SPRING 2017

02 A Consumer squeeze on the horizon?

04 Retail strategies in an inflationary environment

06 Consumer trends putting greater demands on the supply chain

08 MY VIEW: Roger White, Chief Executive, AG Barr

Take your protein pills and put your helmet on. Commencing countdown, engines on. Check ignition and may God’s love be with you…The words from David Bowie’s second album, Space Oddity, released in the UK in 1972 just before we joined the EEC seem somehow appropriate as the Brexit rocket lifts off and we again take a leap into the unknown. Some are exultant and excited at the journey ahead with visions of a new more global future just around the corner; others, are reluctant travellers asking; where we are going, what dangers lie ahead and why on earth did we ever set out on such a madcap, reckless venture in the first place?

What looks certain is that the future is going to be a

very different place for all of us – food and farming included and consequently, now might be a good time for agri-food businesses to start to plan for the future. In this EFFP/Shore Capital Outlook we consider what the immediate prospects are for agri-food businesses in the early part of that journey and what some of the longer-term issues and opportunities are that agri-food businesses might want to start to consider:

• The outlook – and commentary – remain dominated by Brexit (apologies!) – both short and long term.

• After remaining surprisingly strong since the referendum the UK economy is now

potentially showing signs of slowing although rebalancing may be the

real story of 2017. In contrast the wider world economy is

doing better - showing surprising signs

of strength. This at least is a real positive for the UK which when combined with weaker

sterling is a potential

significant boost for the UK’s export

prospects and couldn’t come at

a better time.

• Overall the UK economy is rebalancing away from consumer expenditure and towards exports and import substitution.

• Global agricultural markets have picked up by nearly 20% year on year but high stocks and good prospects in the grain sector look like keeping a lid on things for a while.

• In the UK food sector though, input prices and food prices are rising again as we forecast in our last edition six months ago, due in large part to weaker sterling and combined with other factors this is pushing overall UK inflation up.

• Given the current relative stability in oil and currency markets as well as a degree of stability in underlying agricultural prices overall, we don’t currently see food inflation reaching the same levels seen in previous cycles.

• The Brexit outlook short term is therefore better than thought a year ago – due largely to weaker sterling and a strengthening world economy. But a few clouds are starting to gather and the next two years are likely to be a little harder and consumer expenditure somewhat weaker than that experienced over the past 12 months.

• Longer term now that Article 50 has been triggered it seems prudent for agri-food businesses to be paying a little more attention to the challenges and opportunities post 2019. A review of their business plans and the potential Brexit risks and implications looks like being a good place to start.

AGRI-FOOD OUTLOOK Forecasting and commentary on the year ahead from agricultural raw materials to retailing strategies

Ground Control to Major Tom

CONTACT US

EFFP Siôn Roberts – Senior Partner Mobile 07776 218514 Email sroberts@effp.com

SHORE CAPITAL Dr Clive Black – Head of Research Mobile 07785 990718 Email clive.black@shorecap.co.uk

02 03

The UK economy has not fallen off the cliff since the referendum vote last year and indeed the global economy is picking up in a way not seen for several years – synchronised growth across several key world economies. In the UK continued consumer spending has been key.

But the UK economy is rebalancing – away from consumer expenditure towards export growth (and import substitution). Overall as we enter 2017 the economy is slowing and inflation increasing, largely driven by weaker sterling (figure I). In 2015 and 2016 energy, fuel and food prices all contributed to lower inflation – in 2017 and 2018 they will all contribute to higher overall inflation.

Input costs into food manufacturers have shot up to nearly 10% but show the first signs of stabilising – and food inflation has been somewhat slower to respond this time around (figure V).

But nonetheless after two years where pay increases easily outstripped inflation the opposite is likely to be true in 2017 and 2018. Average earnings have recently begun to show signs of slowing (figure IV). Consumer spending seems likely to slow in 2017, potentially quite sharply as household finances become more constrained. Slower job growth and the cash freeze in working age benefits will also provide a brake on household incomes.

