July, 2010

Research Perspective and Comments & Analysis

Private Label: The Brands of the Future

Previous recessions have shown a clear correlation between the state of the economy and private label market share. In the past, private label sales spiked during a recession, but quickly returned to normal levels at the first sign of an upturn. This time around, however, private label will have a much stickier effect due to a combination of improvements in the quality and marketing of these items as well as retailers’ SKU rationalization efforts, which has carved out more shelf space for private labels. Furthermore, new frugal tendencies amongst shoppers have ignited demand for these products.

Today, private label accounts for one in every three products sold at Kroger, while approximately 15 percent of Wal-Mart’s grocery sales are made up of its own brands. Private label not only offers greater value to consumers, but is increasingly becoming a point of differentiation for supermarkets — not to mention a more profitable one.

So it’s no surprise that retailers are working hard to improve recipes, redesign packaging and even invest in advertising for these products. All of these efforts will certainly help to raise brand awareness. However, there is a much more direct way to grow share of private label items — get rid of the competition. Many grocery chains across the United States and Europe are now focusing their efforts on SKU rationalization, a process that not only enables retailers to reduce inventory and labor costs but, perhaps more importantly in the long run, to give private label items greater prominence on the shelf. Wal-Mart, for example, is in the process of reducing its overall assortment by 15 percent in the United States (30 percent in the UK), while supermarkets such as SuperValu are reducing their SKU counts by up to 25 percent in certain categories.

SKU rationalization is mainly relevant in categories where there is an over-proliferation of brands such as the cereal aisle, and therefore unlikely to have a significant impact on the produce category. That said, it does represent a further power shift into the hands of the retailer, and that, of course, is an area that affects all suppliers. In our latest report, Private Label: The Brands of the Future, we have identified several ways in which brand suppliers can respond to the private label threat, ranging from the slightly more defensive tactics (i.e. launching value sub-brands) to collaborative approaches such as joint promotions and co-branding. Suppliers should also be looking to innovation as well as shopper-centric strategies, whether that is engaging directly with consumers through social media or investing in the direct-to-consumer channel. In fact, you can argue that retailers have been stripping out the middleman for years by pushing their private labels. Brand manufacturers are now recognizing an opportunity to do the same by going direct-to-consumer through brand stores, services and online channels.

In our report, we have also identified ten key private label trends for 2010. There will certainly be a repositioning of the value lines that have featured so heavily during the recession. These lines have helped the grocers to retain shoppers by improving their price perception; however, as the economy improves, the focus will transition to the more profitable premium lines. In fact, we believe that there is room for a super-premium line that has yet to be introduced in the United States. In Europe, where private label penetration rates can be as high as 50 percent (compared to about 25 percent in the United States), we are now seeing the introduction of these super-premium lines that cater to quality-seeking shoppers trading out of restaurants. For example, Tesco is now offering a Restaurant Collection range priced at £10, or $14.

There is also plenty of room for growth with niche sub-brands, which have yet to take off in the U.S. market. For example, France’s Casino recently launched a Halal food range while Carrefour offers a gluten-free line. Transparency is also on the rise as consumers take a greater interest in the provenance of products. In fact, NY-based Wegmans recently began putting the manufacturer name on the packaging of select private label items, a tactic used primarily by German and Swiss grocers.

The most successful private label lines are now embarking on a series of brand-building exercises as they transition from “generic alternative” to “CPG brand.” Safeway and UK grocer, Waitrose, are pioneering this trend globally by distributing their private label lines to other retailers. Currently, very few retailers are able to make this transition, as it requires extremely strong brand equity; however, this is a trend we expect to gain pace, further blurring the line between national brands and private labels.

Going forward, it’s clear that there are ample growth opportunities for private label in the United States. However, private label penetration rates are unlikely to ever reach levels found in markets such as Switzerland or the UK. In Europe, a combination of market consolidation and a strong presence of hard discounters has enabled private label to flourish. The U.S. grocery sector meanwhile remains largely regional and fragmented — even Wal-Mart holds less than a 15 percent share on a national level. However, it is fair to say that Americans’ affinity for national brands will continue to be tested as retailers raise the bar of their private label items.

