The JournalArticle from

April 2010

Association for Corporate Growth

Opportunities and Threats in a

Consolidating Retail EnvironmentBy Greg Pearlman

BMO Capital Markets

A recent equity research report suggests that Wal-Mart is again “lacing up thegloves in the fight to win the modern day price war in food retail in 2010.”Investors responded to the report favorably, bidding shares of the world’s largestretailer up 3% in a single day of trading. For mid-sized consumer packagedgoods (“CPG”) manufacturers, many of which are still reeling from a protracteddownturn in consumer spending, the message is a shot across the bow. Wal-Martand other national retailers will continue their demands for price cuts and otherconcessions unfavorable to suppliers as the battle over U.S. retail market shareintensifies.

In the last five years alone, the market share of the top 10 U.S. food retailers hasgrown from 53% in 2005 to an estimated 59% today, with discounters Wal-Martand Supervalu gaining 4% and 3% respectively. While retail consolidation is nota new trend, the challenges it presents to CPG manufacturers continue to evolve.In this increasingly competitive environment, mid-market CPG manufacturersmust be mindful of risks arising from these rapidly changing consolidation trendsso that they can adapt and become stronger. In this article, we will describe anumber of themes germane to mid-sized manufacturers that serve thisconsolidating retail environment, and explore the threats and opportunitiesinherent to each.

Theme 1: Retailers Continue to Stay Lean Despite an Improving Economic Outlook

During the latest recession, discount retailers saw their pricing advantage

diminish as most retailers adapted by slashing prices to drive value-orientedconsumer to stores. As Wal-Mart’s actions suggest, price competition remainsfierce in the U.S. retail environment, and several major chains seek to re-focustheir message on every day low pricing. Recent improvements in the economicoutlook aside, Wal-Mart, Target and other national retailers have been explicitabout their commitment to continue price reductions in key product categories.

SKU rationalization remains a major worry to mid-sized CPG companies, manyof which already struggle under retailer pressure to bring down costs. Over thelast several years, retailer initiatives such as Wal-Mart’s Project Impact havebeen focused on accelerating SKU rationalization in order to make shelf spaceavailable for broadened private label programs and high velocity national brands.In part due to these SKU rationalization efforts, private label share of U.S.grocery sales has risen to 17% in 2009 from 12.5% in 2004. Further, Krogerrecently eliminated 30% of its cereal varieties; CVS eliminated Energizerbatteries (leaving only Duracell and private label); Walgreens cut its supergluevarieties from 25 to 11; and Supervalu reduced the number of SKUs it carried by25% per store. If global standards are a benchmark, U.S. food retailers still stocka relatively high number of SKUs. For example, a 2008 study revealed that atypical U.S. supermarket carried 47,000 SKUs, nearly three times that of itsaverage counterpart in the UK.

Wal-Mart, one of the leaders of SKU reduction, admitted it may have alienatedsome customers through its SKU reduction initiative and will likely bring backapproximately 300 of the 1,000 SKUs that were eliminated in its WIN-PLAY-SHOW initiative. Irrespective of Wal-Mart’s SKU reduction backtracking,mid-sized suppliers should still expect to see greater share consolidation amongtop brands in many CPG categories. Moreover, formerly popular “green” andother niche products are at significant risk of reduction or all out elimination atcertain national retailers.

Technology changes, such as scan-based trading, pay-on-scan, pay-by-scan, andradio-frequency identification (RFID), continue to attract the attention of mid-market suppliers that worry about the costs and risks of these inventorymanagement methods. While adoption of these systems has slowed considerablysince the last recession began, CPG companies selling through major retailersshould continue to monitor this trend and be prepared for the organizationalchanges required if adoption of these or other technology is mandated.

Theme 2: Retailers Are Becoming More Active Marketers

Retail chains are becoming more aware of the needs of their core consumer, andare more aggressively pushing for targeted solutions from suppliers. Even globalCPG suppliers are losing the latitude to push standard products through multipleretail channels. Their mid-market competitors have long had to differentiate inorder to gain acceptance at larger retailers, and should anticipate this requirementto intensify. The growth of loyalty card programs has provided a wealth ofinformation regarding consumer demographics and spending patterns. Krogerand other chains have partnered with data analytic firms to improve theefficiency and effectiveness of marketing programs, and to better manageinventory. Middle market CPG companies should develop the means to both

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qualitatively and quantitatively measure consumer buying habits and needs, inorder to better align with programs of their retail partners.

This trend is also reflected in the growth of the private label category. Attracted toprivate label’s higher margins and the ability to position store brands as a point ofdifferentiation, retailers have invested heavily to market and develop the category.In partnership with private label manufacturers, retailers have elevated the categoryand now offer private label products that are often equivalent and sometimesexceed the quality of national brands. As a result of retailer focus on the category,share of private label goods increased substantially since the start of the economicdownturn, accounting for over 30% of total sales in a number of categories.

Theme 3: Retailers Search for Means to Differentiate from Wal-Mart

Alternative retail channels, such as convenience and dollar stores, are positioningthemselves as challengers to Wal-Mart and other national retailers based onlocation and convenience. The convenience store channel has evolved as animportant retail channel with recently expanded food offerings, including moresophisticated and expanded prepared and private label food. As a result,convenience store sales grew 50% between 2003 and 2008 to an estimated $174billion. Dollar stores have also exhibited compelling growth as the categoryemerges as a viable competitor to Wal-Mart and other national retailers. Largedollar store chains have reported significant same store sales growth driven by theappeal of the smaller, less cluttered store format and expanded offerings ofgroceries and other consumable goods. In 2009, Dollar Tree increased the numberof stores equipped with freezers to accommodate frozen food by 16% while DollarGeneral is undertaking extensive store remodels to retain higher income customersas the economy improves. In 2010, the dollar store channel is on pace to add moresquare footage in the U.S. than Wal-Mart for the first time ever. Given theirattractive growth profiles, these and other alternative retail channels representcomplementary, and possibly alternative, customer bases for mid-sized CPGmanufacturers.

