The industry has already extracted much of the benefit to be had from improving productivity and concentrating on core brands. Meanwhile, its dynamics are changing. What comes next?
New strategies for consumer goods
Peter D. Haden, Olivier Sibony, and Kevin D. Sneader
Web exclusive, December 2004
At first glance, the leading consumer goods companies' strategy for handling the fierce competition of the past ten years looks robust enough to carry them through the next ten. Indeed, with the industry still caught between price-sensitive consumers and powerful retailers, some of the challenges facing it remain the same.
In the 1990s the industry's executives developed strikingly similar strategies to address these issues: focusing rigorously on the strongest brands and pursuing productivity gains. The results confounded those who forecast the demise of brands and the industry's rapid consolidation. Remember "Marlboro Friday," the day in 1993 when Philip Morris slashed the price of its core cigarette brand by almost 20 percent? A business weekly wrote, "Many brands will perish or never be so profitable again."1 But such pessimists were wrong. Anyone who invested every year since 1993 in the top 50 consumer goods companies (minus the tobacco companies, whose shares were affected by liability lawsuits) received a 12 percent annual return over ten years—results that outperformed those of most industry sectors. Eight of the top ten companies of 1993 (ranked by sales) were still in the list of leaders in 2003, and roughly in the same order.
But the strategy that worked so well might have run its course. A string of recent profit warnings at big consumer goods companies hints that the industry's dynamics may be shifting in important ways. The surge of discount retailing and the spread of private-label products are putting ever greater pressure on the price of branded goods. Companies have extracted much of the financial benefit from restructuring their portfolios and concentrating on core brands. And though managers doggedly pursue further improvements in productivity, most of the obvious gains have already been achieved.
For many companies, this strategy created a virtuous circle. Productivity gains financed investments in marketing and product innovation. Brands gained market share and expanded internationally. Their growth unleashed further productivity gains as burgeoning companies generated new economies of scale. Contrary to conventional wisdom, it did not take a unique, creative strategy to win; companies of different sizes successfully applied the same approach. The key lay in how well, and how quickly, they executed it.
Their results were impressive. A composite index of the top 50 consumer goods companies, excluding tobacco, shows that over the past decade gross margins improved by an average of five percentage points and earnings before interest, taxes, and amortization (EBITA) by four percentage points. The strategy has weaknesses, however.
First, it is proving difficult to propel the virtuous circle beyond portfolio restructuring and core brands. Acquisitions did make up for the lack of organic growth and helped increase margins as companies reaped the benefits of postmerger synergies. But they were costly: the industry-wide return on capital has been flat since 1998 as the amortization of billions of dollars in intangibles and goodwill absorbed from these acquisitions weighed on corporate balance sheets.
Another worry is that the easiest savings from improvements in purchasing, logistics, and manufacturing have already been pocketed. The move to centralized purchasing, for example, saved plenty of money but can take place only once; furthermore, the savings were achieved in a decade of favorable raw-material costs. The industry's strategic position is also troubling. Retailers continue to consolidate, adding to the bargaining power of the bulked-up survivors, and discounters continue to grow, especially in Europe, where chains offering inexpensive private-label and branded goods are gaining strength.
Where now?
Given this list of concerns, senior management could be excused for wondering how companies will grow. In our view, they must accelerate the pace at which they build capabilities in core functions, because day-to-day execution is—and will remain—an important factor for success. They must also serve emerging markets better, respond to the growing emphasis on value in advanced countries, and reap the benefits of scale and scope. Finally, we believe, some companies will strike out in bold new directions: outsourcing, entering new service businesses, or developing product categories that others have shunned.
Improving execution
Discipline in execution is nothing new, but it remains a top priority, despite the likelihood of decreasing returns. The important point is that big differences in the performance of companies persist; in other words, superior capabilities can be built and exploited. In the coming years, success will require ever sharper capabilities in the four main areas that sustain consumer goods companies: brand marketing, sales, innovation, and the supply chain. Average performance and best practices have improved spectacularly in each area compared with a decade ago. Tomorrow's winners will be the companies that not only adopt and roll out best practices more quickly but also introduce new approaches, often borrowed from other industries.
Marketing effectiveness remains a big source of gain for consumer goods companies; most, for example, are still struggling to maximize the value of trade spending—the money passed on to retailers to promote sales. Given how much money these companies invest in marketing, and the declining productivity of traditional advertising in many markets, managers will be under increasing pressure to allocate resources wisely across not only brands but also marketing tools and consumer segments. In sales, managing relations with retailers and the customer interface they control will be particularly important for the biggest multicategory companies, which will seek to take advantage of scale and scope.