No Free Ride For Private Labels

The future for private label is almost universally seen as bright. Yet the intrinsic logic of the interaction between private label and national brands makes the future for private label somewhat problematic, and the peculiarities of fresh produce marketing make private label produce unlikely to triumph.

The key thing to think about is why a retailer would want to sell private label product at all. The answer is generally better margins. How can a retailer get better margins through private label? Well, in a few cases, retailers literally become manufacturers and own manufacturing plants. In these situations, retailers can combine both a manufacturer’s margin and a retailer’s margin to come up with a substantial margin number. But this path involves significant capital investment and risk, so it requires additional margin to compensate for that outlay.

So this leaves retailers with purchasing from co-packers or other manufacturers. Yet how will this increase supermarket margins? To a small degree, supermarkets can get super great prices by persuading manufacturers to sell based on marginal costs rather than fully loaded costs. In other words, a branded cookie company sells enough cookies to keep its plant working at 90 percent of capacity. Some lucky chain or chains may persuade the cookie manufacturer to accept a cheap price to fill its last 10 percent of capacity.

But the ability to get this big margin is limited. At a 90/10 ratio, the branded product can carry all the fixed costs, but if private label grows and branded product gets kicked out of the stores, then the ratio may switch to 60/40 or the manufacturer may drop its brand all together. At this point, it seems clear that the “free ride” for private label will be over and the private label product will increasingly have to carry its fair share of the overhead and capital costs.

So how exactly will private label boost margins? Well, this still leaves reductions in advertising, marketing and sales costs that national brands have to absorb. This is a big chunk of money and seems to offer the potential for big savings.

Yet even this savings is somewhat problematic. First, on some products, such as fresh produce, these costs are minimal. Even the most heavily promoted produce items rarely spend more than a penny a pound on advertising and promotion. Second, where marketing expenditures are higher, a not-insignificant amount of these expenditures goes directly or indirectly to benefit the supermarket — it may be slotting fees or merchandising assistance, consumer research, demos and sampling, etc. Zeroing these out of the product price will lead to reduction in revenues or increases in expenses for supermarkets.

Third, many of the savings may be very short run. Yes, if consumers have been trained by Oscar Mayer to eat B-O-L-O-G-N-A or Hebrew National to eat Kosher food because the company “answers to a higher authority,” then offering private label products that can piggyback on these campaigns without paying for them will result in higher margins. But if national brands shrink, they won’t have the resources to do the kind of advertising and marketing that has built these categories. So the supermarket looking for high margins through private label will have little choice but to start spending money to build and market the category.

The comeuppance of all this is troublesome for those who advocate private label marketing: If retailers have to cover the whole nut of manufacturing and have to invest in marketing and product development to build the private label brands and the category, it is not clear there is any real lift in margins to be had from private label.

The sustainable gain in private label comes from something much more difficult to do than co-packing corn flakes. It involves the creation of unique foods or flavor profiles that will draw consumers back and turn the private label program into a customer draw. Trader Joe’s is exemplary in America with this approach, and we often hear of consumers overnighting a sauce or dressing that Trader Joe’s uniquely has.

In produce, what private label has mostly done is disappoint supermarket CEOs. They were able, at least in the short term, to get a margin boost in grocery with a private label orientation, but produce producers never had such fat margins to cut, and so it never has worked out as well in produce as the retail CEO had expected.

The future for private label may see some quick about-faces because a focus on limiting SKUs, although superficially appealing, may be incompatible with the trade’s existing real estate inventory. Limiting SKU count to reduce costs and complexity may be a dandy strategy for an Aldi, but it seems to belie the whole purpose of a 70,000-square-foot supermarket or a 200,000-square-foot supercenter. These concepts live on their promise to provide one-stop shopping. Wal-Mart has already announced it will return to its shelves some products eliminated during its rationalization process.

In produce, of course, most products carry no brand known to the consumers. In this sense, the produce brands are, and always have been, identified with the retailer carrying the items. The trend, though, is opposite from private labeling, which implies a closer connection between the producer and the “big business” supermarket; the trend is to allow consumers a closer connection to the producer of their food.

That means branding focused on the producer with the supermarket shifting to the background, in a sense, a plethora of brands — national, international, regional and local — which may overwhelm the idea of private labeling most produce.