Theme 4: America’s Changing Demographic Makeup Can Be a Once in a Lifetime

Growth Opportunity

America is rapidly becoming older and more ethnically diverse. The number ofAmericans aged 55 and over is expected to increase by over 30 million, to 97.3million, between 2005 and 2020. By 2020, 29% of Americans will be over 55years old, up from 20% today. In the 1990s, the population of Hispanics andAsians grew four times faster than the population as a whole, while the AfricanAmerican population grew 20% faster. By 2008, the minority population in theU.S. reached 34% of the total population, which is expected to increase to nearly40% by 2020.

The well-established U.S. ethnic foods market is an estimated $75 billion business,representing approximately $1 out of every $7 spent on food. However, thegrowth opportunities come not only from ethnic groups, but also from broaderconsumer groups increasingly drawn to the perceived health benefits and varietyoffered by ethnic foods.

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The aging and diversification of the U.S. population offer substantial growthopportunities for middle market CPG companies that have innovative productsserving an increasing number of potential customers.

Theme 5: Sustainability Is NOT a Fad

Sustainability is no longer a theme of niche consumer groups. With intense mediaattention focused on the environment, the “green” movement has attractedwidespread interest. In response, a large and growing number of companies aretaking up the banner of sustainability, which benefits a broad set of stakeholdersand increases profitability for shareholders in many circumstances. In this light,Safeway and Best Buy have joined Wal-Mart as charter members of theSustainability Consortium, an organization of companies seeking to make productsand supply chains more sustainable. In July 2009, Wal-Mart announced plans to develop a worldwide sustainableproduct index to evaluate its global suppliers on a number of metrics, includingenergy and climate impact, natural resource utilization and material efficiency. Theassessment, which top-tier suppliers are already required to complete, will consistof 15 questions that give insight into a supplier’s impact on the environment andsociety. The final usage of this assessment is still to be determined. At minimum,Wal-Mart will use the assessment as one metric in choosing how to allocate shelfspace to suppliers. In the future, the score may be communicated to consumers,who will be able to make purchasing decisions in part based on a particularproduct’s sustainability rating.

Theme 6: Growing Cash Balances and Credit Availability Whet Appetite for

Acquisitions

Over the course of the latest recession, large CPG companies practicedconservative financial management, reducing acquisition activity to a virtualstandstill while significantly paring back capital expenditures. As a result, anumber of these large CPG companies have accumulated significant levels of cashwith the aggregate cash balance of the 10 largest U.S. food and consumercompanies increasing 76% to $11 billion since the latest recession started inDecember 2007.

Recent increases in strategic activity by these cash-rich companies and otheranecdotal evidence suggests that many large CPG companies are feeling moresecure in their economic outlook and are actively scouting for acquisitionopportunities among strong middle-market companies. Moreover, private equityfirms that raised capital before the credit crisis still have significant capital thatneeds to be deployed over the next several years. These factors increase thelikelihood of more robust M&A markets and opportunities for owners of well-positioned middle market CPG companies to realize significant value.

The Bottom Line – How Mid-Market Companies Can Compete and Win

• Find your sustainable niche within the consolidating retail environment. Alignall of your business operations around whichever strategy best fits yourcompany’s strengths. One size does not fit all. This may lead you to becomea low-cost private label manufacturer or a niche-oriented innovator focusedon high quality products. The key is simply to compete where you can win.

• Help alternative channels compete and win against major national chains.Smaller scale retailers are also engaged in fierce competition. Being on theright side of market share gains will allow your company to grow with newretail partners.

• Innovate across the organization, not just in product development.

• Become highly customer focused by offering customized products to differentcustomers and channels. Adaptability will be a necessity in these changingmarket environments.

• Embrace technology as an investment that will drive growth within evolvingretail channels. Make these investments proactively with a clear strategy forthe near, medium, and long term.

• Be mindful of your company’s sustainability. Many companies have foundthat sustainability is not only good PR but can increase profitability.

About the Author

Greg Pearlman

Managing Director and Head of Food and Consumer Group

Greg is a Managing Director and Head of the Food & Consumer Group for BMO

Capital Markets. He is a veteran investment banker, with 25 years of deal experience

in M&A, as well as equity and fixed income underwriting. Greg holds an MM in

Finance and Management Policy from Northwestern University’s Kellogg Graduate

School of Management and a B.A. from the University of Michigan.

This article is one in a series of contributions by ACG Chicago’s Sponsors and was taken from ACG

Chicago’s publication, The Journal, April 2010 issue. We appreciate BMO Capital Market’s support.

BMO Capital Markets is a leading, full-service North American financial services provider offering

equity and debt underwriting, corporate lending and project financing, merger and acquisitions

advisory services, merchant banking, securitization, treasury management, market risk management,

debt and equity research and institutional sales and trading. BMO Capital Markets has over 2,200

employees operating in 28 locations around the world, including 15 in North America.

BMO Capital Markets is a member of BMO Financial Group (NYSE, TSX: BMO), one of the largest

diversified financial services providers in North America with US$373 billion total assets and more than

36,000 employees as at January 31, 2010.

In the U.S., retail and commercial banking services are provided through Harris, also a member of BMO

Financial Group. www.bmocm.com

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