The path to profitability for emerging CPG brands in the US is becoming more difficult in the post-pandemic era.
This new reality comes at the same time emerging brands are being urged to become profitable sooner than they would have been in the past due to changing consumer preferences, increased uncertainty and elevated investor expectations. The expectations of potentially interested trade buyers are also higher than was the case a few years ago.
Central to the path of profitability for emerging CPG brands is an adequate gross margin, which many emerging brands don’t have from the start.
The cost of doing business for emerging CPG brands has increased considerably across the board since 2020. This not only is the case when it comes to product – ingredients, packaging – but also warehousing, freight and the sales and marketing expenses associated with landing on (and hopefully staying on) store shelves and selling online.
The pandemic and food inflation have also strengthened the dominance of legacy CPG brands and private label. When it comes to groceries, price is more important to consumers in 2023 than has been the case since the 1980s. Even so-called super-premium brands have become more price-sensitive in this era of mega-food inflation.
So over the last three years, emerging CPG brands have been faced with escalating costs, the increased strength of legacy and private-label brands, higher marketing and promotional costs, and more dynamic consumer preferences when it comes to what they buy at the grocery store, which is where over 90% of CPG products are still purchased.
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The biggest intangible challenge emerging CPG brands face on their profitability is on the sales and marketing side. I say intangible because the costs and experience can be very different for each brand, depending on the product (how differentiated it is, for example) and the category – level of competitiveness, cost of entry and the like.
Unlike big brands, which sell direct to retail chains, nearly all emerging brands use distributors. This adds an additional layer of cost, ranging from 10-25% depending on a number of factors, which results in a higher price on the shelf.
Retailers also take higher gross margins on emerging brands, particularly in the natural, organic and premium categories, than they do on big brands. This adds further to the ultimate retail price of an emerging brand product.
Most emerging brand CPG companies also use sales and marketing agencies to some degree or another rather than having a direct sales force. These agencies charge a commission that often includes a monthly minimum for the first six months or a year, which adds more to the shelf price of an emerging brand.
Emerging CPG brands are dependent on distributors. It’s a symbiotic relationship – distributors wouldn’t exist without brands of course – but the balance of power is clearly in the distributor’s court.
The distributor segment for emerging CPG brands – also referred to as natural and specialty products brands or small brands – has consolidated into two major players, UNFI and Kehe Distributors. The two mega-distributors supply the majority of retail chains and independents in the U.S. There was a third, DPI, but Kehe acquired the third major player this month. There are numerous smaller, regional distributors but Kehe and UNFI control the business when it comes to the chains and market share, which is what matters.
For emerging CPG brands in the natural and specialty spaces what this means is the cost of doing business is only going to increase. These distributors, which compete with each other by offering contracts that include financial incentives to retail chains, have numerous fees they levy on emerging brand companies, require promotional funds, and increasingly are serving as gatekeepers to many chains when it comes to brands.
How can emerging CPG brands improve profits?
In terms of the path to profitability, emerging CPG brands need to do two things very early on in that journey, which is to have an adequate gross margin and to achieve repeat purchases from consumers. An adequate gross margin is a must for the EBITDA margin and a high repeat purchase rate is necessary in order to eventually reduce a brand’s marketing and sales promotion percentage.
These two criteria have to come at the same time as sales growth, meaning that it’s all a fine balancing act. Continuous scaling is the name of the emerging brand growth game but it can’t come at the expense of an adequate gross margin and repeat purchase behaviour.
Gross margin and sales and marketing expenses won’t automatically improve with scale. This is a false assumption you hear promoted a lot in the industry. For example, if you have a 35% gross margin but need 45%, obtaining that additional 10% is extremely difficult to do. Similarly, if your marketing costs represent 50% of your sales, reducing it to 25% is pretty much impossible to do.
Most emerging brands today are eventually looking for an exit down the road rather than remaining a small CPG brand for decades or in perpetuity. The minimum range for exits, although it’s just one of many criteria, is generally $50-100m in annual sales.
Many brands try to scale too fast. They then spend excess promotional and marketing dollars, which kills margin.
What this means for most emerging brands is that there’s a lot of time to grow sales. Growing sales involves not just adding to a brand’s store count but also achieving repeat purchases.
The path to profitability is a journey so emerging brands shouldn’t be expected to achieve all that I describe early on. Costs and expenses will, for example, exceed that magic 10% of sales early on, particularly as brands scale in distribution. But what’s essential is to try to keep costs relatively fixed as the brand is grown. It’s a delicate balancing act for sure.
Time is a key variable. Many brands try to scale too fast, including getting into numerous big chains – or the wrong chains entirely – so soon. They then have to spend excess promotional and marketing dollars on trying to stay on the shelf – retailers have performance standards for all brands and getting on the shelf is easier than staying on the shelf – which kills margin and most often results in being discontinued by the chain, which can be a very costly process. This phenomenon over multiple chains often is the cause of pressure on profitability and an emerging CPG brand’s demise.
M&A appetite has waned
The mentality of investors in the CPG has changed significantly post-pandemic. Investors have become much more pragmatic and much more focused on mundane things like profitability than they were just four years ago in 2019.
Those who do the acquiring of emerging CPG brands, which in nearly 100% of the cases are legacy CPG companies, have also become much more discerning across a wide range of criteria.
Big CPG companies are also less hungry for emerging brand acquisitions today than they were before the pandemic because of the phenomenal sales their legacy brands achieved in the two-plus years of the pandemic shutdown and its aftermath.
Food inflation has also made big CPG companies more inward or organically focused because they’ve been able to successfully raise prices to retailers and wholesalers throughout the last few inflationary years. This has brought big dollar sales gains and increased profitability. As a result, emerging brand acquisitions have been less important than before.
The two biggest mistakes I see emerging CPG brands making are not having healthy enough gross margins and not focusing properly on building and achieving repeat sales. I see both as the key building blocks on the path to profitability.
The cooling off of food inflation is helping emerging CPG brands on the cost side of the ledger but industry trends like distributor consolidation aren’t going away. Cost pressures are here to stay.
It’s important to remember the path to profitability for emerging CPG brands is a journey. Time can be an ally. It’s also a delicate balancing act between controlling costs and managing growth, gross margin and repeat purchase rates. The only constant on the path to emerging CPG profitability is change.