—it failed to work. Basically, we needed a car, a friend offered to give us his, but we insisted on building our own—and it didn’t work. America wasted valuable weeks because the decision was made to use a proprietary test.
2. We don’t have enough ventilators, negative pressure rooms, and ICU beds.
We do not have enough ventilators because of a combination of greed and lack of antitrust enforcement. In 2006, after the SARS crisis, civil servants realized that the nation was woefully under prepared for a pandemic. They identified ventilators as a hazard point and set out to stockpile 40,000 of them. This again is contrary to Andreessen’s assertions that Western governments were asleep at the wheel.
They weren’t, they were just outfoxed by private interests.
The ventilators were to cost less than $3,000 each. The lower the price, the more machines the government would be able to buy.
Companies submitted bids for the Project Aura job. The research agency opted not to go with a large, established device maker. Instead, it chose Newport Medical Instruments, a small outfit in Costa Mesa, Calif.
Newport, which was owned by a Japanese medical device company, only made ventilators. Being a small, nimble company, Newport executives said, would help it efficiently fulfill the government’s needs.
Ventilators at the time typically went for about $10,000 each, and getting the price down to $3,000 would be tough. But Newport’s executives bet they would be able to make up for any losses by selling the ventilators around the world.
“It would be very prestigious to be recognized as a supplier to the federal government,” said Richard Crawford, who was Newport’s head of research and development at the time. “We thought the international market would be strong, and there is where Newport would have a good profit on the product.”
By 2011, Newport had three low-cost ventilator prototypes ready. The plan was to have one approved and ready for the use by 2013. Then, like essentially every industry in modern times, the medical device industry consolidated. The business school reason is that bigger medical device companies can offer more products and better services to hospitals. The real reason is that consolidation is pure monopoly strategy. The bigger you are, the more leverage you have in negotiations.
In 2012, Covidien, a large medical device company, bought Newport and five other smaller device manufacturers. Within a year, despite the guaranteed contract and profit, Executives at Covidien shut Project Aura down.
Back to the New York Times:
Government officials and executives at rival ventilator companies said they suspected that Covidien had acquired Newport to prevent it from building a cheaper product that would undermine Covidien’s profits from its existing ventilator business.
In 2014, Covidien was purchased by Medtronic for $42.9 billion and shifted its headquarters from Minnesota to Ireland—to avoid taxes. Today, Medtronic is worth $126 billion. America still doesn’t have enough ventilators.
3. And we don’t have enough surgical masks, eye shields, and medical gowns.
The reason for this is somewhat straightforward. In the early 2000s, private equity started to invest in health care providers. As I’ve written about before, private equity isn’t actually that good at running a traditional business. It is good however, at transferring value from a business into management’s pockets. That’s exactly what happened in healthcare. Costs were cut, services were reduced. It happened in obvious places, like less nurses and doctors, and less obvious places like medical supplies.
Additional supplies come with additional storage costs—so private equity backed hospitals adopted just-in-time supply chain principles. “Keeping goods (PPE) on hand costs money,” NBC news reported, “and to private equity, that’s like putting dollar bills on a shelf.” It also accelerated an existing outsourcing trend. On a per unit basis, the difference between made-in-America and made-in-China PPE is tiny. “But when you’re talking about millions of units, it does add up,” Robin Robinson, the former head of the federal agency in charge of stockpiling protective gear told the Dallas Morning News. Today, only five percent of surgical masks are made in America. The rest are made abroad, who are understandably prioritizing their own citizens over exports.
Marc Andreessen fills the rest of It‘s time to build with similar out of touch truisms about education, housing, and life in America. In his mind, there’s nothing that can’t be solved by software.
We know one-to-one tutoring can reliably increase education outcomes by two standard deviations (the Bloom two-sigma effect); we have the internet; why haven’t we built systems to match every young learner with an older tutor to dramatically improve student success?
First, I absolutely love how he needlessly drops the “Bloom two-sigma effect.” There is nothing more Silicon Valley than using isolated research as a panacea explanation for a structural problem. Second, 15 percent of American students lack access to the internet at home. How are they supposed to connect to tutors? Through magic? My wife works for a low-income school district. They have mailed out tens of thousands of assignments to students—like they’re running a correspondence class in 1974. Peel back the onion a bit more and ask yourself, “Why don’t student’s have home internet?” The answer is simple. They are poor. The families can barely pay rent, let alone spend $75 a month on home internet. The solution here isn’t tutors, it’s low-cost high-speed internet, provided by the government.
This gets to the real issue, the real cause of America’s poor coronavirus response—inequality. You can find it in every aspect of the coronavirus, from who gets sick to who gets laid off. It seems like he forgets this.