Business investment began to fall towards the end of 2016 and is likely to continue to slow although exports should grow – an important opportunity, as we have said, for some businesses in the agri-food sector.

Combined, these factors mean overall GDP growth may slow although perhaps by not that much - just somewhat slower than last year and rather rebalanced.

As far as agricultural raw material costs are concerned into the food sector, global agricultural prices are up 15-20% year on year (figure II). Sugar and dairy prices have been particularly strong but grain prices remain subdued and stocks high.

For the food sector, lower consumer expenditure is likely to eventually put renewed pressure on volume growth but the overall market size – as measured by population numbers – continues to grow and food inflation will boost overall sales numbers. Subject to major global supply shocks in the agricultural sector or a further major change in the value of sterling we see the current rebound in retail food price inflation moving to around 3-3.5% before levelling out and slowly falling back (figure III).

FIG V: FOOD MANUFACTURING PRODUCT PRICES AGAINST INPUT COSTS

[SOURCE: ONS/EFFP]

FIG III: EFFP RETAIL FOOD PRICE FORECAST

[SOURCE: ONS/EFFP]

FIG IV: EARNINGS AND INFLATION

[SOURCE: ONS]

A consumer squeeze on the horizon? Brexit checklist

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[SOURCE: BANK OF ENGLAND]

FIG II: GLOBAL AGRICULTURAL

COMMODITY PRICES [SOURCE: FAO] Businesses need to consider how best to use the window of relative stability we now have over the next two years but also to cast an eye to what might lie beyond.

Post 2019 – the most likely outcome according to the consensus is a new free trade deal with the EU and an implementation period post 2019 to help us get there – but with a not insignificant risk that we don’t get a deal in time and revert to WTO. The UKs overall trade performance will depend critically on the deal achieved. Whatever the outcome costs for agricultural and food goods imported from Europe are likely to rise whatever the outcome once we are outside the single market and new ‘non-tariff barriers’ come to bear.

Other than trade the key areas of impact for agri-food business are around labour availability, regulation and in agriculture the level of support once the UK leaves the Common Agricultural Policy in 2019.

Agri-food Business Brexit checklist:

Short term■ Review business plans: identify any realignment needed given the outlook and risks that need to be mitigated e.g. impact of weaker sterling and the potential introduction of tariffs in 2019.

Longer term■ Food imports: do you face a supply risk or increased costs if trade barriers are imposed in 2019?

■ Food exports: what new opportunities might be opening driven by a more competitive exchange rate and longer term potential new trade deals? Conversely how might tariffs impact exports into Europe?

■ Supply chains: is your business dependent on Brexit sensitive European value chains? What manufacturing footprint will work best for you and your suppliers into the future?

■ Contracts: are these being ‘Brexit proofed’ in case the worse should happen?

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FORECAST

04 05

Food inflation ‘on the cards’ for some time…The migration of a reasonably sustained period of food deflation into an inflationary one in the UK has been ‘on the cards’ for some time. The most simple cause of this assertion may be to reference the June 23rd 2016 UK-EU Referendum. Whilst certainly meaningful, particularly with the UK importing c40% of its foodstuffs and the subsequent sterling weakness, the political quake was not the sole factor behind grocery price movements.

…but deflation took longer to dissipate than expectedFavourable multi-year comparisons had already led us to anticipate with EFFP that deflation would become inflation H2 CY2016 and into 2017; if anything it has taken longer for deflation to dissipate than we previously anticipated, reflecting the real competitive intensity of the British grocery market. Additionally, the movement of sterling versus the US dollar and the mark-up of crude oil prices through 2016

(from lows of c$35/barrel (b) at the start of the year to c$50/b at the year-end) plus specific international (e.g. sugar) and domestic (e.g. bulk cream and pig meat) commodity prices have also contributed to the ironing out of the price reduction cycle.

