Natural/Organic Industry Outlook
Many of the market trends that have been discussed by cooperatives in this magazine and other forums are coming true, but with a stunning ferocity and speed. This article examines our competitive retail world and the rapidity with which that world is adopting natural and organic products.
The over-arching trend is that we are in a rapidly maturing marketplace. A mature marketplace is generally a consolidated marketplace with a few players that are well capitalized, enjoy roughly equal economies of scale, and provide services that are pretty much the same. Price becomes paramount.
The natural/organic industry in the U.S. is a $32 billion industry and a subset of a $450 billion conventional food industry. The following are rough estimates of percentages of sales at retail:
Natural foods retailers -- 37%
Over the long term, supermarkets will be largest sellers of natural and organic products. The industry grew at an approximate 11% annual rate during the last three years. Better than 75% of current natural food consumers surveyed in the late 1990s expressed a preference to purchase their natural product through conventional supermarkets. Already the most mature natural product marketers/manufacturers sell between 60% and 80% of their goods through the supermarket channel. (Whole Foods and Wild Oats are included in this statistic; they are category killers using supermarket layout, operations, purchasing, merchandising, expansion and financial techniques.)
The supermarket industry, along with the food industry overall, is an enormous and mature industry that is currently undergoing further rapid consolidation. It is characterized by large cash flows but comparatively low margins. It is ruthlessly efficient. It is a stable industry lacking great returns on investment (ROI). Consolidated food entities with the clearest market plan, best access to capital (largest and strongest collective balance sheet), and longest reach have the highest ROIs and are the perceived safest investment for capital (private, public, debt).
The upscale supermarkets in most areas in the U.S. have natural products in their stores, now commonly as many as 4,000 items. They are merchandised in a variety of ways: from separate natural sets, to integrated sections of natural products next to the set of same type of conventional products, to natural products integrated into the conventional item set. These sets have been refined over the last several years, and many of the supermarket chain stores plan to double their bannered natural foods sets in the next three years.
The more mature supermarkets are now in control of their natural foods program, as opposed to using the distributor to manage the sets. The chains have hired the staff to give the same attention to natural as the conventional sets. They are working directly with the manufacturers and brokers regarding promotions, pricing, and product mix.
Additionally, the more advanced supermarkets are asking their conventional distributors to pick up natural products. They often have a better cost-plus deal though their conventional distributor than they will ever have through a natural products only distributor, due to the sheer volume of conventional products they purchase. This can mean that they change from a cost plus of 8-11% to a cost plus 3- 6% on those products. The cost structure for self-distributing entities can be even lower. Fleming delivers food to Kmart for cost plus 1%.
To give concrete examples: The larger and more mature supermarket players have natural product private label for commoditized packaged product. Kroger's private label organic aseptic soymilk has retailed for as low as 99¢ in the Cincinnati marketplace. In the Northeast, Trader Joe's has sold private label and branded aseptic soymilk for $1.49 to $1.69, and Whole Foods sells their private label at $1.45 and branded starting at $1.79.
One of our customers called to say she saw Organic Valley's 1/2-gal UHT milk at $2.99 retail in a South Carolina Wal-Mart. To help set the market price and ensure that our stores can be competitive, Northeast Cooperatives (NEC) takes a low margin on this product (to which volume discounts do not apply). Our price to retails is $2.66. If a retail store takes an 11% margin on our regular price, they can match Wal-Mart. The broker, SGN, writes turnovers for Organic Valley milk that would allow stores to match Wal-Mart's price while maintaining a 25% margin -- in fact, they could beat WalMart's price if they wanted to take a lower margin on this extremely high profile, price image item.
That is the issue. We all have to compete with more efficient channels of distribution and retailing now. On price sensitive and price image items we will have to match or beat their prices. Increasingly, this will apply to all cooperative retails as more and more supermarkets have natural products programs in their stores.
The current high/low game -- high everyday shelf prices to support many deeply discounted promotions -- makes the independent natural food channel inefficient and at risk. Inefficiency also comes from: redundant marketing; slack operations; low service density and uncoordinated volume.
A few thoughts on distributor costs through different channels:
- Customers determine what NEC sells, and much of how we sell it. No other factor determines our costs as greatly.
- Frequency of service combined with order or drop size is the largest determinant. The average number of stops that a supermarket distributor makes is 1.5 per truck. The average for self-distributing supermarket chains is 1 stop per truck: 50% lower. The average in the natural foods business (omitting service to Whole Foods and Wild Oats) is 10-12.
- The next cost driver is location. The average supermarket distributor services an area within a 100 to 150 miles radius from a warehouse with roughly $250-$500 million in sales, while natural foods distributors have a 400 miles radius and $80-$150 million in sales.
Supermarkets also are more standard in layout and items carried, meaning that most of the stores serviced use nearly 70% of the items the distributor carries -- a more efficient use of distributor inventories. Self-distributed chains such as Kroger's are considerably higher in their use of their own warehouse inventories. Natural foods distributors do not enjoy anything close to that, due to the highly fragmented marketplace they service.