Andreessen established himself as a serious Silicon Valley-type with his essay “Software Is Eating The World.” The essay’s general thesis is correct. Software is automating vast swaths of the American economy—making things much more efficient. Andreessen failed to realize that a lot of the past world’s inefficient parts were there by design—and they supported this thing we call society.
“Today’s largest direct marketing platform is a software company — Google,” he wrote, “Now it’s been joined by Groupon, Living Social, Foursquare and others, which are using software to eat the retail marketing industry.” This was correct. Prior to the rise of Google, retail marketing was a diverse industry—run by media companies. As software ate the advertising industry, the news industry lost 68 percent of its advertising revenue—a large portion of it transferred to Google’s pockets. The impact wasn’t spread out equally. Large established brands like the New York Times thrived, while 20% of local newspapers disappeared.
I’m sure proponents could argue that the advertising market was now more efficient. But at what cost? No local news creates news deserts, which leads to more public corruption, which leads to a worse society. From a financial perspective, new research suggests that less local news results in higher bowering costs for municipalities. From a human perspective, the middle-class of journalism was gutted.
In 2019, Google controlled around 38% of the online advertising market. Today, just five firms control 75% of the nearly $130 billion digital ad market. That’s billions of dollars that used to be distributed across the media landscape, from national to local publications, concentrated into just five firms.
Again—inequality. We’ve created a system that doesn’t build wealth. It transfers it from one group to another.
The Master Switchby Tim Wu is a masterful book on the rise and fall of information empires. He traces the evolution and industrial organization of the telegram, telephone, radio, television, and the ultimately the internet. His general thesis is that information technologies start with hobbyists, and gradually transition into gated monopolies as they gain widespread adoption. An information monopoly comes with massive responsibility. At one time, AT&T effectively controlled all of America’s telecommunications. From the wire on a telephone poll, to the phone connected to the jack, Ma Bell designed and maintained every aspect of the system. In exchange for the monopoly, and the profits it generated, Bell invested billions of dollars in basic technological research. Bell Labs, the company’s research arm, earned seven Nobel prizes. Over time, the responsibility mindset evaporated.
Tim Wu explains:
The old empires were suppressive and controlling in their own ways, yet each had some sense of public duty, informal or regulated, that they bore with their power. At their best, they were enlightened despots. But the new industries’ ethos held that profit and shareholder value were the principal duty of an information company. What reemerged was similar in body but different in its soul.
When Andreessen wrote It’s time to build he probably meant it as a call to arms. But he missed the point. The coronavirus is a reckoning of the new soul.
On March 23, a day when the United States registered 135 coronavirus deaths, Sanderson Farms, America’s third-largest poultry processor, announced one of their workers tested positive for the virus. It was the first reported case from a major meat processor. Three days later, Smithfield Foods joined the fray by announcing an additional case at its massive South Dakota pork plant. Within days, industry giants JBS and Tyson made similar announcements.
Perhaps it’s because there is no evidence that coronavirus transmits through food, but you would have thought that news like that would have led the national news that night. After all, it’s our collective food supply. Instead, it was mostly relegated to the industry press. The New York Times/Reuters article on the closure of three plants clocked in at 257 words. That’s because America views its retail food industry, a $6 trillion market, in boring terms. There are no big Apple-style keynotes for the year’s newest products. The entire industry just kind of happens—and we buy the finished product at a grocery store. Given the concentrated nature of the industry—most companies probably like it that way.
The uncomfortable reality is that from an operational standpoint, the last forty years created a meat production system almost uniquely positioned to spread the coronavirus and exaggerate its impact.
There’s a good chance we’re about to pay the price.
The rise of industrial meat packing
For the bulk of the century, meatpacking, like dairy and other agriculture products, was a regional affair. Independent operators sold farmers animals and feed. Farmers raised the animals and meat processors butchered them. Processors then sold the meat to Wholesalers, who distributed the finished meat to grocery stores. This ecosystem supported rural economies for a generation. It was also inefficient. Each link in the food chain meant an additional salary. Starting with chicken, and led by Tyson Foods, the meat industry vertically integrated.
Business reporter Christopher Leonard explained in his book Meat Racket:
Under Tyson, all these businesses have been drawn onto one property. The company controls every step of meat production, with each aspect being centrally directed from the company’s headquarters in Springdale. The company’s control spans the lifetime of the animals it raises. Before there is a chicken or an egg, there is Tyson. The company’s geneticists select which kinds of birds will be grown.
Today, a handful of massive plants process America’s meat supply. Around 20% of America’s overall meat supply comes from Tyson, who has about 100 plants. Like most production plants, these facilities are optimized by maximizing output per square foot.
At many meat-processing plants, workers are “essentially elbow to elbow,” said Thomas Hesse, president of United Food and Commercial Workers Union Local 401, the largest private sector union in Western Canada that represents 32,000 members, mostly in food processing and retailing. Though employees are usually wearing protective gear, the risk of contagion is difficult to completely eliminate.
