Private Label Profitability: The Precipice Of An Explosion

1. Private Label Profitability:The Precipice Of An Explosion Sunday, November 14, 1999 Chicago 8912 E. Pinnacle Peak Rd. Ste 650 Scottsdale, Arizona 85255 Phone (480) 513-0547 • Fax (480) 513-0548 • E-Mail: chrishoyt@hoytnet.com

2. Today • The gathering storm of Private Label energy in the United States • What is required to survive and thrive as a private label manufacturer or supplier

3. Hoyt & Company: • Marketing and sales strategists • Involved with Category Management from the start: • Specialists in Category Management and trade promotion spending • Over 100 projects with 30 of top 100 advertisers since 1985: • Annual category business plans • Re-engineering organizations to function effectively in Category Management • All systems and processes relating to Category Management • Restructuring trade promotion spending and tracking to support Category Management strategies and implementation requirements and to maximize efficiencies of trade promotion spending • Made every mistake humans can make. • You are about to benefit from 12 years of trial and error.

4. The Gathering Storm

5. Hoyt & Company Believes That the Private Label Business in the United States Is on the Precipice of an Explosion: • Past growth cannot be used as a predictor of future potential. • Consolidation and determination to increase profits make it a whole new ball game. • Private Label suppliers face both huge threats and huge opportunities. • The U.K. provides an almost line-by-line benchmark for what we believe will be the Private Label trajectory in the U.S. over the next 5-10 years.

6. The Most Distinguishing Factor of the U.K. Marketplace Over the Past 25 Years Has Been the Astounding Growth of Private Labels: • Between 1975 and 1998, Private Label unit share jumped from 25% to 43% of total U.K. packaged good sales while dollar share jumped from 20% to 36%: • Non-packaged goods private labels in the U.K. now account for over 80% of all goods sold in the meat, fish, poultry, fruits, vegetables and deli departments.

7. The Most Distinguishing Factor of the U.K. Marketplace Over the Past 25 Years Has Been the Astounding Growth of Private Labels: • It is clear that there is a consistent relationship between Private Label growth and retailer consolidation: • Top 5 Supermarket Chains, U.K. 1975 - 1998 • 1975 • 1998 • % +/- • Top 5 SOM • Private Labels • 22% • 24% • 63% • 43% • 1865 • 79% Source: PLMA, Tony Cowling, Taylor Nelson, Mark Husson

8. Key Private Label Drivers – U.K., 1975 - 1998: • 1. 1970’s & 1980’s – Sainsbury Private Label Objectives: • Give Sainsbury name status of a major brand • Offer own labels competitive on quality to major national brands at consistently lower prices • Use national brands to promote categories and add excitement (i.e., build traffic) • 2. Late 1980’s, Early 1990’s – Enter The Mass Merchandisers: • QwikSave – Built business on price and cheap P.L.s • Discount share of market catapulted from 9% - 15% between 1989 and 1992 • Supermarkets responded with own cheap P.L.s – e.g., Tesco with BOL

9. U.K. 1975 - 1998 (cont’d): • 3. Since 1992: • 1992 – Analysts concerned about impact of low price brands on retailer profits • Sainsbury introduces first successful premium private label with Novon in the highly competitive HDLD category: • Between 1992 and 1996, private label share of HDLD catapulted from 8-16% • Sainsbury Novon share doubled from 15-33% • Lever’s share of HDLD nose-dived from 40-30% • Sainsbury immediately followed with Classic Cola which chopped Coke and Pepsi share in Sainsbury stores from 85% - 40% in less than one year

10. U.K. 1975 - 1998 (cont’d): • 3. Since 1992, cont’d • Tesco retaliated with Virgin Cola (controlled label) which at one time captured 25% of Tesco’s CSD sales • Virgin is now being phased out by Tesco in favor of Tesco’s own label

11. Net On U.K.: • Over 43¢ of every dollar spent in U.K. supermarkets is now spent on private labels. • U.K. private label brand marketing has all of the sophistication as national brand marketing in the United States: • “Store Brands” – Premium P.L.s priced to compete with nationals and deliver sufficient profits to fund advertising and promotion campaigns. • “Traditional P.L.s” – NBE’s to capture conventional private label consumers and offer high value for price. • “Cheap Budget Own Labels” – Minimum acceptable performance, packaging and priced accordingly.

12. Net On U.K. (cont’d): • U.K. private labels now growing at a steady 1% per year while national brands continue to decline, in some categories as much as 2-3% per year. • Supermarkets are now the second largest advertisers in the country, behind only automobiles: • Tesco, Sainsbury and Asda are each individually among the top 10 advertisers in the realm. • The amount of exposure the U.K. consumer has to retail organizations in the U.K. is overwhelming compared to that of major branded suppliers.

