Industry Trend Analysis - Food & Drink: Key Themes For 2018 - MAR 2018

BMI View: In 2018 c onsumers around the world, particularly in developed markets, are becoming more informed about the health benefits, origin and sustainability of ingredients in their food, and are exercising caution over certain food groups entirely. Other trends of note in the year ahead are vertical over horizontal M&A, the end of the craft beer boom years, the start of the Marijuana boom and the latest outlook on technology changing the face of the food and drink sector.

Food & Drink Key Themes 2018
Themes Description Metrics Winners Losers
Source: BMI
Healthification Across Consumer, Company And Government All three stakeholders embracing this ongoing trend. More government policy in this area in 2018 Healthier product launches, 'sin' taxes, legislation, social media diet trends Niche brands, health focused companies, government revenue Legacy F&D manufacturers
Vertical M&A Not Horizontal F&D majors buying up niche brands but not other F&D majors M&A activity, 'healthy' branding, no mega-mergers Niche brands, health-focused companies Legacy F&D manufacturers not seeking new revenue streams
Craft Beer Boom Years Are Over Craft beer growth rates come down, opportunities in craft spirits, low alcohol wine Lower craft beer M&A activity, lower production, slower growth rates Drink majors that have acquired brands, niche spirits Craft beer brands competing for shelf space
Beginning of the Legal Marijuana Industry Product developments in California and Canada, serving as case studies for others Marijuana M&A, marijuana spending, share price performance Marijuana companies, edibles segments Potentially will cannibalise alcohol and tobacco sales
Technology In F&D Sector Technology changing the food delivery, food retail (grocery) and meal kits segments New tech products and innovation, startup funding, F&D e-commerce Food and grocery delivery, Food tech companies, use of tech in MGR Meal kits, legacy F&D not embracing tech
Free Trade Elevates Political Risk Ongoing free trade negotiations will impact F&D companies, political uncertainty from elections NAFTA/Brexit negotiations, currency fluctuations, reduced consumer confidence Retailers that either use domestic manufacturers or are geographically diversified Retailers with operations reliant on importing products from EMs

1) Healthification Building Momentum Across All Stakeholders

Healthification, the awareness about health benefits associated with certain types of food, has been a constant theme over the last few years, and is the defining trend of the food & drink industry. We therefore expect the healthification trend to continue in 2018. This trend will be more evident in developed markets and has typically been driven by consumers changing preferences and companies innovating to meet this demand.

In 2018, we believe the government will play a larger role in driving the healthification trend as governments step up efforts to lower obesity levels through healthy initiatives and introduce so-called sin taxes, levied on goods and products seen as harmful for consumption like alcohol, tobacco and sugary drinks. We have seen countries like the UAE, Saudi Arabia and Portugal impose a 'sin tax' in 2017. We expect this momentum to build in 2018 as countries like the UK and Ireland are set to impose their sugar tax in April 2018. We forecast this trend to continue on the back of growing concerns about diabetes and rising obesity levels. Meanwhile, beyond 2018, markets like Vietnam are also scheduled to introduce a special consumption tax (SCT) on sugary drinks in 2019 while in Singapore the government has pushed drink manufacturers to reduce the percentage of sugar in their drinks to less than 12% by 2020.

Consumers will also be driving the healthification trend in 2018 as they continue to become more informed about the food choices they make through the help of social media platforms and other awareness campaigns. Consumers are also demanding greater information about their food, pushing the demand for greater transparency in food labels. Subsequently, consumers are becoming more ethical, showing greater concern about animal welfare and the sustainability of meat production. On the back of this, consumers are demanding more organic, vegan and vegetarian food options in line with the perceived health benefits of these foods.

Finally, food & drink majors have started to respond to consumer's demand for healthier food options and will continue driving the trend. In response to consumers switching to vegan and organic diets, food manufacturers have either launched vegan or organic versions of their existing brands or have acquired smaller organic or vegan manufacturers ( see ' Food Manufacturers Respond To Vegan Trend', September 20 2017) which we project will continue in 2018. Meanwhile, drink manufacturers have also responded to the sugar tax through shrinkflation, which involves reducing the size of the can while keeping prices the same ( see ' Shrinkflation To Boost Pepsi Profits', July 3 2017). Another strategy used by drink manufacturers is substituting the sugar in drinks with alternatives. Coca-Cola is planning to launch 'Coca-Cola Stevia No Sugar' in a market outside of the US in 2018, sweetened solely with stevia leaf extract.

