Your Pantry: COVID-19 and Beyond

Most fast-moving consumer goods (FMCG) companies are reporting unprecedented growth in sales and earnings as their product categories benefit from coronavirus-driven demand. One thing we are watching with interest is what the companies are saying about consumer behaviour during lockdowns, and how that behaviour is likely to impact category consumption going forward.

We can summarise the trends into four groups. The first is categories where greater at-home usage is driving the supermarket sales. These include laundry detergents, handwash, sanitisers and wipes, which is understandable given heightened hygiene concerns. Closure of bars and restaurants has driven a shift to cooking at home, which has resulted in an increase in usage of dishwashing tablets, garbage bags, seasonings, and frozen vegetables. Companies have also reported increased at-home usage of over-the-counter medicine and vitamins, despite it being questionable whether these have any beneficial effects in relation to COVID-19.  

In the second group are categories where consumers are stockpiling, driving demand well ahead of any increase in actual at-home usage. The most obvious and visual example is toilet paper, where news stories have highlighted the empty shelves and sometimes physical altercations over precious rolls, with Procter & Gamble describing “pantry-loading” as “extreme”.  Similarly, it is likely that consumers have stockpiled canned goods and frozen meals “just in case”, well beyond their actual desire to eat these products. It is likely that when normality resumes, we may see demand collapse temporarily in these categories as people use what is in their cupboards.

The third group comprises categories where at-home usage has not actually increased, but consumers have temporarily stocked up driven by fear of shop closures, lack of product availability, and wanting to reduce the need to visit crowded supermarkets. Diapers, infant formula, and toothpaste and toothbrushes fit this description, although generally, the level of stocking up is more moderate than the extreme levels observed in the second group of categories.

Finally, the last group consists of categories which actually reported sales declines. Impulse category sales (e.g. chocolate at the counter of your petrol station or supermarket) have been weak due to lower in-store foot traffic. Zoom calls with some of our colleagues also provides anecdotal support to the commentary that usage of razors and shampoos is down significantly from normal levels. Nightclubs and bars being closed, and social distancing measures proscribing close-quarters encounters has had a dampening effect on demand for gum, mints and condoms. We will likely see a similar impact on sales of sunscreen in the coming Northern Hemisphere summer, as restrictions remain around outdoor activities.

Whilst the commentary has been interesting, we are reluctant to jump to conclusions or create narratives around how the industry may evolve longer term based on what we observe in these extraordinary times. Ultimately, we continue to believe that the high return on capital enjoyed by the sector will continue to erode over the medium to long term, propelled by several structural changes. The pressure will be more acute for certain companies in certain categories, however, there are a few generally applicable issues.

One of the main reasons why big FMCG companies were able to sustain such high returns on capital historically was their cosy relationships with retailers. Part of this cosy relationship involved FMCG companies paying large sums to access the best shelf space, and retailers in turn giving the #1 or #2 brand the “category captain” role, where the brand effectively manages the category’s shelf space on the retailer’s behalf (as one commentator remarked, a “fox in the hen house” scenario).

This dynamic is changing, forced by the retailers out of necessity. A consumer shift to healthier eating has resulted in retailers adding more floor space for fresh and prepared meals to the detriment of traditional centre-of-store products. At the same time, retailers like Kroger and Walmart invested vast sums on data analytics over the last 10 years and now have a much clearer picture about what sells well within their stores, reducing their reliance on “category captains”, and have better leverage when it comes to price negotiations. The picture of individual consumer behaviour becomes even stronger when that shopper moves online. Finally, margin pressures from investments in e-commerce and competition with hard discounters like Aldi have resulted in retailers pushing harder in price negotiations, especially in relation to weaker brands, as well as pushing their own private label brands where they make better margins.

The relatively new world of e-commerce has lowered industry barriers to entry and we have seen some high profit margin categories fragment. Historically, when one launched a new FMCG brand, a huge capital outlay was required to set up a manufacturing plant, pay retailers slotting fees to put the product on their shelves and fund a national TV and/or radio campaign to build the brand. This was assuming that one could get financing. Today, one can arrange a contract manufacturer to make the product, build demand via social media influencers, and distribute via Amazon’s third-party seller platform, all at relatively low costs. Capital has been widely available from venture funds.

Aggressive cost cutting as espoused by 3G Capital and practised at companies such as Kraft-Heinz became in vogue at the same time as industry barriers to entry were eroding. Most FMCG companies undertook large cost-cutting programs to boost margins, reduced support provided to retailers for promotions and preferential displays, and cut spending on their supply chains, research & development and advertising. The companies that were most aggressive in this respect have seen organic growth stall and through 2018-19 began to commit more resources and sacrifice profit margins in an attempt to improve their sales performance. It is an open question whether these actions will be sufficient. We remain sceptical.

The sector has outperformed recently, with a significant upward re-rating of valuations, driven by the temporary boost to earnings from greatly increased demand, investors fleeing to these stocks as a safe haven amid great uncertainty and US 10-year Treasury yields collapsing from ~1.9% to ~0.70% over the last five months^[1].  Despite these factors, we remain cautious on the sector and are reluctant to chase performance given our views on the structural challenges faced by the industry.  

^[1] As at 6 May 2020. Source: FactSet.

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