Wednesday, November 14, 2007

Wednesday Marketing Memo: Organic Foods

Analysis: New study suggests organic food and beverage products moving into the mainstream in U.S.

For the past three months we've been discussing our analysis here that the organic foods market is in the process of moving from what has been a small niche to the beginnings of widespread, mainstream status in the U.S.

By this, we aren't suggesting organic foods will replace conventional products anytime soon and become the norm for the majority of consumers. Rather, what we mean is we see a clear trend in the organic category from what has thus far been a specialty niche, purchased by a few select groups of consumers, to what is becoming a category sampled and purchased regularly by a wider sector of U.S. shoppers, and offered more and more for sale by mainstream food and other format retailers.

A new study by market research firm Mintel suggests we've been on the right track in our analysis. The just-released Mintel study reports that organic food sales have grown a whopping 132% since 2002. In this same five year period the study says organic beverage sales have grown nearly as much, at 92%. Combined, the organic food and beverage categories today make up a nearly $6 billion a year market in the U.S., according to Mintel.

The organic food and beverage growth trend is clear according to the study. Over half (52%) of American consumers purchased organic foods in the past year, while over a quarter (26%) bought organic beverages. This is a significant increase (and hence the clear trend) over 2002, when just 34% of U.S. consumers purchased organic foods, according to a 2002 Mintel study. Of even greater significance in terms of a clear trend line--and the movement towards mainstream status as we've defined it above--is that 32% of U.S. adults reported they purchase organic foods on a regular basis or as often as possible. That leaves plenty who haven't yet done so, but the growth is very significant.

As we suggested above, organic food and beverage products are being sold by more and more food retailers and even by other retail format operators, including mass merchandisers, drug stores and others. This is do to three primary reasons. First, is the growing demand by consumers for organic products. Second, food and other format retailers have found selling organic products can be good for profits as they have much higher gross margins than conventional grocery items, for example. Lastly, combined with both factors above, food and beverage manufacturers are developing and introducing organic products at the most rapid pace in the history of the category.

For example, the Mintel study says 2006 saw nearly 1,600 new organic food and beverage products launched in the U.S. In contrast, less than half that many (722) were launched in 2002. Additionally, food retailers (Whole Foods, Safeway, Kroger, Publix, Wegmans and many others) have launched multi-item private label organic foods lines and continue to add items to these lines at a rapid rate.

As the organic food and beverage market begins to mature, as it is, the rate of growth will decrease. This is logical, and the Mintel projections for the next five years bare out that fact. Mintel says the organic category will have strong, consistent growth over the next five years. The market researcher estimates organic foods sales to grow by 59%, while the organic beverage market will grow by about 65%, between now and 2012. That's huge growth despite the leveling-off from the current growth rate numbers mentioned above.

"This (the organic market) isn't a niche market full of environmental health nuts and affluent hippies anymore," says Marcia Mogelonsky, a senior research analyst at Mintel. "Organic is now part of the picture for everyone from the Hispanic immigrant mother to the hip suburban teen next door. With health issues and food contamination issues in the news, many people have begun looking for more safer, more natural food and drink," Mogelonsky says in explaining the growing "mainstreaming" of organics.

As we've mentioned often here, price remains a major barrier to even faster adoption or "mainstreaming" of the organics category we believe. The overall retails still remain too high for many people to purchase organics on a regular basis. And often these "too high" retails act as a barrier to entry for consumers who want to try organics but are scared off by the price premium over conventional food and beverage items.

This pricing factor is changing a bit--but not enough we believe. With retailers like Wal-Mart, Target, Costco, Safeway, Kroger and others getting into organics merchandising in a big way, overall retail prices have been driven-down a bit. The market is working in this regard. However, these retailers, along with Whole Foods and others, are still using organics as "margin enhancers" all to often. This isn't wrong. We just believe they should lower the retails a little bit and obtain just slightly less margin enhancement.

