Mo’ Margins Mo’ Problems

Investors have a tendency to gravitate towards leading brands and high margins. Such traits are often an indication of a high-quality business and meaningful intangible assets. While brands can be very valuable, they are not free. Brands require considerable investment and ongoing maintenance. Furthermore, similar to many things in business, there are cycles, trends, and risks associated with even the best brands. For example, many consumer brands have recently faced challenges as consumer perceptions, behaviors, and spending patterns change – few are immune. In fact, one of the strongest consumer brands I follow, Ralph Lauren (RL), recently reported a -16% decline in quarterly sales as it responds to structural shifts in retail.

The value of a brand fluctuates and is subjective. If a company places too high of a value on its brand, it may price its products or services too aggressively, risking sales and distribution relationships. The price difference between premium brands and lower quality brands or private label is also known as the price gap. The price gap is a very sensitive issue and risk for businesses with leading brands. If the price gap is too low, the company risks receiving an inadequate return on assets (the brand). If the price gap is too high, the company risks losing volume and customer loyalty. 

For example, my favorite ice cream is Publix GreenWise, a private label brand. I tried GreenWise after Breyers increased the price of their ice cream via smaller packaging (half gallon to 1 ½ quarts). In effect, the price gap between Breyers and Publix’s private label brand became too large and noticeable, so I gave the GreenWise brand a try. To my surprise the alternative was very good, and in my opinion, even superior (in taste and organic ingredients) to the more expensive leading brand.

Another risk consumer brands face is increased competition and consolidation within the retail industry. Bloomberg recently wrote an article discussing the growing threat of European grocers entering the U.S. market (link). As retailers and grocers are being squeezed by aggressive competition, their suppliers, including leading consumer brands, should also expect to be squeezed. As such, it may become increasingly difficult for leading brands to gain market share, raise prices, and maintain above average profit margins.

To illustrate, imagine you’re a grocer with low single-digit margins and European grocers are entering your markets. Keep in mind the strategy of your new and aggressive competitor is to take market share by undercutting you on price. Now imagine a branded company with 15-20% operating margins, a healthy dividend, and large buyback program coming to you and requesting a price increase necessary to maintain their margins. It’s similar to a wealthy 1%’er with a portfolio of FANGs asking the 99% for financial aid!

The J. M. Smucker (SJM) Company reported earnings last week and discussed many of these competitive issues. I consider J. M. Smucker to be a good business with many leading brands. That said, they’re currently operating in a challenging environment, with organic growth slowing to a crawl. Specifically, sales are expected to grow 1% in 2018, with EPS increasing 2%-4%.

On their quarterly conference call, management was asked if the pricing environment has become more challenging. Management noted they have heard about “additional pressure” but they have been successful in pushing through price increases. That said, they acknowledged it is taking a little longer to get price adjustments through with a couple larger customers.

Management was also asked about growing promotions in private label. They responded their customers view private label “as one of the arrows in their quiver to get them price points to compete with those channels [discount grocers and retailers]. And so we’ve seen aggressive activity in all the commodity-based things, in coffee, and across a number of different categories, right? So are we concerned about that? Yes.” Management went on to note they are fortunate to be the leading brand in their core categories.

On the pricing gap between their brands and private label management stated, “We understand what price points we need to hit on that product to maintain the right pricing gaps. In the vegetable oil business, we understand — we have great detail on the gap we need to have with private label. We can be above private label in all of those cases, but we can’t let those gaps get too large.”

As competition and consolidation in retail increases, leading brands will not be immune to volume and pricing pressures. Last week I discussed Casey’s General Stores (CASY) and how their customers are moving away from cigarette cartons to packs. Management also mentioned the shift from brands to generics. To slow this trend, leading brands will need to monitor their pricing gaps closely. If they maintain or increase the pricing gap, lower sales and volumes should be expected (Ralph Lauren is a good example). If the pricing gap is reduced to maintain volume and market share, margins could suffer.

While investors are attracted to leading brands and attractive profit margins, in the current consumer environment, I believe elevated margins should be analyzed carefully for sustainability and trend. High margins have always attracted competition; however, given current pressures on consumers and retailers, it may be purchasing managers that becomes the bigger threat. Given the difficulty many brands are having growing volume and passing on price increases, it appears this process may be well under way.