Defying Consumer Confidence — Wither M&A?

It's no secret that consumer sentiment has taken a beating over the past several months. Rising fuel prices and commodity costs, the weak dollar, political uncertainty, declining home values, the "credit crunch" and its associated mortgage meltdown — all have contributed to a significant decline in consumer confidence levels as measured by The University of Michigan's Consumer Sentiment Survey. What does all this mean for M&A in the consumer products arena? From our perspective, the short answer appears to be a resounding, "it depends."

Consumer spending accounts for nearly 70% of GDP, according to reports. Anytime the consumer sneezes, the broader economy runs the risk of catching cold. Given the breadth of the consumer product category, however, it is extraordinarily difficult to make broad and sweeping generalizations that are applicable to all segments of the marketplace. While looking at prior periods of economic uncertainty would normally provide a framework of expectations, today's market environment is unique on several levels. Factors such as rising commodity prices and fuel costs are variables that have created new dynamics and rendered historic models less reliable. While some pockets of traditional strength and stability may well continue to perform, it's entirely likely that others will fade in prominence and/or be replaced by new market leaders that may even accelerate in more uncertain macroeconomic environments.

Consumer staples and other nondiscretionary consumer products have traditionally been viewed as relative safe havens during difficult times. For example, because people will need to eat regardless of business cycles, the desirability of (and prices paid for) food processing, manufacturing and distribution companies have often increased significantly when more cyclical industry segments have swooned. Moreover, such upticks have often been relatively broad in their effects. For example, branded products appealed to investors because of their perceived "staying power," growth characteristics, extendibility and price premiums. Prepared foods were viewed as "in sync" with the needs of dual-income households and demands on consumers' time. And private label products rose in popularity because they offered a value proposition that resonated well with stretched consumers. Similarly, other "staples" such as basic health and beauty aids and cleaning products have also performed well in downturns — though consumer preferences may shift somewhat between particular products and price points. It's also unlikely consumers will abandon the category as a whole, regardless of economic circumstances.

So why might today's environment be different? Simply stated: commodity prices.

Unlike the years between 2000 and 2002 when commodity prices were more stable and relatively manageable, the costs of some basic commodities (e.g., corn, wheat, fuel, etc.) have spiked dramatically and been extremely volatile over the past year or so. The effect seems to be most pronounced for those "in the middle," meaning small- and mid-sized companies with much larger suppliers and customers.

For example, mid-sized food manufacturers are forced to buy their input materials from the likes of Cargill, Archer Daniels Midland or similar giants from whom they are price takers, and then sell their products to grocery behemoths like WalMart, Kroger, and SuperValu, leaving little or no ability to pass along cost increases. They are being strained on both ends and are likely experiencing significant margin pressures. While the current operating environment may be most troublesome for small- and mid-cap names, large-cap food companies have also felt the pinch and collectively experienced a 4.5% drop in North American profits in the fourth quarter of 2007, according to estimates.

Since it's difficult to make a case that the organic growth of consumer staples industries as a whole can significantly outpace the growth of the population over an extended period, such companies have traditionally relied extensively on M&A to fuel growth and meet the expectations of investors. Margin compression (on the part of both buyers and sellers) will undoubtedly have an effect on M&A activity.

Does that mean M&A activity will cease?

We doubt it. We do, however, believe that buyers, particularly strategic buyers, will likely become much more selective with respect to the targets they pursue and will be most focused on the holy grail of growth. For example, Kellogg's November 2007 purchases of Bare Naked granola and Wholesome and Hearty Foods is probably indicative of large-cap food companies' ongoing fascination with the fast growing natural and organic food segment. Successful middle-market food companies such as Amy's Kitchen and Pacific Natural Foods may indeed be in a sweet spot that will capture the attention of larger food companies despite, and perhaps because of, market conditions.

Discretionary and so-called "luxury" consumer products are an entirely different story. In today's economic climate, the goal often seems to be to "get out of the middle." Consumers, particularly those with incomes below $150,000 that have historically "traded up," are more likely to scale back spending habits on expensive discretionary items. In contrast, extremely high-net worth individuals do not appear inclined to markedly reduce spending or curtail their lifestyles. This dichotomy helps create a bifurcation in the market between high-end and low-end luxury/discretionary products and the retailers who sell such products.

For example, branded purse and leather goods merchant Coach has indicated it plans to start moving further upstream by turning 40 of its nearly 300 stores into more upscale formats. Somewhat paradoxically, jewelry retailer Tiffany, perhaps the epitome of high-end retailing, has announced that some of its new stores will not sell the company's highest priced items and will instead focus on $200-and-under silver jewelry. The list is virtually endless.

There is no simple answer as to the direction of M&A activity in the consumer products arena. Various segments of the market will blossom while others wither on the vine. Product portfolios will be pruned and enhanced. Cost pressures will virtually halt transactions in selected sectors while simultaneously accelerating deal flow in others. Sacred cows will be slaughtered. The only constant will be change — and those who succeed will be the individuals and entities best able to anticipate, react to, and embrace such change.