Healthification At All Levels
Consumer Company Government
Source: BMI
Veganism/Vegetarianism Shrinkflation (Snickers, Toblerone UK) Sin tax (UAE, Saudi Arabia)
Ethical consumption New recipes (Kraft Heinz - artificial flavours, preservatives and dyes removed from Mac & Cheese) Labelling/Nutrition information (Chile, US)
Superfoods Replace sugar (Coca-Cola Life and Coca-Cola Stevia No Sugar) Food safety regulations (China)
Plant-based alternatives Buy 'healthy' companies (Nestle acquired Sweet Earth). Offload 'unhealthy' divisions (Nestle's confectionary unit) Health initiatives (Canada, Singapore)
Social media Reduce alcohol content in alcoholic drinks (Heineken, Carlsberg, AB InBev and Tesco low-alcohol wines)

2) Vertical M&A Not Horizontal

Throughout 2018 we expect to see a rise in vertical mergers and acquisitions (M&A) over horizontal M&A. While the past five years have seen mega-mergers in the food & drink industry, we believe this era is largely over and do not expect to see major transactions in 2018. Beginning with the takeover of Heinz by Berkshire Capital and 3G Capital in 2013, this spurred the subsequent merger with Kraft Foods in 2015 for USD100bn, to create Kraft Heinz. Anheuser-Busch InBev (AB InBev) followed in these footsteps completing its USD130bn merger with SABMiller in 2016. Others, such as British American Tobacco merging with R.J. Reynolds Tobacco Company in 2015 for USD49.4bn, have demonstrated that this is occurring across the food, drink and tobacco industries.

Kraft Heinz is the major player in this space, causing shockwaves when its USD143bn bid for Unilever leaked to the public in February 2017. This has led to rabid speculation that Kraft Heinz may be looking to acquire other companies including Kellogg's, Campbell Soup, Mondelez International, PepsiCo, General Mills, Colgate-Palmolive and Kimberly-Clark. For the food producers, we do not expect to see any mergers, as they are all struggling with falling sales. Valuations are low as a result, with Unilever, Mondelez, Kellogg's and the others already introducing zero-based budgeting and cutting costs in order to boost margins - investment strategies that Kraft Heinz's owners 3G Capital pioneered. Issues with Berkshire Hathaway's holdings in Coca-Cola make a move for PepsiCo more challenging. Given its attempt to purchase Unilever, the more likely targets for Kraft Heinz are outside of the food & drink industry, for example personal care companies such as Colgate-Palmolive and Kimberly-Clark.

Other rumours hinted at an AB InBev merger with Coca-Cola; however, given the relatively recent merger with SABMiller and the fact it was forced to sell its majority interest in Coca-Cola Beverages Africa in October back to Coca-Cola for competition reasons, we do not expect to see a major move here either. Furthermore, our Country Risk team revised up the end-2017 Federal Reserve funds rate forecast from 1.00-1.25% to 1.25-1.50%, reflecting the increasing probability of a 25 basis points (bps) rate hike in December 2017. We also expect 50bps of hikes in 2018, at least two hikes during the year, ending at 1.50-1.75% and a further 50bps hike is also expected in 2019, up to 2.00-2.25%. This will act to deter companies from making major moves funded by debt if the cost of borrowing is going to increase over the coming years.

While we expect to see less horizontal M&A activity, we do expect a continuation of the vertical M&A trend, with food & drink majors increasingly buying up smaller, niche brands that are impacting market share, as consumer dietary patterns change. Core product offerings such as cornflakes cereal from Kellogg's, soup from Campbell Soup and Kraft mac and cheese dinners are resonating less with consumers in 2018; instead, they are opting for a range of newer brands, which offer a healthier approach, innovative flavours or a brand identity that better connects with shifting consumer preference towards healthification.

For example, in 2017 alone Nestle has acquired plant-based foods manufacturer Sweet Earth and high-end specialty coffee roaster Blue Bottle Coffee. Maple Leaf Foods acquired plant-based protein foods manufacturer Lightlife Foods, Coca-Cola bought rival Topo Chico, Danone completed its acquisition of dairy alternative producer WhiteWave Foods and Campbell Soup is in a protracted acquisition of natural and organic meals company Pacific Foods. We have long expected that Hain Celestial Group will be a potential target for the food majors, and other niche or craft brands in the food & drink industry will continue to be acquired during 2018 in our view. It can be difficult for majors to innovate and create these new brands internally given their large size, so buying up growth is an attractive alternative to tap the booming demand for these products.

