Consumer and Shopper Insights January 2011

Revitalizing the consumer-goods sector

For almost 40 years, the consumer-goods sector was a safe haven for investors. It rewarded them with annual returns well above the market averagesecond only to the energy sectorand in a bumper period from 1985 to 2002, it outperformed the S&P 500 index by almost 20 percent per year.
By Richard Benson-Armer, Peter Czerepak, and Tim Koller

Since then, the story has been less impressive. Consumerpackaged-goods (CPG) companies have battled rising commodity costs and failed to deliver significant value from a wave of M&A; price increases have been limited by the emergence of powerful retailers and changes in consumer behavior in favor of cheaper products offering greater value. Over this period, the CPG sector has delivered only small increases in returns, growing by around 4 percent year on year, slightly outpacing the S&P 500. CPG companies need a new blueprint for generating shareholder value. Through our work with industry players and by examining lessons of the past, we have identified five imperatives. Three are strategic: prioritizing revenue growth, looking for ways to reconfigure business systems to deliver higher margins, and being smarter about M&A. The other two are managerial: ensuring commodity price increases are passed on to consumers, and aggressively reducing selling, general, and

administrative (SG&A) expenses. While not all five imperatives will be appropriate for all players, CPG companies need to identify those critical to them and drive improvement if they are to reposition themselves for success.

The five lessons of history

From 1985 to 2002, CPG companies achieved average annual margin expansion of about 8 percentage points. Since then, the growth rate has more than halved (Exhibit 1). The difference? Players have lost sight of the importance of undertaking initiatives that expand revenue and margins in smart, selective ways; instead of focusing on what really matters, CPG companies have pursued initiatives that have been slower to deliver value. The five imperatives we have identified heed the lessons of both periods. Prioritize revenue growth Revenue growth is a critical driver of value creation given the already-high

margins and high returns on invested capital that CPG companies achieve. We have found that higher-than-average top-line growth is disproportionately rewarded by equity markets: the stock price of US household-product companies increased an average of 7 percent annually over a five-year period when they had above-average sales and margin growth, while the share price of peers with below-average sales and margin growth declined 1 percent annually (Exhibit 2). That said, not all growth is created equal. For example, some high-growth Asian markets offer CPG companies significantly lower margins than their current averages, while Latin American markets offer less attractive growth profiles but substantially higher margins. In many cases, Latin America is the better option to create value for shareholders over the next few years. In all cases, organic growth delivers greater value than that generated through M&A.

Exhibit 1: Historically, the consumer-goods sector has seen three stages of value creation.
Weighted average CPG TRS index vs S&P 500 TRS index1 1967 = 100%, adjusted for inflation Stage I: 196785 Organic growth CAGR2 % CPG S&P 500
1,600 1,400 1,200 1,000 800 600 400 200 0 1967 69
CPG sector S&P 500

Stage II: 19852002 Margin improvement CAGR % 12.1 10.2

Stage III: 200209 Mergers and acquisitions CAGR % 3.7 2.2

2.7 2.4

The bumper years between 1985 and 2002 were exemplified by aggressive international expansion, with players such as Colgate benefiting from increased exposure to profitable Latin American markets. It is imperative that companies prioritize revenue growth both in emerging and established markets, whether this growth is driven by leveraging product innovation or by entering new categories. Heinz appears to have taken this message to heart; the company recently announced plans to aggressively expand in emerging markets both organically and through acquisitions. Redesign business systems to align with price (or value offered) In the past, CPG companies drove category and margin growth by introducing innovative premium products that took advantage of consumers willingness to trade up. Such efforts to exploit increasing consumer wealth and spending delivered outsize returns, such as those achieved by Procter & Gambles Gillette as it launched increasingly sophisticated razor blades in its Mach product line. Now more than ever, companies are playing across a spectrum of price points; consumers are seeking value productsa trend exacerbated by the recent economic slowdownand they show few signs of reverting to previous buying behavior. Just one outcome of the shift has been an increase in sales of private-label products, which today represent about 18.9 percent of North American grocery-store sales, up from 16.4 percent in 2006. Against this backdrop, winning CPG companies look for ways to demonstrate product value and increase margins across all price tiers and product categories, including value offers. Success is often achieved through systematic changes to the business system, some large and some small. On a grander scale, Sara Lees

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1 CPG: consumer packaged goods; TRS: total return to shareholders; US-listed companies with real revenue (2003 currency) of more than $1 billion in any of the past 40 years. 2 Compound annual growth rate. Source: Corporate Performance Analysis Tool; McKinsey analysis

Exhibit 2: Higher-than-average top-line growth is disproportionately rewarded by the stock market.