Although every consumer goods company views innovation as vital, few are happy with what they have accomplished in this respect, especially compared with pharmaceutical and consumer electronics companies. The most successful consumer businesses will treat innovation as a strategic and organizational challenge, striving particularly to blur the distinction between home-grown and external ideas (obtained through acquisitions or partnerships) and tailoring their approaches to different types of innovation.
Some leading companies will also find ways to squeeze more efficiency from their supply chains by offshoring some of their operations, employing new technologies (such as radio frequency identification tags to track inventories), or redesigning processes to reduce waste and variability, as manufacturers in other sectors have done.
Winning in emerging markets
Although almost all consumer goods companies are active in countries such as Brazil, China, and India, few take advantage of their full potential. Many concentrate on the minority of the population that can afford expensive, Western-style goods, leaving local competitors to target the overwhelming majority of consumers with modest means. The locals have the edge in supplying neighborhood stores, which global companies find harder to reach, and have held off the big players by selling some products at very low prices while nonetheless generating profits. The Peruvian soft-drink maker Kola Real, for example, has gained ground not only in Peru but also in the large and profitable Mexican market.
It is hardly news to senior executives that big consumer goods companies must tailor their products to meet local needs; indeed, companies such as Procter & Gamble in China and Unilever in India have had some success with that formula. But many others still find it hard to come to grips with the big changes required in branding, distribution, and manufacturing strategies. Competing for the mass market in developing countries means rethinking the way things are done—not easy for huge, successful organizations. Those that do well there will become truly global corporations and will shake up the industry's balance of power.
The value conundrum
Serving value-conscious consumers in mature markets is also increasingly necessary. This notion might seem counterintuitive, since many companies have focused on introducing expensive innovations at the premium end of their markets. Nonetheless, though the premium segment is growing in many categories, the shift toward value is a more important trend for companies that mainly target the mass market. Retreating to a narrow premium segment might make sense in categories such as vodka but would prove self-defeating in household cleaners. In addition, price competition stalks the premium segment: a growing number of retailers, such as the United Kingdom's Tesco, excel at offering consumers premium private-label alternatives.
The growth of discounters has accelerated the trend toward private-label goods and split companies into two camps. A few hard-liners continue to make and market only branded products and deploy marketing and sales skills to defend their share at the low end of the market. Many other manufacturers, in a spirit of "if you can't beat them, join them," supply retailers with private-label products, at least in some categories and countries. A number of paper-product companies, for instance, have developed a sizable private-label business outside their home markets while retaining a strong branded domestic business.
To decide which approach to take, companies must weigh their strengths and weaknesses. Those whose brands are below second or third place in market share and don't occupy a clearly defined niche might find making private-label goods the most attractive option. The same goes for companies that can't sustain the advertising and research spending needed to keep brands on top.
But underestimating the risks would be dangerous: private-label supply is no longer an amateur sport. The skills required to stand out in that business are different from the core know-how of a supplier of branded products—not just in manufacturing but also in product development, logistics, and sales. The decision to develop those new skills must be a conscious, strategic one, not an afterthought.
One is that single-mindedness, responsiveness to consumer needs, and the ability to move quickly will continue to help category champions match or beat the giants' performance. Some of these champions will continue to consolidate fragmented categories—a trend that has already affected categories such as beer and some segments of personal care, among others. A handful, aiming to defend their independence, might join forces in mergers of equals, thereby avoiding the acquisition premiums that have hurt the industry's performance in the past. Others will seek to defend their independence by entering into alliances and joint ventures to find new avenues for growth (as PepsiCo and Unilever have done in tea-based drinks). Ultimately, new category champions will emerge as the heavyweights spin off some of their categories or break themselves up into several companies. This development would represent the final triumph of the focused category champion model.
In the alternative scenario, the heavyweights would find creative organizational solutions to the traditional trade-offs between the global management of a number of categories and brands, on the one hand, and local responsiveness, on the other. These companies would harness their considerable resources, for example, to pioneer breakthroughs in fundamental technologies. The payoff from using electronic identification tags to track inventories more efficiently would make it easier to swallow that technology's high cost. And they and some retailers would develop strategic partnerships leveraging scope advantages based on better insights into shoppers' preferences. Companies that succeed with these strategies will be in a good position to justify acquisitions—prompting a new wave of industry consolidation and challenging the prevailing orthodoxy that favors category champions.
Try unorthodox strategies
Some companies now limited by the orthodox approach might consider quite different strategies to spur growth. They have several innovative options.