Futures Market Too Low, Fed Voters Too High
US - Fed Funds Rate, %
Note: Figures represent midpoint of Fed funds range; FOMC projections from September 2017 meeting. Source: Bloomberg, BMI

3) Craft Beer Boom Years Are Over

We believe that the boom in craft beer has largely finished moving into 2018, with signs in 2017 that production and the number of new breweries is tailing off. We still expect that craft beer consumption will outpace that of traditional beer by some distance, and the demand will still be there for niche brands, but growth rates will come down from high double digits to more stable rates. This is partly due to higher base effects, as craft beer consumption has reached mainstream levels of spending. Looking at the most recent statistics from the Brewers Association, we have seen a slowdown in production in 2016 (latest available data), with the volume of barrels increasing by 0.9%. This represents a slowdown from the highs of the boom over 2010-2015, when production of barrels averaged 18.4% per year.

Changing dynamics in the industry that took place over 2016 and 2017 will begin to be felt in 2018. Many of the top craft breweries have been bought out by the major beer producers over the last two years. AB InBev, Molson Coors and Constellation Brands have responded to the craft beer boom by acquiring some of the faster growing enterprises, hoping to tap into the growing trend towards craft and niche brands, while also addressing their falling sales and market share. This has led to craft breweries such as Goose Island, Kona, Lagunitas, Redhook, Four Peaks, Devil's Backbone, Wicked Weed and countless others being owned by these major global companies. With the resources of AB InBev at their disposal, Goose Island can ramp up production, increase its advertising and ensure it gets distributed into more retail locations.

The rise of these 'ex-craft' brands will make life more difficult for independent breweries, as competing for shelf space will become more expensive. Ex-craft brands do not market themselves as a Molson Coors or AB InBev subsidiary, so consumers who are not diligently following M&A activity in the craft beer industry will continue to buy these products believing that they are independent. For true craft breweries, advertising their independence, their local/regional provenance and use of local ingredients will be critical to ensure success in 2018. Many retail stores, bars, restaurants and other alcoholic drinks establishments will continue to support these craft brands as they look to appeal to millennial consumers, but again this will become a more competitive arena as craft brands jockey against each other for limited shelf space and beer taps in these locations.

Following the merger between AB InBev and SABMiller, the Department of Justice has pledged to scrutinise any future craft acquisitions, in order to ensure the company is not monopolising the market. As AB InBev has acquired about 10 craft breweries in the past few years, we would expect to see it slow down its acquisition spree and focus on building up its existing craft brands. While most acquisitions have occurred within the US, we expect to see more M&A activity in other markets as beer companies look to expand into craft across developed and emerging markets. Another area of growth for brewers is in the low/non-alcoholic beer segment. This area is not expected to cannibalise on traditional beers, but is actually bringing in new consumers who are not typical beer drinkers. We have long highlighted the Middle East as a region of growth for non-alcoholic beers, but there is also a growing sub-segment of young consumers who are teetotal or avoid the health drawbacks of alcohol consumption. Heineken has reported strong growth in its low alcohol beer over 2017, for example, and we also have high expectations for low alcohol wine in the UK.

Beyond beer, we are still optimistic on the outlook for craft spirits which still have plenty of room to run compared to craft beer in our view. Craft whisky, gin, rum and mezcal are recording some of the strongest growth in the alcoholic drinks industry. There has already been some M&A activity in this arena with Constellation Brands acquiring High West Distillery, Pernod Ricard buying out Monkey 47 gin and Avion tequila and Bacardi taking over Angel's Envy bourbon among other transactions. Going local will again be critical in winning over new consumers, as they eschew mass production in favour of their community.

Craft Production Slowdown
Global - Production (bbls)
Note: 1 barrel = 31 US gallons. Source: Brewers Association

4) California And Canada Paving The Way For Marijuana Industry

Canada is set to legalise and regulate marijuana production and consumption by July 2018 and in late November 2017 the government announced that cannabinoid-infused foods and beverages would also be approved alongside this legalisation. Also important to this is that recreational legalisation will also occur from January 1 2018 in California, offering the largest potential market in the US. This paves the way for the development of consumer products for the marijuana industry beyond inhalation, which is the most common form of consuming marijuana. We do not believe this will remain the case following legalisation, as there are growth opportunities in 2018 among the other methods to cater to a wider range of consumers. We believe the real growth drivers will be in the edibles segment, which will become a star performer backed by a wide range of marijuana-infused food and drinks. It offers an easier entry point to first-time or inexperienced users who may be wary of smoking.

