The 2022 Outlook for Food and Beverage Companies and Investors
By Ken Bravo, Managing Director – Food, Beverage and Agriculture, Capital One
We’re quickly approaching two years of broad disruptions stemming from the Covid pandemic. What might this mean for food and beverage companies over the course of the next 12 to 18 months?
Food and beverage companies have had to adapt to fundamental economic and social changes including, but not limited to, the abrupt transition to at-home eating and associated “pantry loading,” staff shortages, quarantine disruptions, Covid protocols throughout the manufacturing process, virus variants and resurgences, vaccination-related challenges, and supply chain disruptions.
As a result of these challenges and the government’s expansionary monetary, and fiscal policies, in June 2021, the North American (and much of the global) economy started to experience material levels of inflation. The overall price increases and pressure on the labor market worked their way into the food and beverage supply chain. Today, on a year-over-year basis, we have seen food costs increase between 5% and 15%. The ability of suppliers to pass through multiple price increases was unprecedented. With resulting inflation at a 40-year high, the Fed has signaled as many as four rate hikes for the coming year.
What does all of this mean for food and beverage companies and their investors? The answer depends on several factors, including the relevant business sector, geographic location, positioning along the supply chain, size/scale of the company vis-a-vis its competitors, and the financial leverage/strength of the individual company.
Let’s start with rampant labor shortages since many large businesses today operate with thousands of open positions. We spoke with the CFO of a major, vertically integrated North American animal protein company who noted a labor shortfall equivalent to 10% of the company’s work force. The result is that they have fewer shifts than they would with a right-sized labor complement, with no near-term relief in sight. Management teams across the broader food and beverage industry will continue to actively manage these shortages to minimize operational disruptions/shortfalls and maximize revenues/margins in the face of sub-optimal workforce availability. Industry leaders are also looking to increase automation to reduce the strain of the labor shortage and continuing wage increases.
For the first time in years, F&B executives are also facing significant inflation and its impact on the cost of borrowing, which is expected to increase throughout the year. During the past two years, the Fed increased the nation’s money supply by an astonishing 40%, an action that kept interest rates at historical lows. The size of rate increases coming our way may not be large on a nominal basis but will be significant in proportion to existing rates and result in sizable relative percentage increases in interest costs, especially for businesses that are highly leveraged.
Proactive finance managers should be considering ways to limit or reduce debt and fix rates on a portion of their long-term debt – although some analysts may argue that today’s fixed rates already price in expected Fed rate increases. We recommend early discussions with financial market experts to clarify and manage balance sheet risk, interest rate uncertainty, and to explore financial and commodity hedging strategies.
Lenders are reviewing portfolios for potential downgrades and borrowers should expect average leverage amounts to soften as bankers and other credit suppliers dial back their risk appetite. A move towards more conservative lending practices combined with higher interest rates as many businesses absorb higher labor and other input costs, means lower financeable EBITDA from margin compression and reduced enterprise valuations.
While pandemic-period M&A valuation and leverage ratios kept up with pre-Covid market benchmarks, we may well see a period of reduced M&A activity as buyers are normally quicker than sellers to adjust price bids to their valuation beliefs and expectations. This may be especially true for financial investors who tend to seek higher leverage in their investment processes.
However, the biggest factor preventing food and beverage M&A activity is not financing or leverage – it’s cost inflation and smaller players’ ability to pass through price increases. The scope of the impact depends on the relevant competitive industry dynamics of each category and the inherent demand price elasticity.
The biggest issue we’re seeing within current M&A processes is how the relevant parties are dealing with Covid-related EBITDA adjustments. Sellers are trying to factor in adjustments for cost inflation and buyers are seeking clarity in regards to the volume impact of price increases, as well as trying to determine which cost increases will be temporary and which will be permanent. Until the dust settles, this uncertainty will slow down the M&A market – except for companies in high-growth markets such as better-for-you and plant-based alternatives.
Nevertheless, strategic investors are going to be more careful and selective. Financial investors will have the opportunity to invest in good companies that need capital to reduce labor requirements and address Covid-impacted operations, or to weather the storm in markets where price increases are limited or impact volumes.
Food and beverage companies with business models focused on ESG and/or technology are expected to continue to attract capital from financial investors. In addition, businesses that benefited from the Covid pandemic may explore sale options, particularly in the case of family-owned businesses experiencing generational change in ownership.
CFOs and finance officers will also need to consider the impact of output price increases as companies try to pass on higher input costs. Larger companies and/or those with greater market pricing power generally will be more successful in doing so, while younger and/or smaller companies may face thinner margins due to a weaker competitive position in their markets. Feedback from several industry managers, investors and bankers suggests that for the most part, cost increases have already been passed on, hence the resulting food cost inflation.
To illustrate some of the aforementioned points, here is interesting perspective from F&B insiders:
During the initial portion of the pandemic, food and beverage companies experienced deflation in input costs which helped offset some of the profit reducing pandemic driven volume decreases. However, now that has turned around and we are experiencing major pricing pressure (~8%) on both ingredient and labor costs; we thought our labor challenges would reduce when the pandemic relief bill rolled off last fall but that hasn’t happened; as a result, we continue to suffer theoretical vs actual plant utilization issues; we have passed on our input costs through price increases and will just have to wait and see how that impacts 2022 product volumes and revenues.
– Board member of one of America’s largest bakeries, January 2022
We have not raised prices and we’re absorbing higher costs right now. We’re focused on growing our customer base and our growth maximizing strategy. We’re also doing our best to control our inventory.
– Executive at a direct-to-consumer company that experienced significant customer growth with each of the three main Covid waves, February 2022
Food and beverage companies are going to continue to experience some additional inflationary, labor and supply chain pressures in the coming months. Now, more than ever, business leaders and owners need to proactively manage balance sheet liquidity and debt levels, double down on operational efforts to contain costs and improve efficiencies, and pay particular attention to a fluid pricing environment to protect market position and margins.