October, 1998

From the Editor

Weather A Possibile Storm

The specialty food industry has such a rarified reputation – the finest foods consumed by those with the most refined palates – that it is reasonable to ask what the implications of an economic decline would be for the specialty food industry: probably not as tough as some would imagine. First, food in general is recession-resistant; people have to eat. Second, even specialty food is an inexpensive treat. If people cut back elsewhere, they are likely to turn to fine food as a kind of inexpensive pleasure. Finally, the elite image of the specialty food industry is as much PR as reality.

Much specialty food is ethnic food, which, often, is a staple to particular ethnic groups. Those with a kosher diet don’t start eating pork because the economy is in trouble. Even areas such as natural and organic foods are deeply tied into a way of life for many consumers – they will not drop this association quickly or easily. Still, prudence dictates attention to the world around us.

The economy may be poised for serious trouble. Employment is still tight, and so the common man sees no evidence of recession in wages or unemployment, at least not yet. The signs are there, however, and if a recession comes, it will have a substantial impact on those looking to establish businesses and to borrow money to expand them. The industry itself, as measured by sales and profits, though, is likely to be sound. This combination creates a real chance to build business for those strong enough not to panic and smart enough to identify opportunities.

The collapses in Asia and in Russia have had serious repercussions on the financial markets worldwide. At the time of the Great Depression, one of the problems was that people were allowed to borrow as much as 90% of the value of a stock through leveraged margin accounts. That is no longer allowed. However, hedge funds – a kind of minimally regulated investment group – have, in effect, become the modern-day 90% men. These funds borrow a great deal of money to increase their investments but, perhaps more important, the funds’ heavy use of complicated financial instruments, such as derivatives, makes it hard to even evaluate what the liabilities of these funds might actually be.

Long-Term Capital Management, the largest of the hedge funds, recently was saved from bankruptcy due to an intervention by financial institutions orchestrated by the Federal Reserve. The fact that the Fed thought the possible collapse of Long-Term Capital was of sufficient concern to intervene clues us in to the fact that financial institutions must have very substantial exposure to these hedge funds or be invested themselves in the same type of instruments that Long-Term Capital invested in.

If Long-Term Capital had to liquidate its positions, the thinly traded market for these securities means prices would collapse. Other hedge funds and financial institutions would find themselves in violation of loan covenants and margin requirements so they would have to sell too. Lots of sellers with few buyers means a financial collapse. The Fed held this off – for now.

Though catastrophe has been averted, there are implications none the less. Most notably, banks and financial institutions know they are vulnerable. As a result they will naturally try to upgrade the quality of their loan portfolios. Of course, there is nothing the banks can do to upgrade the credit of a hedge fund, a foreign government or a junk bond holding, so the only alternative is to restrict loans to only the most credit worthy corporations and individuals.

The implications of this for the specialty food business are negative. Very few specialty foods companies, from the retail to the manufacturing end, are the kind of large, diversified AAA credits that banks are looking for. It means it will be significantly more difficult to get financing to open or expand a small or medium size business.

Venture capital pools also will likely dry up as investment sources for the industry. These investors have no desire to simply own a good business. They desire an “exit strategy” – a way to cash out over a period of time. Yet with the stock market not giving strong valuations to smaller companies and financing for buy-outs less available, venture capitalists won’t get in because they can’t see a way to get out.

So, not surprisingly, if the economy craters, there is plenty of bad news for the specialty food industry. Still, though company valuations may decline, and capital investment may be harder to come by, the fundamental business of the specialty food industry is likely to do just fine. People will still buy and consume specialty foods. Sharp operators will find a real opportunity to increase margins and gain market share.

Why don’t I expect specialty food sales to collapse in a recession? During a recession, people do cut back. Their incomes may go down, or they may just fear the loss of a job and decide to save for a rainy day. Perhaps they feel poorer because stock market investments have gone down and this so-called “wealth effect” reduces their willingness to spend.

Whatever the cause, in a recession, people reduce spending on big-ticket items. They decide that the new house isn’t necessary, the vacation place is an extravagance and even the old car in the driveway can last another couple of years. Paradoxically, these large cutbacks can actually increase the disposable income available for small extravagances – a nice bottle of wine, a favorite sorbet, a treat of chocolate.

Very commonly, trends change and public displays of affluence become unseemly in bad times. This means less eating out and more entertaining at home. To put it another way, the family may not fly to Italy for a holiday, but that only serves to increase the budget for Italian cuisine.

Traditionally the food industry has been recession-resistant, not only because people have to eat but also because, in the U.S., we spend such a small percentage of our disposable incomes on food that it is simply not a significant place to economize. Indeed for very little additional money, one can purchase a real treat for the family, an opportunity much to be desired when the trip to Disney World is being put off.

This matters a great deal because, though market valuations may fluctuate, and those who look to raise funds may face a challenge, the business itself is likely to do just fine.

Indeed because of trouble in the financial markets, it is possible that new competitors will find entry in the specialty food business more difficult. This will reduce competition and create profit opportunities for existing players.

For strong players, a recession is likely to be a great business opportunity. Why? Well those who panic will cut back on marketing and promoting their business. They will hear words like recession and think of the end of the world. Sure, if the whole world collapses and we have a new Great Depression, then no business will be healthy. Much more likely though is a recession for a period followed by a recovery. What a great opportunity to build market share. What a fantastic situation to position one’s company for the next upturn.

There are deep and fundamental reasons why the specialty food industry has been growing: Technology and communication have created a smaller world in which food experiences and tastes flow freely…consumer demand for variety and choice leads to a proliferation of SKUs…an aging population looks for natural foods to maintain health and a good environment.

There can be twists and turns on the track, but no recession is likely to detail these fundamental reasons for the growth in specialty foods. We may well have a recession, but realize that recession is just a word that marks the starting point for the next recovery.  FDM