Modest food inflation seen February 2017The February 2017 ONS CPI data recorded a modest amount of food inflation in the UK at 0.3%. We believe that this figure will continue to rise to a zone perhaps somewhere between 3-4% over the next year or so; it could be higher, it could be lower. Whilst we do not know what the peak will be and how long the inflationary cycle will last, we do feel that lessons from the last over-inflationary cycle will have been learnt by the supermarkets and that this will condition retail strategies in forthcoming quarters.

Retailers to learn from past experienceSo, what do we mean by this? Well, whilst subject to debate, we do not believe that it is

unreasonable to assert that between 2006 to 2012/13 the retail industry over-inflated; the 2006 year was one of a perfect inflationary storm where sterling weakness combined with rising oil prices and a negative harvest surprise. From this surprise the industry, remembering that the Big Four supermarket groups in the UK had more than an 80% share of the multiple market at that time, entered a cycle where, somewhat controversially we admit, the suppliers dominated the trade.

Supply domination presented the LADs with an opportunityThat domination let in the limited assortment discounters (LADs), which seized upon the opportunity to reach a combined share of c12% in 2017. That growth by the discounters and the pain and distress caused to the incumbent supermarket groups through over-inflation and complacency is a stress factor that lives within the Big Four today. So, whilst the LADs will still have a cheaper overall basket than the supermarkets on like-for-like KVIs, fresh foods

Retail strategies in an inflationary environment

and proprietary brands much of their advantage has been ceded.

Competition to mitigate some inflationary pressureAccordingly, whilst inflation is undoubtedly in the system, the competitive dynamics of the industry, particularly the need for the Big Four to sustain an in-touch mentality with the LADs, will serve to cap over-inflation to our minds this time around. In this respect, another process where we expect a more measured outcome than was the case in the last inflationary cycle will be promotions. Promotions have long played a relevant role in the UK grocery psyche, perhaps going back to the days of rationing, where shoppers sought out deals.

Learning promotional lessons tooWhilst so, the promotional tail started to wag the dog and participation in the UK touched 40%, with some categories in the 80%+ zone. Over-promoting damaged retailer and supplier

brand equity alike, noting as we do the active but deep and narrow promotional participation of the LADs. In a pending inflationary environment we shall watch with interest to see where promotional participation goes this time around. We sense that a more precise and intelligent market is more likely to follow this time around.

Manageable inflation is preferential to deflationMost industries prefer to work in modest inflationary rather than deflationary environments. The last decade or so has revealed to British supermarkets, maybe not to the LADs, the perils of over-inflation and sustained deflation. As the domestic market enters an inflationary phase, we believe that overall this will be beneficial to retailers and their supply chains alike. However, this will only be the case up to a point; that being when prices rise to a level that shoppers cut the number of items they buy (reduce volumes), reduce the value of what they buy (trade down) and/or go somewhere else cheaper (shop around).

Better retailing or the LADs will be waitingThe LADs will be awaiting with bated breath for signs of weakness with which to attack the supermarket groups, noting as we do that those LADs are not immune from tidal increases in input costs as evidenced by their lead higher of banana and liquid milk prices in the UK in 2016. The skill for all is to have good customer insight, a strong connection with shoppers as to what they can afford and cannot, what needs to be promoted and what does not and how to grow relevance, trip numbers and basket size and how not too. Retailing is always the same but always different.

Dr Clive Black Shore Capital Markets

06 07

A number of challenges arising for FMCG supply chainsWhy is this the case? Well whether you are a global FMCG or a business operating in the UK, consumer trends are changing at pace and more recently there is the added challenge of the weakness in sterling post the EU referendum vote. This has added incremental cost for many raw materials priced in dollars or euros. That’s before we start thinking about the potential for tariff shifts and any changes to the accessibly of products post Brexit.