New business models
Traditionally, consumer goods companies have been vertically integrated: they design, make, market, and sell their products. Increasingly, however, they will depart from this model and outsource some or all of their production to third parties—a trend that has already started in apparel and consumer electronics. The final form these consumer goods companies take will differ markedly from one category to another, but a range of business models could replace the integrated monoliths that now dominate. Contract manufacturers that make but don't brand products, for example, will coexist with pure branding companies that do no manufacturing. Often the former will build capacity by acquiring and restructuring assets from the latter.
This approach is less radical than it sounds. Coca-Cola and many other beverage companies routinely outsource bottling operations. High-end perfumes often come from contract manufacturers. And in some segments, such as home and personal-care products, the outsourcing strategy is steadily gaining ground: the contract manufacturer Budelpack, based in the Netherlands, recently announced its acquisition of manufacturing assets from Colgate-Palmolive, Henkel, Sara Lee Corporation, and Unilever.
Where brands continue to rule, the rationale for outsourcing is simple: management can concentrate entirely on dealing with customers and consumers—the main engines of growth. Indeed, many companies find that they can think more creatively about developing new products and stretching their brands into new categories when they no longer have to worry about keeping factories occupied. This approach would also promote a great leap in a company's return on capital employed.
The supply company too can create value. A management team focusing 100 percent on operations is better placed to build skills and generate improvements than the management of an integrated company. Operational excellence has a direct impact on profits; our evaluation of the best pure private-label suppliers shows that their profitability is on par with that of their average-performing branded counterparts. Moreover, the prospects for growth are better, since supply companies can produce goods for a variety of customers and tap into the growing market for value-oriented products.
Not every maker of branded goods should play this game. In some cases, proprietary manufacturing expertise is a source of competitive advantage that cannot be risked, even with watertight contracts to protect products and processes. In other categories, margins are too slim and the potential to cut costs is too slight for profits to be shared with a contract manufacturer. Concerns about product safety or the sourcing of ingredients are also easier to address with in-house operations. To decide whether outsourcing makes sense, companies need to assess each product and category in individual geographic regions—and, of course, evaluate possible suppliers.
These businesses and other successful forays into the world of services share several important characteristics. They have real consumer appeal and avoid head-on competition with mainstream retailers. They are managed separately from the core of the enterprise to avoid stifling them with big-company controls, costs, and attitudes. Most important of all, their senior executives understand that developing new businesses takes time and that nascent ones cannot be measured by the same yardsticks applied to established brands.
The move toward services is challenging. It requires new skills and runs the risk of damaging core brands by stretching them into territory that is hard to control. Moreover, during the initial growth phase, returns are paltry compared with those from a core business. Still, as consumers everywhere demand more service, some companies will find ways to provide it. In principle, any corporation, whether large or small, could enter this new arena, but the bar is high: you need not only creativity to invent attractive concepts but also determination to realize them.
The forgotten categories
A handful of companies might gain an advantage by focusing on product categories, such as traditional grocery products and canned foods, that global operators have forgotten. While multinational companies were busy consolidating, a new breed of consumer goods player stealthily gained ground: private equity firms that acquired local businesses in categories that multinationals were divesting or ignoring.
So far, the evidence suggests that firms such as BC Partners and Hicks, Muse, Tate & Furst have been highly successful in the industry. Their formula is well-known: acquire a stand-alone business, either from independent shareholders or from a multinational reshaping its portfolio, add financial leverage consistent with predictable cash flows, and give management the incentives and authority to improve the performance of the acquisition. After spending a few years building it up, such firms sell it—to a trade buyer, another private equity firm, or the public through a stock offering.
This approach provides a template for some consumer goods companies searching for growth. They can optimize a portfolio of local businesses—concentrating on categories that are too small or fragmented for the giants—without much regard for the synergies among them. Usually, these categories (which include some canned foods, breads, fresh-and-ready meals, and seafood) are relatively small, sensitive to local tastes, or dependent on local supply chains.
The industry's largest companies might have difficulty playing such a game: after all, they have spent the past decade getting rid of small brands and would have a hard time explaining an about-face to investors. But some midsize consumer goods companies could make this a viable strategy. They have little hope of becoming global category champions, because they lack the brands, the marketing capabilities, and sometimes the financial wherewithal. Rather than mimicking the global giants, they could adopt a different mind-set and organizational model, taking the private equity firms as their inspiration.
Ever greater price competition means that the pace of change in consumer goods is likely to accelerate. The companies best placed to thrive will be those prepared to take their quest for growth into new arenas.
About the Authors
Peter Haden is an associate principal in McKinsey's London office, Olivier Sibony is a director in the Paris office, and Kevin Sneader is a director in the New Jersey office.
The authors wish to acknowledge the contributions of Christian Barker, Peter Freedman, and Nicola Calicchio Neto.
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