Basically, our food supply is dependent on getting thousands of people in a closed space and having them work closely together. It’s a recipe for disaster.
Last week, the Smithfield pork plant that had its first case in late March, was forced to close.
By April 15, when Smithfield finally closed under pressure from the South Dakota governor’s office, the plant had become the number one hotspot in the U.S., with a cluster of 644 confirmed cases among Smithfield employees and people who contracted it from them. In total, Smithfield-related infections account for 55% of the caseload in the state, which is far outpacing its far more populous Midwestern neighbour states in cases per capita.
We have a situation where thousands of low-paid workers, concentrated in a confined space, are choosing between paying rent and potentially getting sick. The concentrated structure of industrial meatpacking means that America’s meat supply is caught between their collective Sophie’s Choice.
Antifragile Theory
Nassim Taleb burst into the American consciousness with his 2007 book The Black Swan. In it, he argued that society is primarily shaped by unpredictable events with massive impacts—which are then rationalized after the fact. The book received almost universal acclaim; the London Times argued it “altered modern thinking.” In 2009 he followed the landmark release with Antifragile, an attempt to describe a framework to thrive in a black swan world. “In spite of the chronology…” Taleb wrote in the book’s introduction, “Antifragile would be the main volume and The Black Swan its backup of sorts.”
The book lays out a framework for developing systems that thrive in the disorder caused by black swan events. Fragile systems collapse under pressure, antifragile thrive. One of the central tenants of Antifragile is that large institutions pose a threat to a system’s overall stability.
In spite of what is studied in business schools concerning “economies of scale,” size hurts you at times of stress; it is not a good idea to be large during difficult times. Some economists have been wondering why mergers of corporations do not appear to play out. The combined unit is now much larger, hence more powerful, and according to the theories of economies of scale, it should be more “efficient.” But the numbers show, at best, no gain from such increase in size—that was already rue in 1978, when Richard Roll voiced the “hubris hypothesis,” finding it irrational for companies to engage in mergers given their poor historical record…As with the idea of having elephants as pets, squeezes are much, much more expensive (relative to size) for large corporations. The gains from size are visible but the risks are hidden, and some concealed risks seem to bring frailties into the companies.
Later:
But these systems learn because they are antifragile and set up to exploit small errors; the same cannot be said of economic crashes, since the economic system is not antifragile the way it is presently built. Why? There are hundreds of thousands of plane flights every year, and a crash in one plane does not involve others, so errors remain confined and highly epistemic—whereas globalized economic systems operate as one: errors spread and compound.
Summarized:
The benefits of economies of scale, the rationale the mergers that created the massive meat processing companies, overshadow massive risks—which reveal during a crisis.
A few closures wouldn’t matter to a system with thousands of operators, because the production impact of closures would be negligible to the overall system.
Unfortunately, we don’t live in an anti-fragile system. In fact, everything from dairy to condiments is now concentrated higher than any time in American history. Today, four firms control about 60% of the chicken industry, 63% of pork, and a staggering 80% of beef production.
Remember the pork facility that Smithfield shutdown? Well, it’s huge. “The facility,” Reuters reported, “is one of the nation’s largest pork processing facilities, representing 4% to 5% of U.S. pork production, according to the company.”
Just one week after March 15, 2020, when President Donald Trump claimed the US had ‘tremendous control’ of the coronavirus pandemic, California Governor Gavin Newsome ordered all state residents to stay home. “The order,” the New York Times reported, “represents the most drastic measure any governor has taken to control the virus.” Similar orders may become the norm, as ‘worse case” expert predictions place the COVID-19 death toll at potentially millions of people.
Given the public health scope of the coronavirus, it
seems somewhat trivial, but the effective shutdown of the American economy will
have massive impacts on the CPG world. On one hand, there’s probably never been
more demand for a lot of the CPG world’s products (packaged foods, paper goods,
and hand sanitizer in particular). On the other hand, it’s going to be harder
and harder to source many of the products that Americans use every day.
The result will be a nation of 350 million people, who are used to living in relative abundance, adjusting to a life of relative scarcity. Many in the industry expect that long lines and empty shelves are going to become the short-term new normal. A recent survey by DigitalCommerce 360 revealed that 44 percent of surveyed retailers expect production delays. 40% percent expect ongoing inventory shortages throughout the year. What’s frustrating is that the coronavirus isn’t the cause of the scarcity—it’s a symptom of a more significant issue: the outsourcing of the American supply chain.
CPG Supply Chain System Shocks
It’s a 12-hour flight from San Francisco to Taiwan. Once
there, you’ll find Hsinchu, a city of about half a million people. Hsinchu is
relatively obscure unless you manufacture computers. If you work in the industry,
you know that in the late 1990s, the two largest semiconductor manufacturers
were located in the same Hsinchu industrial park. An earthquake struck the
island in September 1999. The damage forced the country to press pause on a
week’s worth of production.