Average stock appreciation by sales and margin-growth groups1 %

7.1

3.4 2.5

Average return
3.0

1.0
A Above-average sales growth, aboveaverage EBIT2 margin expansion B Above-average sales growth, belowaverage EBIT margin expansion C Below-average sales growth, aboveaverage EBIT margin expansion D Below-average sales growth, belowaverage EBIT margin expansion

1 Figures reflect 200409 performance for 44 US-listed consumer-goods companies. 2 Earnings before interest and taxes.

partnership with Philips Electronics on the Senseo coffee pod is an example of a business-system shift that provides clear value to the consumer; later entrants in this space, such as Flavia, followed suit. More targeted activities typically involve designing value into products, whether by removing costs from a product (for example, reducing weight associated with many corrugated and plastic package components), aggressively targeting value consumers (such as Procter & Gamble introducing its successful line of basics products), or by adding benefits that warrant higher prices (for instance, offering whole-grain cereals). Be smarter about M&A M&A has historically created great value in the CPG sector, but that value has been almost entirely concentrated with the selling shareholders, as synergies for the buying company particularly revenue synergieshave failed to meet expectations. There are not many large M&A opportunities remaining. However, there are attractive opportunities in this industry at the product and businessunit level. There is a clear role for smart, strategic M&A activity, and we see opportunities not only for acquisitions but for smart selling, through which current owners can create more value and reinvestment potential by divesting a business unit, product, or brand. We believe the sector is set for increased M&A activity. Current trading multiples and deal premiums are at their lowest point since 2000, there has been clear evidence of increasing consolidation in most consumer categories since 2003, and the stronger operational performance of larger players indicates that they will be able to realize margin improvements through further consolidation. In addition, there is increased private-equity interest in the sector, and companies are carrying large cash reserves and have reduced debt since 2008.

Companies should focus on targeting smaller independent players, buying brands or business lines, or buying divisions of companies where incumbents are not the natural owners or long-term winners. In the packaged-foods sector in the United States, for example, we see few available large or midsize deals in attractive categories, but the degree of consolidation possible in specific subsectors is much higher. These deals could be in the range of $1 billion to $2 billion, where a focused acquisition strategy can unlock significant value for the acquirer. Nestls acquisition of Krafts frozen-pizza business, DiGiorno, highlights this potentialit could create significant value, given the overlapping distribution network and ability to scale the frozen offering to the customer. Pass on commodity price increases From 1985 to 2002, CPG companies diligently passed commodity cost increases on to consumers and

maintained prices when raw-materials costs declined. We estimate that this single management action contributed 50 percent of all value created by the industry in the past four decades. Yet in recent years, the industry has destroyed significant value by not effectively responding as commodity prices rose faster than consumer prices. In fact, periods of economic recovery following the last three recessions resulted in five-year cumulative commodity cost growth of around 4 percent (1982 to 1987), 8 percent (1991 to 1996), and 40 percent (2002 to 2007) for the CPG sector overall, while players passed on price increases of about 9 percent, 9 percent, and 15 percent respectively. The net result is that from 2002 to 2008, the failure to pass on commodity price increases led to a decline of about 1 percentage point in average margin (Exhibit 3). While the current economic environment makes pricing actions difficult,

Exhibit 3: CPG price increases outpaced commodity cost increases in two of the last three recovery periods.
PPI1 RM1 Recession Recovery

Overall CPG sector

CPG product prices vs raw-materials price2 growth Indexed, 1980 = 100 CPG industry3
180 200

190 170 180 160

150 140

170 160 150 130 140 120 130 110 120 100 110 90 100 90 80

PPI: +9% RM: +8% PPI: +9% RM: +4%

PPI: +15% RM: +40%

Only in the most recent period did commodity costs rise faster than prices

8080 81 1 82 2 883 884 855 86 87 88 89 90 91 992 993 944 95 5 96 6 97 7 989899 99 0 00 1 01 2 003 034 045 05 06 084 90 91 2 9 9 9 8 8 3 4 8 86 87 8 8 3 9 0 0 0 2 0 0 06 7 07