This opens up the potential for a massive range of marijuana food-based products that can be used to target this market, attracting companies in the confectionery, baking and drinks manufacturing segments to produce marijuana-infused candy, chocolate bars, popcorn, coffee, shakes, sodas and everything in between. Local companies in Colorado and Washington are driving these trends including Mirth Provisions' infused sodas and sparkling tonics brand Legal, infused coffee from Catapult and Auntie Dolores, a range of gourmet snacks such as pretzels and popcorn cooked with cannabis oil. This ramped up in November 2017, when alcoholic drinks company Constellation Brands signalled a major intent to explore this market by agreeing to a USD191mn deal for 9.9% of Canadian marijuana company Canopy Growth. Constellation has announced that it plans to develop cannabis-based beverages that do not contain alcohol, a sensible approach as there are still legal and medical challenges that stem from mixing alcohol and marijuana. It will also be restricting its sales to Canada and not the US until it is legal at the federal level, allowing it to experiment with a range of products in foreign markets before it attempts to break into its domestic market. This followed Lagunitas Brewing in September which launched an India pale ale (IPA) made with marijuana terpenes, the aromatic compounds of fragrant oils from the cannabis plant. However, the beer, which is only available for a limited time in California, does not contain tetrahydrocannabinol, which is the active ingredient responsible for causing a euphoric high.

For 2018, we expect marijuana-infused products to mostly be viewed more as a novelty product, as it is unclear if the average or first-time consumer will substitute these for traditional products such as beer, depending on taste, texture and aroma among other reasons. Over the longer term, products with CBD (the non-psychoactive cannabinoid) will be important for the medicinal functions as anti-inflammatories and anti-anxiety remedies. US retail stores across California already sell hemp-based CBD-infused sports drinks, juices, nutritional shakes and teas. Products developed in Canada and California will dictate how the market will play out in other US states and countries that choose to decriminalise marijuana. We also believe we will see more food & drink companies as well as tobacco producers look to enter this space, through M&A or acquiring licences as they look to tap into a brand new vertical.

Marijuana Hype Builds As Legalisation Nears
Share Price Rebased From December 30 2016
Source: Bloomberg

5) Technology Defining Food & Drink

Technology as a disrupting force in the food & drink industry has also been one of our key themes for the past iterations of this yearly analysis. For the most part, this is changing the food delivery, food retail (grocery) and meal kits segments, as online ordering and home delivery continues to drive competition in the sector. This is more difficult for food manufacturers, although Nestle is trying with the launch of its XiaoAI, an artificial intelligence family nutrition assistant and smart speaker that can answer questions on nutrition and health and provide custom recipes. Launching successful online platforms for individual brands is an area we expect these companies to explore, as going direct-to-consumer has advantages for cost savings and the ability to form more successful relationships with customers.

  • Innovation and technology will have the largest impact on the grocery sector in our view over 2018, with plenty of potential for disruption. This begins with the acquisition of Whole Foods by Amazon in September 2017, which will see the tech giant bring its own data, products and technology to the premium grocery retailer. Incorporating Whole Foods products into its Amazon Prime subscription service and convert Whole Foods' locations into click-and-collect centres are among the more basic changes we expect to see. In 2018, we believe we will see trials of its 'walk out' technology. China is actually ahead of the rest of the world in this area, with a number of grocery retailers trialling cashier-less stores, including Alibaba's Hema supermarkets. Other retailers will follow the lead of Amazon and Alibaba in this space, with the potential for the use of artificial intelligence, augmented reality, automatic replenishment, customised recommendations and other technological progress taking its first steps in 2018.

  • For meal kits, we predicted that 2017 would be a difficult year for these new companies as the infrequent order basis and challenge of embedding these products into consumer habits would hint at long-term problems. Blue Apron had an initial public offering (IPO) in June 2017, which was highly touted in the run up but fell flat on the day amid scepticism from investors. It has since been forced to lay off 6% of its staff in fulfilment centres and corporate offices as it tries to get back to profitability. It has declined from USD10 per share when it debuted on the NASDAQ to less than USD4 as of December 4 2017, and we see little hope for improvements over 2018, without a major strategic rethink.