Barry Lynn describes what happened next in his book End of the Line:
The first Americans to feel the effect of the quake were, therefore, workers at factories that depend on components made in Taiwan; within days, thousands of manufacturing employees were sent home from assembly lines from California to Texas. The next Americans to feel the quake were investors. As Wall Street began to make sense of the disaster, traders quickly off-loaded stocks of some of the biggest electronics firms with Dell, Hewlett-Packard, and Apple among those that fell furthest. Last of all, Americans felt the quake as consumers. By Christmas, shoppers faced shortages of everything from laptop computers to Furby dolls to Barbie Cash Registers, all of which had been hit hard by parts shortages.
Barry Lynn – End of the Line
All of this over a one-week delay caused by an earthquake. Now, the entire economy, including the CPG industry, is facing a shutdown that may last months.
The slowdown is a reminder of how heavily many US companies rely on Chinese suppliers, whether for finished goods or component materials: Procter & Gamble, whose brands include Charmin, Pampers, and Tide, warned investors in late February that about 17,600 of its products would be impacted by the disruption in China, where it has 387 suppliers shipping more than 9,000 materials.
“Each of these suppliers faces their own challenges in resuming operations,” Jon Moeller, P&G’s CFO, told analysts. “The challenges change with the hour.”
Hilary George-Parkin – Vox.com
The past two decades saw an incredible increase in the
internationalization of the US manufacturing supply chain. Most large companies
have supply chains that cross multiple boarders. There’s massive benefits from
this–most notably cost. But there are also risks–big ones–often ignored by
most until they happen. Today, we’re seeing the risks play out in real-time.
The result will be an interesting dynamic. CPG companies
that resisted the allure of the creation of cheap, but complicated supply
chains, may actually prosper–simply because they can source raw materials
effectively. Luckily, most food processors fit into this camp. There
shouldn’t be any major issues sourcing and processing food for market.
The idea that any of this is an unpredictable shock is simply nonsense. It’s merely an information lag. The circumstantial evidence dates back to Taiwan and the late 1990s–anyone who argues otherwise is incompetent or ignorant.
Their (Li and Fung) international network of sourcing and logistics relies on three things: cheap energy, cheap materials and political stability. Climate change has the potential to upend all three.
Consumer packaged goods (CPG) companies are everywhere. However, most consumers know the brands not the companies. Sprite, Tide, and Moleskine notebooks are all packaged goods brands purchased and used by millions every day. Coca-Cola, P&G, and Moleskine are the CPG companies that produce them. From an operational perspective, a CPG company manufactures products, sells them to retailers, who then sell them to consumers.
The table below gives a few more examples:
CPG Company
Brands
Coca-Cola
Coca-Cola, Diet Coke, Honest Tea
Conagra
Slim Jim, Duncan Hines, Hunts
FritoLay
Lay’s, Doritos, Cheetos
Nestle
Cheerios, Gerber’s, Pellegrino
Proctor and Gamble
Crest, Gillette, Tide
Uniever
Axe, Dove, Lipton
CPG Brands have been around for hundreds of years, although in modern times, CPG categories are mostly considered to be fast moving goods like food, drinks, and cleaning products. Put it this way, if you buy it regularly, it’s probably a CPG. Today, CPG brands are marketed around a variety of traits. Some like Clif Bar and Gatorade are performance-based. Others, like Dove soap, are centered around equality and self-love. Originally, CPG brands were built around one thing: safety.
Why is this? In the early 1900s, most goods were effectively brandless, sold out of general stores from bulk supplies. This led to manufacturers and retailers taking advantage of an unwitting public.
Lemon extract often contained no lemon. Bottled soft drinks used coal tar, a carcinogen, as a colorant. Some ketchups used saccharine, even then suspected as a hazardous adulterant, as a preservative. The “tin” in tin cans contained as much as 12 percent lead, which leached into the fruits and vegetables. Zinc chloride, used to prepare the tops for soldering, often ran into the cans during the soldering process, poisoning the food inside.
As a result, CPG companies began to brand themselves in terms of quality and safety. If a consumer saw Dove soap on the shelf, they knew it was a quality bar that floated, and they’d purchase it with confidence. Manufacturers were now incentivized to differentiate their products. If you’re looking to learn about the business processes and operations that enabled this differentiation, check out this article, which details the rise of Kraft-Heinz. If you’re looking to learn about private label business strategies read this article on TreeHouse Foods. The rest of this post focuses on the high level business strategy of a CPG company. The goal of each is to try and sell as many products as they can, to as many customers as they can reach.