Supermarkets get 95% of their product from their primary supplier in the applicable categories and try to bundle categories into one supplier to minimize costs. They try to limit the number of total store vendors to under 50 (that's for everything and every department). Natural food stores in the East usually only devote 70% of their available volume to their primary due to "deal" shopping and are doing well if they can reduce the number of vendors to fewer than 80.
All Natural foods distributors and retailers will have to:
- figure ways out to become as well capitalized as their competitors with similar size balance sheets;
- become as efficient while enjoying similar types of economies of scale;
- retain and enhance customer service and niche marketing (remain nimble and not become ponderous);
- share information in a disciplined fashion so that it is acted upon; and
- make changes with great intensity and speed, just as the best of the competition does.
Now that we have spoken about the competition that most of us experience or soon will experience, here are a few further thoughts on the future of our industry:
•Manufacturing: 3500-4000 firms, with fewer than 300 doing most of the business.
•Distribution: 5 major distributors -- Tree of Life, a subsidiary of a multi-national Dutch conglomerate; United Naturals (UNFI), publicly traded; Nature's Best, family-owned; and Blooming Prairie and Northeast Cooperatives, cooperatives owned by their member/customers.
•Retail: 14,000 stores plus several thousand GNC outlets (this number does not include supermarkets). The total is shrinking fast from stores being closed or sold by their current owners, who often report they can no longer compete with local supermarkets and category-killer stores such as Trader Joe's.
Most owners of manufacturing, brokerage and distribution firms and larger retails in the natural/organic industry are positioning their companies for acqusition by the conventional food industry (or by Whole Foods/Wild Oats), if they have not already done so. Current valuations on many larger natural/organic entities are too high to make sense in the public financial markets but may make sense to large conventional food companies with large cash flows seeking entrance into a high margin industry. For these companies, the natural/organic products are cannibalizing their conventional food business. They have no problem using their more efficient systems to manufacture, market, distribute and retail products that are higher margin than the conventional products. The major shift in the conventional foods industry is a change in awareness that "natural and organic" have to become part of every company's business plan. There is a strong sense of not wanting to be "left behind."
The few natural/organic companies which are public are rapidly becoming controlled by their stockholders as the founders liquidate their stock positions. This removes a key barrier to being acquired by larger companies. Examples of this are United Naturals and Whole Foods, both of whose stock is increasingly in the portfolios of large mutual funds and investment brokerages. Some even have taken out options with their major stockholders, such as that of White Wave with Suezia/Dean Foods (currently in dispute) and may be the intention of Heinz's 19% stake in Hain. If the precipitating events occur, those conventional manufacturers will own those natural/organic companies.
Although much of the natural/organic distribuiton and primary manufacturing segments are heading for consolidation into the conventional foods industry over the next 5 years, retail is different. Supermarkets are not interested in acquiring natural foods stores; they already have enough storefronts to cover their marketplaces. They do want to acquire the natural foods stores' customers and sales.
In the end, the natural/organic industry is really only a subset of a huge, low margin, old economy industry sector.
The dominant financial interests (Wall Street) and food industry are satisfied and encouraging of natural/organic consolidation into the food industry. It is quite profitable to roll up companies from this rapidly expanding niche growth industry, which is reaching into traditional retailing. There are many willing buyers in the conventional food indusltry who are able to leverage these acquisitions through their traditional distribution channels.
The advantages of natural/organic consolidating into the conventional food industry are many, including:
*greater distribution and penetration into more American homes;
*more efficient distribution of product through the channel;
*responsible stewardship of financial resources.
The disadvantages of natural/organic consolidating into the food industry are many, and likely include:
*marginalization of an independent natural/organic industry;
*reduction in innovation and creativity;
*reduction in "doing the hard work" pushing the frontier of natural/organic;
*significantly less concern for rigorous organic standards;
*slow down in integration of naturral/organic and alternative health modalities; and
*further discouragement to organic farmers who hope to gain a financial stake and remain financially viable.
As natural/organic products are pulled through more mainstream channels, values that are important to the majority of current natural/organic consumers -- product standards, traditional methods, farmily farms, responsible treatment of stakeholders such as employees -- are at risk.
Emerging Core Concept: Northeast Cooperatives believes that building, nurturing, and expanding a robust independent natural/organic industry is essential and achievable, although very challenging and daring. It is an appropriate legacy of the food cooperative movement, while using the effective structure of cooperative business to aggregate many small players. This core concept is not operating against the rapidly growing natural/organic component of the conventional foods industry. Rather it premises the advantages to consumers, society and the food industry if a dynamic natural/organic industry is grown and expanded alongside the conventional foods industry.
In a mature market place, which the natural products industry is becoming, price and convenience are the leading issues. The minimum standards for both will be set by the consumers, who will have many choices of channels offering natural products. The profile of the average natural foods shopper will largely be a shopper in a supermarket or mass merchandiser such as Wal-Mart or Costco.
A followup article will assess our responses to date, note successes and opportunities, and focus on some of the new initiatives contemplated within our co-op retail sector. We will also examine some very interesting new businesses that are arising in the natural foods retail sector, ventures intended to promote and enhance the competitiveness of smaller retails in the face of the juggernauts describef above.