In the last three recovery periods, CPG prices grew an average of 11% and RM prices grew 17% CPG product price increases have exceeded increases in raw materials in two of the last three recovery periods Raw-materials costs have risen significantly over the last decade; it appears they will continue to exceed PPI
1 PPI: producer price index; RM: raw materials 2 Weighted by sector-specific indices for raw-materials inputs (eg, soft drinks: aluminum, plastics, resin, raw sugarcane). 3 Raw-materials index weighted as a % of sector cost of goods sold, and PPI weighted as a % of sector sales. 4 Sector weighting for 2008 based on 2007 revenues. Source: US Bureau of Labor Statistics Division of Consumer Prices and Price Indexes; McKinsey analysis; Corporate Performance Analysis Tool

winning companies still manage to defray increased commodity costs. While it is impossible to predict commodity price changes, companies should be prepared to pass on increases and potentially maintainrather than reduceproduct prices if commodity costs decline. Both actions require actively investing in pricing capabilities and creating the right organizational structure to support pricing.1 The risks from failing to do so are enormous. For instance, if commodity prices increase by about 20 percent during the next five years but CPG companies hold prices constant, up to 4.5 percentage points of margin could be lostor about 33 percent of current earnings before interest, tax, depreciation, and amortization (EBITDA). In contrast, if commodity prices fall by 5 percent but prices are held constant, companies will increase margins by around 1 percentage point, translating to an 8 percent EBITDA increase. Aggressively reduce expenses Optimizing supply chains to remove excess costs and create more efficient and responsive organizations used to be a hallmark of the CPG sector. Yet between 2001 and 2009, SG&A expenses not only kept pace with revenue growth, but also outpaced wage inflation (Exhibit 4). In addition, advertising expenses increased steadily, from 6.7 percent of sales in 1996 to 8.8 percent of sales in 2006, driven by media-cost inflation. Many efforts to reduce SG&A fail to have the intended impact or prove to be unsustainable. We regard reducing these costs as a management imperative, and CPG companies need to examine

Exhibit 4: SG&A as a percentage of sales steadily increased through 2001 before it leveled off.
PPI1 RM1 Recession Recovery

Overall CPG sector

CPG product prices vs raw-materials price2 growth Indexed, 1980 = 100 CPG industry3
180 200

190 170 180 160

150 140

170 160 150 130 140 120 130 110 120 100 110 90 100 90 80

PPI: +9% RM: +8% PPI: +9% RM: +4%

PPI: +15% RM: +40%

Only in the most recent period did commodity costs rise faster than prices

8080 81 1 82 2 883 884 855 86 87 88 89 90 91 992 993 944 95 5 96 6 97 7 989899 99 0 00 1 01 2 003 034 045 05 06 084 90 91 2 9 9 9 8 8 3 4 8 86 87 8 8 3 9 0 0 0 2 0 0 06 7 07

In the last three recovery periods, CPG prices grew an average of 11% and RM prices grew 17% CPG product price increases have exceeded increases in raw materials in two of the last three recovery periods Raw-materials costs have risen significantly over the last decade; it appears they will continue to exceed PPI
1 PPI: producer price index; RM: raw materials 2 Weighted by sector-specific indices for raw-materials inputs (eg, soft drinks: aluminum, plastics, resin, raw sugarcane). 3 Raw-materials index weighted as a % of sector cost of goods sold, and PPI weighted as a % of sector sales. 4 Sector weighting for 2008 based on 2007 revenues. Source: US Bureau of Labor Statistics Division of Consumer Prices and Price Indexes; McKinsey analysis; Corporate Performance Analysis Tool

everything from removing middlemanagement layers to driving supply chain efficiencies and minimizing process and decision-making complexity. Some have seen great success on this front: for example, InBev reduced SG&A costs at Anheuser-Busch from around 32 percent of sales to about 26 percent of sales from 2007 to 2009. There was nothing radical about the measures taken to achieve this improvement: the company reduced head count, consolidated support services, eliminated unnecessary expenditure, rationalized contractor services, and optimized the network. * * * The recent performance of the CPG sector can best be characterized as a failure to reach its potential: while returns remain better than the broader market, they are a

far cry from the boom from 1985 to 2002. All companies have the opportunity to drive value creation beyond current levels, and it is critical that executives across the C-suite identify the appropriate strategic and management imperatives and push to improve performance.

http://csi.mckinsey.com Richard Benson-Armer is a director in McKinseys New Jersey office, Peter Czerepak is an associate principal in the Boston office, and Tim Koller is an expert principal in the New York office.

See Walter L. Baker, Michael V. Marn, and Craig C. Zawada, Building a better pricing infrastructure, www.mckinseyquarterly.com, August 2010.