Today, most CPG companies adopt a business model that pushes towards horizontal or vertical integration to accomplish the goal.
CPG, P&G, and Horizontal Integration
Up until about twenty years ago, the definition of a CPG company was straight forward. P&G was a CPG company that manufactured a variety of household products that customers purchased at retail stores.
Research and development: Creating a product that consumers want.
Production: Figuring out how to manufacture the improved product at scale.
Supply Chain: Ensuring that you have enough raw commodities to manufacture the product.
Transportation: Getting the product to the customer (retailer).
Sales: Ensuring the product gets prime placement for a customer through negotiations and pricing.
Marketing: Generating consumer awareness and demand through advertising.
These processes are incredibly scalable and repeatable across multiple categories of goods. Once a company builds up a production system or a sales department, it can sometimes seamlessly plug new items and offerings into the established business process.
Horizontal integration is simply when a company in one category, expands into another category. In the case of P&G, it started in bath soap, moved to laundry soap, then paper products, coffee, potato chips, and even dog food. Each category may seem different, but the core business processes are the same. The general process of producing, selling, and distributing aspirin and cough medicine to retailers is identical. The more products that a CPG company can sell into a retailer, the more leverage it generates. Fifty years ago, a lot of vertical integration was done organically, through research and development. Today, it’s primarily done through acquisitions. The logic is simple. Lax anti-trust enforcement means that retailers are becoming more and more powerful, which means that a CPG company needs more brands to bargain with.
CPG Companies and Retailer Segmentation
Just because the goal of a CPG company is “to sell as as many products as they can, to as many customers as they can reach,” it doesn’t, however, mean that a CPG company will sell its products to all retailers. The retailers it chooses to sell to should fit within the brand’s perceived segment.
Initially, a branded CPG company like P&G was hesitant to sell products through discount stores—as it believed the stores tarnished their middle-class identity. But money talks. Many opted to sell smaller pack sizes and value options when dollar stores became a consistent revenue driver for manufacturers.
On the other hand, Nike is a premium brand. It’s mostly an apparel company, but they certainty produce some CPG-like products. You will probably never see Nike products at Dollar General. Instead, it opted to target high-end retailers and athletic stores, but even that is changing.
Nike plans to continue working closely with 40 partners, ranging from brick-and-mortar standbys like Foot Locker Inc. and Nordstrom Inc. to newer partners like Amazon and online luxury boutique Farfetch, on new apps and in-store experiences. It said it wouldn’t eliminate the thousands of other retail accounts that it currently manages, but Nike Brand president Trevor Edwards said “undifferentiated, mediocre retail won’t survive.”
Nike’s decision to abandon Amazon had many drivers. The first is probably Amazon’s refusal to combat counterfeiting. The second is perhaps Nike’s desire to integrate vertically. Vertical integration is when a company internalizes every business process—from 1-6. Instead of buying another brand to create more leverage against retailers, it buys a commodity supplier or builds its own storefront to create efficiencies within production and distribution.
This strategy obviously can’t be executed by all CPG companies—especially fast-moving consumer goods (FMCG). It would be completely unrealistic for Coca-Cola or Campbell Soup Company to open stores that only sold their products. It’s also entirely impractical for a FMCG to develop a profitable direct-to-consumer business. Customer acquisition costs are too high for the products given that Facebook and Google own an effective duopoly on online advertisement. Most CPG vertical integration comes from retail stores themselves–who do so through private label.
Private Label CPG and Retailer Vertical Integration
So far we’ve focused primarily on branded CPG. That is, the name brand products that every knows and loves. But brands do not operate in a vacuum. Coke is not just competing against Pepsi, but against Walmart’s Sam’s Cola. For as long as chain retailers have existed they’ve sold some level of unbranded or private label products.
For the bulk of the 20th-century private label, brands were considered inferior to branded products. That changed, however, when many products became standardized through better production and supply chain practices. Today, private labels aren’t just low-priced offerings, but brand builders for the retail chains themselves.
The three best-selling private label categories in food and nonfood may still be predictable—milk, eggs, and bread in food; food-storage and trash bags, cups and plates, and toilet tissue in nonfood. However, today’s large and sophisticated retailers are able to develop credible private label offerings for categories where traditionally customers were more wary of straying from their favorite manufacturer brand names. Nowadays, store brands are present in over 95 percent of consumer packaged goods categories. Among the fastest-growing categories for private label sales are lipstick, facial moisturizers, and baby food.
Once you see a Retailer’s operating model, you’ll understand why there is such a push from retailers.
Retailer’s Operating Model
The image below is a typical retail operating model.
The shelf price is the price consumers pay a retailer. The margin is the difference between what the retailer paid the CPG company, minus the retailer’s labor and fixed costs. As you can see, there isn’t much in the retailer’s margin. This graph doesn’t include all retailer considerations (consumer preferences, product demand via mass advertising, differences in revenue per square foot of shelf-space, etc.). Still, you can certainly see why retailers want to get to vertically integrate through private label.