Changing consumer trends: A healthier tomorrowTurning back to the consumer, we would highlight the increasing demand for lower calorie products as part of a growing health and well being trend. In the world of soft drinks there has also been regulatory intervention in the UK with the announcement of the ‘sugar tax’. We believe it is ironic to some extent given it is the category within the broader food and snacks segment that has done the most to reduce added sugar. However, the levy which comes into being in April 2018 is resulting in an acceleration of what were probably existing manufacturer’s strategies to use their technical capabilities to reformulate products to reduce sugar content. We also see that just recently the public health body for England has published new guidelines for sugar reduction and reformulation in food, challenging manufacturers to reduce the amount of sugar in their products by 20% over the next four years.

Affordable eating out of home taking calories from the supermarketsOther key trends we would point to include where calories are consumed which is seeing an increasing shift from the supermarkets (so at home) to other channels such as food service and impulse where we would also include the convenience channel. In addition, consumers are now arguably increasingly less loyal to brands especially the millennial generation. The growth of the discount channel is also driving an increased requirement for alternative pack formats as well as putting pressure on brands with often good quality private label options at lower prices testing the price premium of brands.

More innovation requiredSo what does this mean for the supply chain; the need for efficiency is as great as ever but it is getting to the point of efficient production that is the difficult part. Brand owners are increasing innovation levels to retain consumers and recruit new ones. This is highlighted by Heineken in which it has seen a doubling of its innovation rate to 11% of revenue in the past 5 years. Innovation increases the SKU range and adds complexity. The need for additional pack formats to meet the needs of the additional growth channels also adds complexity.

Searching for any incremental efficiencySo what we are seeing now is a strategic focus on companies looking to create greater agility in their production capabilities to try and mitigate the added complexity in order

to remain as efficient as possible. This is not just about beverages; Unilever, which has over 400 brands in home personal care and food, has a strategy called Connected 4 Growth. This strategy is about being more consumer centric in order to drive faster on-trend innovation and having the agility to do so. Companies are also increasing using zero based budgeting and benchmarking tools to assess how efficient they are compared to their competition.

An agile supply chain is needed in a highly changeable consumer environmentThe demands on the supply chain now are arguably as great as they ever have been with a highly transparent world when it comes to pricing for products, the ingredients used and a consumer environment that is highly changeable. Agility is key so investment is required to ensure there is a technical capability to respond to the changing needs of trading environment. We should also not forget about assurance of supply as in order to manufacture a product the right raw materials will always be required at the right time and at hopefully at the right price. Forward buying of raw materials and also currency is helpful for providing greater visibility but then there are complications to consider such as the abolition of the EU sugar quota on 30th September 2017. So all in all, we live in interesting times and for the supply chain manager to deliver a high quality product on time and as efficiently as possible, we believe the challenge has never been greater.

Phil CarrollShore Capital Markets

Consumer trends putting greater demands on the supply chainSimple is preferable but increasingly not a reality. Looking at the supply chain assuming the demand side is strong, the ideal scenario for manufacturers would be producing a single product in a single format per line in their factories utilising all the capacity available for maximum efficiency. Unfortunately, whilst this simplification has never really been an actual reality for most, the trading environment of recent years and for the foreseeable future in the food and beverage industry has been accelerating away from this idyllic scenario. This is presenting brand owners in particular with a number of challenges in order to drive efficient top line growth to maximise profitability.

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1. How confident are you in the future for the UK’s food and drink manufacturers?

The UK’s food and drink manufacturing sector is long standing and robust which makes me confident about its future. It has moved through various economic cycles and has come through difficult times reasonably positively. It is a core part of the industrial landscape in this country and whilst food production might not be front of mind for many consumers, people still appreciate the high quality, efficient production of our domestic food industry.

2. Now that Brexit has been triggered, what do you think should be the number one priority for the UK’s negotiation team?

Form AG Barr’s perspective, we would like to see pace, clarity and pragmatism feature in the negotiations to produce a balanced trade position as early as possible. The trick will be to balance the need for clarity against holding out for the best possible outcome. We would prefer an earlier agreement rather than extending the process to obtain the last possible piece of value.