Gross margins of 45-60% aren't unheard of by retailers such as Safeway and Whole foods on organic grocery products. Supermarkets like Safeway make less than half that amount in terms of the gross margins on conventional grocery items. We suggest some margin reduction is in order. A 10% retail margin reduction in the category would go a long way towards making organic food and beverage prices more competitive with conventional goods. This, we believe, would speed the adoption of organics by even more customers--leading to a larger market, which is good for all. And even with a 10% margin reduction, retailers like Safeway, Kroger and others would still be doing very well indeed in the category.

We also argue there remain lots of inefficiencies in the organic foods supply chain. Manufacturers can decrease their cost of goods and production expenses by adopting some of the practices of larger consumer packaged goods companies. There's also savings out there in transportation and warehousing. And much can be done to improve marketing--and thus increase sales volume.

Additionally, most food retailers--large and small--still obtain most of their organic food, grocery and beverage products from third-party distributors. While this practice can actually save money in some cases, it generally doesn't as it's practiced today. For example, many large supermarket chains are on "full service" programs with natural foods distributors. In other words the distributor handles all aspects of the process--from ordering to stocking the products on store shelves.

This semi "hands off" approach by retailers leads to margin creep. Many distributors work on 25-35% gross margins on these full-service programs. They need to in order to make any money. Often the retailer doesn't even know what the distributor's overall margin in the category is. The extra distributor margin goes into the retail price of the organic goods since the retailer isn't about to take it from its margin. This practice, along with other distributor inefficiencies like logistics, buying practices, poor marketing and more, contributes to higher than needed retails on organic food and beverage products.

We believe there's easily another 5-10% margin savings between increasing organic foods' manufacturer efficiencies and improving and streamlining the third-party distribution system. In fact, Safeway, for example, now distributes the majority of the organic grocery products it sells in its stores directly, through its natural and specialty foods buying and distributing division. The retailer only uses a third-party distributor for slower moving items. The problem, however, from a consumer pricing (and category mainstreaming) standpoint is that Safeway hasn't put much if any of this savings into lower organic category retails. Rather, it's gone to margin. The grocer is offering some significantly lower retails on its private label brand O' Organics however, which is Safeway's line of organic, premium quality grocery items.

Perhaps this is where the organic food and beverage market is going? Large, mass market food retailers like Safeway, Kroger, Wal-Mart, Costco and others will continue to lower the retails on their private label organic brands, while holding the line retail pricing-wise on the national and regional branded organic items produced by manufacturing companies. This would allow the retailers to maintain their margins on the private label (with a slight reduction perhaps) while also keeping the higher margins on the manufacturer brands. Private label brands generally have lower costs of goods for these retailers, so they can continue to reduce the retails, while at the same time getting better deals from their vendors, and still ring-up high gross margins on the products.

Mintel's study agrees with our analysis that organic food and beverage product retails remain too high overall. Two thirds of the respondents reported they would buy more organic items if the products cost less. These consumers said current retail prices tend to turn them off on the organic category. This data, according to Mintel, tends to support our argument above that there could very well be a move by consumers to more store label organic products since it seems the trend is for these retailers to offer the brands at lower retail prices than manufacturer branded organic food and beverage items.

A key decision within the industry will be how fast the various players want to see organics become more mainstream. We believe pricing is key to the rapidity of this phenomenon, despite the significant growth projected by Mintel (59% organic foods, 65% organic beverages) for the next five years.

It's clear to us that in the main retailers are now taking charge of the category with there successful and expanding private label organics lines. As such, they'll be the primary players in this growth and mainstreaming process. That's not to say organic food and beverage manufacturers and distributors don't still have a significant role to play--they do. However, like they are in the conventional grocery products category, food retailers are rapidly becoming the key players (along with consumers) in the organic category.

And of course, lets not forget Whole Foods Market, Inc. With the supernatural grocer's acquisition of Wild Oats and its aggressive new store building program, Whole Foods remains in perhaps the number one position in the industry in terms of influencing the speed of organic category mainstreaming by its retail pricing policies.

Does Whole Foods want more consumers to be primary shoppers at its stores? The answer is yes. That's where the new growth comes from. Perhaps lowering its retails on organic food and grocery products say by 10% across all categories would convert numerous secondary shoppers to primary shoppers and lower the price barrier to entry for consumers wanting to try Whole Foods but being put off by the reality or perception that its prices are just too high?

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