If a retailer owns the production of private label good, they mostly capture all the margin between the production cost and the shelf price. The high fixed cost associated with production gave manufacturers power in a negotiation, but as retailers have become larger and larger, the cost became a non-issue.
The end result of this is that established CPG brands aren’t just facing competition from other manufacturers, but they’re facing intense competition from retailers–who used to be their partners.
In Conclusion, What is a CPG Company?
It’s tough to give a complete and exhaustive definition of a CPG company. That’s because they are so varied in what they produce and how they sell. But definitions help, and hopefully, this helps better understand what a consumer packaged goods company is and the business model it uses to makes money.
At a high level, a CPG company is a firm that manufacturers products that consumers regularly buy. It then sells those products to retailers, who sell them to the end consumer. The goal is to sell as many products, to as many consumers as possible. Today, CPG companies succeed by generating leverage over retailers by offering a variety of goods through horizontal integration. Conversely, retailers are vertically integrating, and offering their own private label goods to compete with CPG companies.
How did things go so wrong for Kraft Heinz, one of the nation’s largest, most recognizable food companies that’s backed by one of the nation’s most beloved investors? In February, Kraft Heinz announced a 2.7% decline in net sales for 2019. This comes just one year after the company wrote down $15.4 billion because legacy brands like Oscar Mayer and Kraft failed to keep up with changing consumer tastes. Its long-term debt was downgraded to junk bond status after management refused to cut its dividend. Oh, and it also was investigated by the Securities and Exchange Commission for misrepresenting financial results.
During
a scheduled conference call reviewing the past year, CEO Miguel
Patricio told investors that “2019 was a very difficult year for Kraft
Heinz.” The situation is a far cry from just four years ago when the company headlined its annual report “Kraft Heinz Reports Solid Financial Performance with Integration on Track.”
So
what happened? To understand Kraft Heinz’s fall, you need to understand
how the company came to be and how its strategy and approach to
budgeting differs from the traditional model of a consumer packaged
goods (CPG) company.
Private equity comes to town
This
all goes back to when 3G Capital, a Brazilian private equity firm,
entered the picture in 2013. The firm had earned itself a reputation for
generating profits. Like most PE firms, its model was based on cash
flow and cost cutting. The general strategy looked like this:
Identify an established brand that 3G management believed it could manage more efficiently.
Acquire it with other people’s money.
Maximize its efficiency through cost cutting.
Use the resulting profitability to finance additional deals.
The firm had used the formula to turn Burger King
and Budweiser into cash machines; it sold 1,200 Burger King locations
to outside investors and reduced the head count by almost 36,000. In
three years, net income rose 34%. “These things are seemingly working at
Burger King,” an analyst told Businessweek in 2014, “and causing questions to be asked about the strategy of others in fast food.”
With financing from Warren Buffett, arguably America’s most respected investor, 3G gained control of H.J. Heinz
for around $23 billion in 2013. Two years later, the group acquired
Kraft for $49 billion. The result was the fourth-largest food company in
America with a roster of stable brands, including Oscar Mayer, Jell-O,
Maxwell House, and Planters. “This is my kind of transaction,” Buffett said after the deal went through, “uniting two world-class organizations and delivering shareholder value.”
Since 2013, more than 10,000 people — one-fifth of the workforce — have been laid off from Kraft
and Heinz, with seven plants shut, highlighting the human cost and
upheaval involved in producing the highest profit margins in the food
industry. The founders of 3G have transformed the beer, fast food, and
food manufacturing industries with bold acquisitions, which are quickly
followed by a brutal but disciplined attack on costs, a surge in
profitability, and high returns to shareholders.
The
“brutal but disciplined attack on cost” has a name: zero-based
budgeting. The logic behind it is compelling while being simultaneously
against the branded CPG industry’s entire business model.
How zero-based budgeting works
Traditional
corporate budgets are derived from historical information. Imagine that
you’re in charge of in-store marketing at Kraft. Last year, you spent
$15 million on a variety of in-store marketing events. After analyzing
inflation, competitor data, and new item distributions, you estimate
you’ll need an additional $500,000 in funding to support the business.
Your boss agrees, so you get the budget.
Zero-based
budgeting doesn’t work that way. In zero-based budgeting, every single
company expense (from in-store food samples to pencils) is classified
into a specific category. Each category is assigned a manager who builds
a budget from scratch, justifying every single expense. Budgets are
analyzed and awarded a cap. Managers are then incentivized based on how
much they spend under the cap.
The result is a ruthless accounting of company expenses.
In
the first few years, Kraft Heinz eliminated over $1.7 billion in annual
spending. This included excessive expenses like private executive jets.