3. What is AG Barr doing to consider and plan for a post Brexit world?

Broadly we do not feel as exposed to Brexit as other manufacturers as we are predominantly a domestic business. We buy a lot of fruit but it tends to be from further afield than Europe, such as India and South America so our interest remains in the individual trade deals with those countries once we leave the EU trade block and making sure we have continuity of supply.

4. Will this change your supply chain at all?

We don’t see it changing much as most of what we buy will still be dominated by global markets and priced in foreign currency, apart from the possible exception of EU sugar which is a commodity regime due to be changed towards the end of the year anyway. We will continue to monitor this situation, and as many other manufacturers know we crave certainty rather than uncertainty but on the supply side, no one aspect is stopping us from making capital allocation decisions.

5. How has the weakness in Sterling post the UK’s EU referendum vote impacted AG Barr as a business?

This has cost us on an annualised basis some four to five million pounds. It must be remembered that there are swings and roundabouts throughout all this, but as a business that doesn’t have significant dollar or Euro income, the net position is that our costs of goods have gone up.

6. From a trading perspective is it easier for AG Barr to operate in a deflationary environment or an inflationary environment?

It is a difficult question to answer. Both can be tricky. It depends on the steepness of the curve on both sides as well as the length of the cycle. In an ideal world we would have consistency or stability, but this isn’t realistic. It is when we are faced with extreme situations that it becomes particularly difficult to deal with. There is always some lag in inflationary and deflationary environments and this needs to be managed. When deflation at retail is misaligned with underlying cost inflation, the situation becomes particularly challenging.

7. Do you use any unusual or exotic ingredients in the manufacturing of your products and how do you ensure you have a sustainable supply of those ingredients?

We buy lots of exotic ingredients such as mangoes, guavas and passion fruit through a lot of in-country sourcing arrangements. We tend to buy direct from producers from many different countries and have long term, on-going relations in place which delivers us the quality and continuity of supply we need. We call our responsibility agenda ‘doing the right thing’. This also involves minimising waste whenever possible. You can badge it up in any way you like but ultimately it makes good business sense.

8. What has AG Barr been doing to mitigate the potential impact of the upcoming UK soft drinks levy for drinks with added sugar?

At the end of the day this starts with the consumer not the regulator. We have been on a programme for many years of reformulation, innovation and business development associated with the trend for healthy eating mentioned previously. The regulatory change will come in next April and we will see where we are in the cycle, but ultimately, we will continue to be driven by consumers not regulators.

9. How has AG Barr responded from a manufacturing perspective to meet the changing consumer environment?

Our consumer insight and understanding has led to innovation and product development such as pack format and product reformulation. But it has also meant that we have had to continue to invest capital in our supply chain to make sure we are flexible and able to keep up with the innovation that we’re creating. That said, consumers do not expect to pay more for these trends so we must maintain strong cost control. We balance capital investment to improve flexibility and innovation whilst keeping control of our costs to meet the challenges of the changing consumer environment.

10. What do you see as the big consumer trends over the next five years?

Whilst we track a host of consumer trends, the big three as we see them are firstly health and diet, secondly convenience, which is about packs, formats, shopping habits, in home storage and consumption on the go, and thirdly personalisation. This last trend, which might also be referred to as premiumisation, refers to the ‘generation Z’ of consumers who are looking for products that meet their individual needs with immediacy. This will be an increasingly important trend over the next three to five years and will challenge the high volume, high efficiency model to which many of us are used to working.

WE CRAVE CERTAINTY RATHER THAN UNCERTAINTY”

‘‘

MY VIEW: Roger joined AG Barr in 2002 as Managing Director and was appointed Chief Executive in 2004. He is currently Senior Non-Executive Director of Troy Income and Growth Trust. He was named Scottish PLC Chief Executive of the year in 2010 and is a past president of the British Soft Drinks Association.