Being CFO of a food multinational in 2011 is a complicated business. When input prices were in a downward spiral and global inflation was relatively stable, food companies could sit back and watch while many of their peers battled a permanently depressed market. Not any more.
A once-dormant market is suddenly highly volatile. The UN’s Food and Agriculture Organization says its index of 55 common food commodities surged 25% in the year to January 2011. At the start of 2011 sugar and meat were at alltime highs. The record levels set in 2008 have been surpassed and overall prices – in real and nominal terms – now sit at, or close to, their highest in two decades.
The political upheaval of the Arab Spring, and instability in southern Africa, can be traced to the high cost of food. More trivially, but no less markedly, multinational food companies are trying to manage price pressures that were unimaginable years ago.
The International Monetary Fund calculates that between 1974 and 2005 real food prices, adjusted for inflation, fell by nearly 75% as improved technologies dampened costs. Compare this with 2007, when the UN food prices index rose by 40% in a year. Or with a wheat price which now can routinely rise or fall by 15% in two days. Over the 12 months to May 2011, corn prices rose 80% in the futures market; oats were up 70%, wheat 54% and soybeans 37%.
The problem is not necessarily price itself. Rising input costs are universal and will broadly be absorbed by consumers. And after a 30-year lull, only a reckless optimist would not have expected food commodities to rise at some point. The real quandary is increased volatility and the difficulties it causes for forecasting. How can you decide whether an acquisition or investment will deliver when the price of raw materials seems so intangible? How can consumer demand be accurately gauged when pricing levels in a decade’s time could fall within a huge range of variables?
Unsurprisingly, tried and trusted strategies are increasingly unfit for purpose. And that means multinationals are thinking again about food.
Commodity pricing is particularly troubling for multinationals because it leaves them relatively powerless, at the mercy of markets they cannot control and may not fully understand. “There are two things companies can do about food prices,” says Ian Starkey, a Consumer Goods and Retail partner in KPMG’s UK practice. “They can get better at supply management or they can take volatility out of the question by hedging. They can’t influence the price themselves – no company is big enough to move the market for extended periods of time.”
Hedging, once exotic, is becoming the de facto method for dealing with volatility (see below). But Starkey says executives should examine why they are undertaking it: “Hedging by itself does not necessarily reduce costs. It isn’t a price-saving technique. If you hedge all the time, you’re still subject to the commodity cycle.” It also won’t turn a poorly performing company into a good one, he cautions: “If your job is converting maize to cereal, your profitability is tied to how well you perform that task. And hedging can’t exist without reference to capital costs. If it costs more in charges and overheads to hedge than you think you can gain, you shouldn’t do it.” Hedging is an imperfect strategy, but it is becoming ubiquitous by default – if your rivals are insulated to some extent against price rises, your business ends up doubly exposed.
Almost every company is examining its supply chain, looking to optimize, broaden its supplier base where appropriate and ensure security of supply. Many are also radically rethinking pricing. Christopher Fraleigh, CEO of North American Retail and Foodservice at Sara Lee, told a forum in March: “What we’ve developed over the last five or six years is a much more sophisticated, value-based pricing approach. When commodities increase, we have a pretty good feel, based on where we are, where our competitors are, how much price we can take. We’ve been raising prices pretty steadily.”
Fraleigh explained that Sara Lee’s price rises encompass 20-50% of its portfolio at any one time: “When we talk about adjusting pricing, this past year it has largely been either an absolute increase in our list price, or a lot of times we will adjust our trade spending, When hot dogs or breakfast sandwiches go on sale, they may go on sale three times in a year instead of four times; or the depth of the discount may be a little bit less in price. That tends to have a little bit less ‘sticker shock’ from a consumer standpoint.”
Food giant Kellogg’s announced a change of tack in 2011, adopting a strategy of raising prices sharply after a year of heavy discounts and deep promotions that meant it was swallowing a rise in grain prices. “We lost some of our momentum in 2010,” the company’s CEO John Bryant told analysts. “We’re trying to get that back.”
Kraft says its 3.7% global price rise was enough to cover a 7% rise in input costs in Q1 2011. But commodities create more losers than winners. Meat processors, reliant on corn and soybeans to fatten animals, are facing huge spikes. Luxury chocolate makers are seeing cocoa prices soar. Unlike Kellogg’s, whose products are mostly staples, such discretionary purchases are on the chopping block in a weak consumer marketplace. As Bryant puts it: “There’s not a lot of places for consumers to go for a cheaper food than, say, a bowl of cereal with milk at 50 cents a serving.”
“Established food brands can benefit from the fact that, while their own food input prices are rising, so too are those of their competitors,” says Starkey. “If the price differential between an own-label product and an upmarket alternative is reduced, consumers may be more likely to make the jump to the premium product. There is certainly a competitive upside of price inflation for such companies.”