It also included eliminating things that don’t cost a lot, like taking
away free Kraft snacks in break rooms and limiting each employee to 200
printed pages a month. Workers may have hated it, but investors loved
it. According to Berstein Research, for every dollar of sales, the food industry typically earns about 16 cents. Eighteen months under the new regime, 3G was earning 26 cents for every dollar it sold.
There’s
nothing inherently wrong with documenting and assigning
responsibilities to spend. In fact, 10 to 15 years ago, you could almost
certainly make the argument that many CPG firms were bloated. But the
problem with this approach is threefold:
It
assumes the underlying brands independently operate with stable and
strong business infrastructure — and that both are capable of doing more
with less.
It
discounts the fact that legacy brands — almost all of Kraft Heinz’s
portfolio — require promotional spending to maintain past sales
performance.
It
fails to take into account that businesses aren’t linear. They are a
collection of interdependent processes, each one influencing and
impacting the bottom line in aggregate. It isn’t always possible to
account for and rationalize every single expense because the results are
often dependent on numerous factors.
In
year one, a cut in marketing and promotional spending may not impact
much. Change doesn’t happen overnight. The initial success means the
cuts are repeated for three straight years — because why not? The
manager is incentivized to cut. Everything is fine until reality catches
up. A legacy brand with reduced promotional support in an ever-changing
category is a recipe for disaster. Suddenly, sales stop and management
is forced to take one of the largest write-downs in a decade.
Creating true value
CPG
companies are valuable because of the sum of their interlocking parts. A
company can have the best product in the world with a great marketing
campaign, but what does it matter if it can’t consistently manufacture
it? The following major business processes drive consumer product
companies:
Research and development: Creating a product that consumers want.
Production: Figuring out how to manufacture the improved product at scale.
Supply chain: Ensuring that you have enough raw commodities to manufacture the product.
Transportation: Getting the product to the customer (retailer).
Sales: Ensuring the product gets prime placement for a customer through negotiations and pricing.
Marketing: Generating consumer awareness and demand through advertising.
Zero-based
budgeting is about making each process the most efficient version of
its current state. But despite how zero-based budgeting operates in
theory, business processes aren’t independent. Businesses typically get a
greater return on sales spend if they’re backed by a marketing campaign
and vice versa. Some processes, like research and development, are not
linear. It may take years for a product innovation to break through.
For
an example of a more successful way to acquire a company and integrate
it into the core processes — rather than trying to grow through cuts —
we can look at what happened with P&G and Charmin.
Building new value through acquisition
In
1957, P&G acquired a Green Bay, Wisconsin-based papermaker named
Charmin. At that time, Charmin wasn’t the national powerhouse we know
today. It was a regional afterthought with about $20 million in sales.
To put the acquisition in perspective, P&G had an advertising budget of over $80 million the same year.
Like
the more recent Kraft Heinz deal, the logic for the acquisition was
compelling. Acquisitions are evaluated based on how well they plug into a
company’s existing operations and strategy — both vertically and
horizontally. Vertically, P&G had technical experience with
pulp-making, a key component of papermaking itself, through the Buckeye
Cotton Seed Oil, a company it owned that manufactured component
materials for film. Horizontally, it had a long history — first with
soap, then with detergent — in marketing and distributing low-cost
consumer products. On paper, everything looked fantastic. P&G had
both the technical and business skills to build the brand.
What could go wrong?
For starters, Charmin wasn’t a product consumers wanted. Today it’s the most popular branded toilet paper in America,
but in the 1950s, it regularly placed last in blind tests against
products from paper powerhouses Kimberly Clark and Scott Paper. The poor
quality meant that Charmin only controlled about 14% of the Midwest and
Great Lakes market. Out-of-market retailers weren’t willing to give
shelf space to a product that couldn’t win in its own territory.
When P&G went up to Green Bay, it realized that Charmin failed in just about every process — specifically production. Rising Tide, the history of P&G, explains:
Charmin
benefited almost immediately from P&G’s more sophisticated
financial and marketing techniques, but the transfer of technical
knowledge proved troublesome. At the time, papermaking was considered an
art, in the same way soap making had been earlier in the century.
Charmin “had no clearly established product or process standards.”
Despite
having technical paper experience, P&G struggled to develop a new
product. Mass production requires a strong paper to withhold against the
stress of the pushing and pulling of papermaking machinery. But making
it strong meant a thicker, harder paper — not exactly the words people
want to be associated with toilet paper.
After
years of experiments, P&G engineers developed CPF, a paper
manufacturing process based on a Japanese technique that involves
inserting an air drying step into the manufacturing process. CPF
resulted in a softer and more absorbent paper that had a cheaper
per-unit production cost than traditional methods. Rival firms got wind
of the new process but were powerless to respond because they were
locked into extensive and costly legacy manufacturing systems.
