Popular Brands Are Not Necessarily Profitable Brands

Mark is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It is important to understand that correlation does not imply causation. Many profitable companies boast of popular, well-known brands, but that does not necessarily mean that customers are loyal to popular brands or are willing to pay more for branded products. J. M. Smucker (NYSE: SJM) is a leading player in the domestic packaged food industry engaged in the manufacturing of jams and other processed foods.

Despite the fact that its peanut butter and fruit spread products have the largest market share in the domestic market, Smucker has been unable to successfully pass on raw materials cost increases to its customers in the form of higher prices.

Not all brands are created equal

While Tiffany can charge customers more for diamonds placed in its trademark blue boxes, consumers are not likely to pay premium prices for branded peanut butter and fruit spreads. Moreover, Smucker’s gross margin has fallen from a high of 38.8% in fiscal 2010 to 34.4% in fiscal 2013, a reflection of its inability to pass on a significant portion of the increase in the cost of ingredients to its customers.

Furthermore, the pace for revenue growth has significantly slowed down for Smucker. Its three-year revenue growth rate of 4.9% pales in comparison with the five-year and 10-year revenue growth rate of 26.2% and 18.7%, respectively. This is partly attributable to cost conscious consumers switching to cheaper alternatives such as generic brands. Soda drinkers are the exception when it comes to their loyalty to either Coca-Cola or Pepsi; most consumers of peanut butter and fruit spreads do not exhibit such intense customer loyalty.

Negative on revenue profile

In fiscal 2013, Smucker’s top 10 customers were responsible for about 63% of its total revenue. In particular, a quarter of its sales were contributed by its largest customer, Wal-Mart. The high customer concentration puts Smucker in a relatively weaker bargaining position vis-à-vis its customers. In addition, the increased adoption of private label products further tilts the balance in favor of Smucker’s customers.

Also, Smucker is targeting long-term revenue growth of 6%, with about half of that expected to come from M&A. While it has a strong track record of successfully integrating past acquisitions such as the former Procter & Gamble Folgers coffee brand, each new brand and business is unique and comes with its own set of risks. 

Last but not least, Smucker does not offer investors sufficient exposure to the most attractive growth opportunities in the developing markets. It generated slightly less than a quarter of its fiscal 2013 sales outside North America.

Future outlook

While Smucker registered record revenue and net income for fiscal 2013, the outlook for 2014 is muted. Management has guided for flat revenue growth and a modest 5% increase in diluted earnings per share for full year fiscal 2014. The lower than expected growth estimates for its single serve K-Cup coffee business (management guidance of 15% growth in fiscal 2014 versus 65% in fiscal 2013) and peanut costs remaining high in the first half of fiscal 2014 are the key factors contributing to these disappointing forecasted numbers.

Peer comparison

Smucker’s peers include ConAgra Foods (NYSE: CAG) and TreeHouse Foods (NYSE: THS).

ConAgra Foods is one of the country’s largest manufacturers of branded packaged food products, with a commercial business segment supplying food ingredients to restaurants and foodservice operators. Similar to Smucker, ConAgra Foods has faced intense pressure from private label substitution over the past few years. It has responded positively to this threat with its acquisition of Ralcorp, the largest U.S. private label food manufacturer at the end of 2012.

Besides offering exposure to the growing private label market, Ralcorp is expected to contribute annual cost-related synergies amounting to $300 million by fiscal 2017. In view of that, management has guided for a minimum diluted EPS growth rate of 10% in fiscal years 2015-2017.

TreeHouse Foods is the largest domestic manufacturer of private label salad dressings, drink mixes and instant hot cereals. TreeHouse Foods shares some similar issues with Smucker, in terms of customer concentration risk and the lack of international exposure. Almost all of its sales are generated from the U.S. and Canada, with its top 10 largest customers accounting for more than half of its top line.

It reported a healthy set of results for the second quarter of fiscal 2013, with quarterly adjusted EPS increasing 8.3% to $0.65. In addition, it achieved a higher gross margin of 20.8%, compared with 20.2% a year ago, on the back of operating efficiencies and a better sales mix. TreeHouse Foods also raised the lower end of its full year adjusted EPS guidance from $3.00 to $3.07.

Looking ahead, its recent acquisition of Associated Brands, a leading manufacturer of private label specialty teas and powdered drinks will help to further cement its market leading position in the private label dry grocery market.

Conclusion

Brands are no longer sustainable competitive advantages in the packaged food products industry, as evidenced by the increasing popularity of private label products. You should avoid Smucker as it is likely to see its branded products cede more market share to their private label counterparts. In addition, Smucker’s high customer concentration, significant reliance on M&A and lack of exposure to growing geographical markets are negatives. With retailers seeking to enhance margins with private label products and consumers becoming more cost-conscious, I favor stocks with private label exposure like ConAgra Foods and TreeHouse Foods over Smucker.

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