Clearly, the consumer landscape is changed radically by high cost pressures. And, while developed economies may be protected by regulation, there are dangers of a dark side. “The turbulence in the economy and pressures on corporations may mean a squeeze on the supply chain. It is conceivable that as suppliers try to retain business in a highly competitive market they start doing the wrong thing,” says Hitesh Patel, a partner at KPMG’s UK Forensic practice. “As the cost of food products goes up, unethical business practices such as price fixing cartels, bribery and corruption to secure lucrative contracts, substandard or counterfeit products being passed off as premium quality, or shortchanging in volume on delivery, to name a few, will become more likely. We are more likely to see problems like suppliers cheating on deliveries or even tampering with food. Bribery and corruption are also liable to rear their heads, although this is more likely in emerging markets than in developed economies.”
Countries with well-developed supply chains cannot insulate themselves against volatility. Pricing strategy and hedging can help, but many multinationals now see geopolitical solutions as the long-term key to cooling markets.
Speculators are one target. Starbucks President Howard Schultz believes coffee price hikes – costs have risen from 45 cents per pound a decade ago to around US$2.30 today – cannot be blamed on supply or demand issues. “Through financial speculation – hedge funds, index funds and other ways to manipulate the market – the commodities market is in a very unfortunate position. This has resulted in every coffee company having to pay extraordinarily high prices for coffee,” he says.
Schultz calls for greater transparency in the commodities market and says that, at the very least, buyers should be identifiable. Anti-poverty campaigners have likened the commodities market to pre-crash sub-prime in regulatory terms.
But hedge funds cannot be responsible for every market dynamic, and the rational economics view states that aberrations will be corrected in the long term. The key questions are how and when. Rice offers one intriguing example. It fell 10% in the first two months of 2011 and is currently trading at around half its 2008 price, on the back of bumper crops among major growers such as Thailand, Vietnam and India. The UN claims that without falling rice prices, food riots in early 2011 would have been more widespread.
Rice production has been boosted by improved farming technology and the introduction of new hybrid seeds that can increase yields by as much as 20%. Genetically modified (GM) crops such as these, though politically explosive and far from universally proven, are one lifeline for food groups. More widespread acceptance of GM technology would offer more certain yields and predictable forward volumes across many different commodities.
“Although the debate on GM crops is often an emotive one, it is clearly one that needs to be had,” says Starkey. “Increasing pressure on crop prices – in particular as resources are diverted by the growing demand for biofuels, such as the demand for corn to be used for ethanol production – is going to make that discussion more vital.”
GM could also dampen some of the social concerns surrounding food security. Jeffrey Sachs, an economist at Columbia University and special adviser to UN Secretary General Ban Ki-Moon, has said: “We’ve entered a new global scenario with respect to food, hunger and conflict… an era where things are likely to get tougher, not easier, in terms of production. We’re hitting boundaries that are very important to understand and very important to counteract.”
Referring to the ideas of the 18th-century economist Thomas Malthus, who grimly predicted that one day the human population would grow to the point it could no longer feed itself, Sachs added: “We think we’ve beaten the Malthusian challenge for the last two centuries, but Malthus still has a spectre hanging over us. What we’ve not proved is that we can feed the entire planet on a sustainable basis for the long term.”
For CFOs, feeding the planet is only one part of profitability. But it is increasingly difficult to separate food security, increasing demand from emerging economies and the power of market speculation, all of which contribute to volatility. To many analysts, the timing of agribusiness Glencore’s record IPO is a sign that markets may have peaked. Shrewd commentators will take any glimpse of certainty they can get their hands on.
To hedge or not to hedge?
How trading is helping multinationals get a handle on commodity costs
When Anheuser-Busch InBev, the world’s largest brewer, announced its Q1 2011 results, most analysts focused on how US unemployment and monsoon conditions in Latin America had kept drinkers from reaching for their favorite tipple. For CFO Felipe Dutra, however, the results represented a small triumph for forward planning: by hedging its barley position throughout 2011, AB InBev had been insulated against hikes which saw prices double during one tumultuous six-week period in late 2010.
Hedging – effectively, betting on future prices by buying at a set position – is the mainstay of most commodities traders’ working day. But now it is spreading from the trading floor to boardrooms such as Dutra’s, as food and drink manufacturers decide the volatility of raw material prices has simply become too hot to handle.
The very largest multinationals have always included a hedging function in their finance department, often to buy oil for their transport fleets. Now, many more mid-tier businesses are considering it, including food service companies with wafer-thin margins and ‘just-in-time’ supply chains. Corn, soy beans and dairy products have joined coffee and sugar on the list of commodities being bought, generally on 18-month or two-year contracts to mitigate agricultural cycles.
Generally, consumer markets companies which hedge buy a commodity at an index price using a linear instrument. More complex derivatives instruments are off the menu for now. Even so, says KPMG’s Ian Starkey, it is advisable to bring in staff with trading experience to supplement the finance department: “Although it is a tool for management, hedging is very complex and requires a significant infrastructure, including controls, an IT capability to track forward positions and a derivative accounting function.
“Hedging is a strategic commitment which needs to be embraced by every level of the organization and the investor base. Failing to communicate that it is a tool, not a way of predicting the price, can be disastrous.” It can be difficult to explain making a wrong call if shareholders don’t understand the aim of hedging in the first place. It can be even harder to explain accidentally taking control of a futures contract, which Starkey says has happened to at least one food company.