Adapting existing processes
Investing
in research and development and production processes resulted in
P&G having a better product, but retailers didn’t want to sell it.
Competitors made sales presentations that showcased how poorly the old
version of Charmin performed. “Who needs a brand that’s been on the
market for five or six years and is a weak number two or a weak number
three in its category?” P&G’s former sales director later told
interviewers.
This
is where P&G’s existing horizontal sales and marketing processes
came into play. P&G put its marketing skills to use, inventing a new
branding campaign, “Don’t squeeze the Charmin.” It then redesigned the
packaging. Toilet paper was traditionally sold in opaque paper
packaging. Charmin marketers put it in clear plastic, creating an
attention-grabbing effect on the shelf.
Armed
with a superior product, a revamped brand, and better packaging,
Charmin launched pilot programs in select cities. Within months, Charmin
climbed to the top of each test market. The initial success gave sales
representatives a story to sell. It’s hard to imagine now, but as the
brand expanded into new cities, retailers couldn’t keep it stocked. “The
thing just took off like nothing had ever taken off before,” Ed Artzt, a
sales and marketing executive, recalls.
After
two years, Charmin was the bestselling toilet paper in every region it
competed in. R&D created a better product, which led to a great
marketing plan, which led to big sales increases in retail stores. The
process was long, difficult, and cost millions of dollars, but it was
worth it. “The acquisition of Charmin,” David Dreyer wrote in the
company’s history book, “became the basis of several billion-dollar
brands and one of the company’s leading growth producers.”
Where does research and development go at Kraft Heinz?
It’s
staggering to contrast Kraft Heinz’s integration approach to P&G
and Charmin. It’s even more staggering when you look at one specific
business process: research and development.
As the Charmin example showed, research and development is at the center of a branded CPG firm. Consumer preferences change, and it’s up to manufacturers to develop new products that consumers want. In the food industry, consumers are transitioning away from fatty packaged food and toward healthy and fresh alternatives. According to Businessweek, from 2014 to 2017, the top 10 packaged food companies lost over $16 billion in revenue. No one is entirely sure what this means for legacy manufacturers like Kraft Heinz, but during this transition, Kraft Heinz slashed R&D budgets. In the three years before the merger, Kraft spent about 0.8% of revenue on research and development, already somewhat low for CPG firms. The table below shows how it only got worse once Kraft Heinz merged:
Data via firm annual reports
Making
matters worse, when Kraft Heinz actually made an investment in R&D,
it chose poorly. In an attempt to compete with healthier products, the
company invested $10 million to reformulate hot dogs — at about the same time the World Health Organization labeled the food as a contributor to the risk of colon cancer.
A different approach
To be clear, 3G management took on an almost impossibly tall order with a $72 billion acquisition of Kraft and Heinz. First, history is littered with failed mergers and acquisitions. Billion-dollar transactions rarely work out unless you’re the bank booking the M&A fee. Second, both companies were established CPG firms. Unlike P&G and Charmin, there was no real value in bringing Kraft’s products into Heinz’s existing business processes because Kraft’s processes were probably just as efficient. It’s not like Heinz hadn’t mastered producing and selling ketchup for the last 100 years.
P&G
acquired a regional toilet paper brand and spent enormous sums of money
developing a better toilet paper. It supported the product with
world-class marketing and sales. Charmin dominated the industry for the
last 60 years. 3G could have mimicked this approach. It could have
acquired Kraft and then targeted smaller, regional brands that produce
healthy options that would benefit from the company’s established scale
and business processes.
Instead, it pursued a strategy centered on two tactics: optimizing operations through cost cutting and generating leverage against retailers by creating the fourth largest food company in America. The former slowly and then suddenly deteriorated the value of the company’s legacy brands. The latter hasn’t materialized. In the case of the reformulated hotdogs, Kraft Heinz struggled to sell them to Walmart, which constitutes about 20% of the company’s yearly sales. The grocery goliath preferred Ballpark Franks and its own private label, leaving the new company in the same position facing many legacy manufacturers.
The
result is a company with legacy brands hemorrhaging sales to healthy
upstarts and an organization ill-prepared for the new reality.
“[Innovation] is a big driver for growth for the future, has to be
especially in the food industry,” Patricio, Kraft Heinz’s CEO, told investors in 2019. “But we have to do bigger innovation. We have to do fewer innovation[s]. We have to do bolder innovation.”
But
because Kraft Heinz is spending so little on R&D, these innovations
have yet to yield meaningful results. That’s because without properly
funded R&D, Kraft Heinz is stuck either treading the same path while
ignoring consumer trends or failing to innovate significantly and
quickly enough. Last year, in fact, one of the biggest new product
launches from Kraft Heinz was salad frosting.