  • In the delivery space, for both food (takeaway) and grocery, the key is faster delivery times at a lower cost. Offering in-store pickup at a lower rate is also advantageous, as it can help cut down on costs from both the retailer and consumer perspective. Consolidation has taken place in the food delivery space over 2017 and this is likely to slow down in 2018, as most major firms have been consolidated under monopolistic umbrellas such as GrubHub Seamless in the US, Delivery Hero in Germany and JustEat in the UK. This bodes well for these companies, as they will be able to use this market leadership to leverage higher fees out of the restaurants that are listed on the site, boosting their profitability. Most recently, GrubHub acquired Eat24 from Yelp in August 2017 for USD288mn. The fact that Yelp was able to sell for more than twice the amount it had paid for Eat24 in February 2015, at USD134mn, bodes well for the future of companies operating in the food delivery space. It is likely that further M&A activity in this space will be limited to the large firms picking off smaller threats where they emerge, or in underserved markets in order to maintain their dominance.

Losses Widen At Meal Kit Companies
Blue Apron Financials (USDmn)
Source: Blue Apron

6. Free Trade Elevates Political Risk

'Social' risk and political risk is an area we have highlighted as one of the key themes for Consumer & Retail companies in 2018 ( see 'Year Ahead 2018: Consumer & Retail' , December 8 2017). Faced by boycotts, bad social media coverage and other brand damage through supporting or opposing policies can have a negative impact on sales, although these have typically been short-term phenomena. The food & drink sector is the consumer sector that has been the most entangled in 'social' risk to date, impacting restaurants, manufacturers, retailers and others. This will be ramped up through political risk, both through ongoing negotiations on major trade deals and through elections in key markets. Both are likely to impact investment and long-term strategy decisions, making 2018 a standout year for the impact of the political landscape on the industry.

At the forefront of political risk-related developments are the ongoing 'Brexit' negotiations as the UK moves closer to its March 2019 exit of the EU, and between the US, Canada and Mexico, who are looking to finalise renegotiating the North American Free Trade (NAFTA) trade agreement before Mexican presidential elections in March 2018. Both will have significant repercussions for the food & drink industry given the major consumer markets involved and we have previously outlined some of the potential scenarios for each ( see ''Cliff Edge' Brexit: Consumer & Retail Implications', November 10 2017 ; 'What Our Clients Want To Know: NAFTA Q&A', November 23 2017).

The probability of the UK leaving the EU in March 2019 with no transition arrangement or trade deal in place has risen in recent months given a lack of progress in negotiations and ongoing divisions within the UK government over how to proceed. While our core view remains for a transition period of up to two years to be eventually agreed on by the two sides, UK agriculture subsectors that run a trade deficit (eg butter, corn, poultry, cheese, beef, rice, and pork) would see domestic demand and prices rise as imports become more expensive. Retailers, already facing tough market conditions, would attempt to limit price rises by currency hedging/cutting costs, but would ultimately see revenues and margins compressed. Discounters and grocery players (essential goods with strong supplier bargaining power) are best positioned to cope in this environment.

A lack of progress in NAFTA renegotiations, increasingly stringent demands from the US, and the tight time line set by negotiators, make it increasingly likely that NAFTA will collapse. Farm and agricultural lobbies in the US believe that the industry would be subject to steep tariffs from Canada and Mexico if the deal collapsed. On top of this, the Grocery Manufacturers Association (GMA) has also come out in support of NAFTA modernisation but not a withdrawal of the deal, noting that Canada and Mexico represent the two largest markets for exported processed food and beverages, approximately USD17.6bn in 2016, about one-third of exports to the whole world of almost USD40bn. Poultry, high-fructose corn syrup, fruits and vegetables, beef and dairy are some of the sub-sectors most at risk.

Elections in key food & drink markets may also add additional risk, although we note that these staple products are essential goods and not sensitive to volatile political or even economic risk. A shake up to manufacturing from a change in industrial strategy with new leadership or an increase or decrease in support for certain segments of the industry would be the more damaging results. Italy, Mexico and Brazil are the major markets we are watching this year, with elements of political uncertainty across all of them.

Canada And Mexico Exports At Risk From NAFTA Renegotiations
US Food & Drink Exports (USDbn)
Source: UN Comtrade