13. Net On U.K. (cont’d): • In many categories, the demarcation between national brands and store brands has been so diluted that the consumer no longer distinguishes between the two, much less cares. • The “balance of power” struggle in the U.K. is over. U.K. retailers: • Control the shelves • Control the windows • Control the “telly” • Control the distribution

14. Counter Arguments – “It Will Never Happen Here – The U.S. Is Different!” • The U.K. is small geographically vs. the U.S. which is very heterogeneous and regionalized in nature. • The U.S. consumer is habituated to national brands and has more disposable income than the U.K. consumer. • Advertising costs too much in the U.S. and retailers would never be able to afford the sustained advertising necessary to establish a store brand as a national. • Meanwhile, U.S. national brand manufacturers are much more powerful than in the U.K. and are not just going to sit idly by while supermarkets and other retailers chip away at their franchises or shares.

15. All This May Have Been True In The Past BUT... • While Hoyt & Company does not wish to degrade or minimize these arguments, we believe that there is presently a combination of factors at work in this country which will shortly and inevitably bring fierce and renewed retailer energy behind the private label sector – energy, power and commitment unlike any other country has experienced before.

16. Factor #1 – Consolidation: • Top 5 Industry Players – Food • Year • % ACV • 1992 • 1998 • 1999 • 2002E • 2007E • 19% • 24% • 33% • 50% • 60%

17. Private Label Share Data In Other Countries Show That With Few Exceptions, It Is The Large, Powerful Retailers Who Invest Most In Their P.L. Programs And Who Almost Uniformly Have The Highest P.L. Shares: • Top RetailerP.L. Share ($) • Avg. P.L. Share • Country • Top Retailer • % Difference • U.K. • Canada • Netherlands • U.S. • France • Belgium • Spain • Tesco • Loblaw • Ahold • Kroger • Carrefour • Delhaize • Continenté • 45.0 • 37.0 • 33.0 • 24.5 • 20.0 • 20.0 • 20.0 • 37.1 • 20.0 • 16.3 • 16.3 • 20.5 • 16.3 • 12.0 • +21% • +85% • +127% • +50% • -3% • +23% • +66% Source: Mark Husson, Merrill Lynch, 1999

18. Factor #2 – Private Label Profitability: • Private Label gross margins are estimated at 34% vs. national brands at 24%. • The narcotic appeal of P.L. margins is shown in the following table which illustrates P.L. profit contribution in the CLCP category for one major national retailer.

19. Factor #2 – Private Label Profitability: • Contact Lens Cleaning Products, 52 Weeks, 9/99 • Segment • Total Profit • P.L. Profit • P.L. % Total • Total Vol. • P.L. Vol • Re-wetting • Weekly • Daily • MPS • Peroxide • Hard • RGP • Aerosol Salines • Liquid Salines • TOTALS • $1,335.7 • 1,644.3 • 743.7 • 2,501.5 • 38.9 • 1.9 • 1,103.9 • 61.4 • 193.6 • $7,625.0 • $189.4 • 352.6 • 10.9 • 1,778.3 • – • – • – • – • – • $2,331.3 • 14% • 21% • 1% • 71% • – • – • – • – • – • 30.6% • 5,156.9 • 6.1%

20. Factor #3 – Need For Differentiation On Basis Other Than Price: • 60% ACV among five supermarkets will escalate competition to unprecedented heights: • Not two years ago, one often-quoted survey noted that over 83% of consumers thought all supermarkets were alike. • Supermarkets cannot compete on price and raise profits at the same time. • One of supermarkets’ key weapons will be premium Store Brands: • Wal-Mart is already on this track • Consolidation –> Increased Store Penetration –> makes advertising cost-effective • 60% national penetration is magic number – reason why Wal-Mart wants so desperately to get into the East

21. Consumer Migration Across Channels Only Intensifies Competition And Exacerbates The Need To Differentiate: • 1999: • 100% of consumers shop supermarkets 1.8 times per week. • 94% of consumers shop mass merchandisers 2.3 times per month. • 86% of consumers shop drug chains 1.3 times per month. • 52% of consumers shop convenience/gas 1.1 times per month. • 49% of consumers shop clubs 9 times per year. Source: A.C. Nielsen, Channel Blurring Study, 1999

22. Factor #4 – Rapidly Growing Population Segments To Whom Private Labels Appeal: • Elderly • Lower Incomes • Lower Housing Values • Large Families • Higher % Working Women • High Levels of Education Source: Stephen J. Hoch & Sanjay K. Dhar, Wharton, Feb, 1996: “Why Store Brand Penetration Varies By Retailer”

23. Average HH Income – Despite What The Government Might Claim, Here Are The Startling And Abysmal Facts: Source: U.S. Census Bureau: 1967 - 1999

24. If The Average HH Bought P.L.s Exclusively On Every Shopping Trip To A Supermarket, It Could Save Up To $3,000 Per Year, Depending On Where It Lived: • P.L. Savings Vs. National Brands, 54 Item Shopping List • Brand-NamePrice • Store-BrandPrice • Supermarket Chain • Overall Savings • A&P • Jewel • Safeway • ShopRite • $135.70 • 138.81 • 139.33 • 135.91 • $91.13 • 114.36 • 114.71 • 98.56 • $44.57 • 24.25 • 24.62 • 37.35 • Avg. of Above 4 Retailers: $32.69 • X 91 Trips/Year: $2,975 Source: Phil Lempert, 1998: “Store Brands: Their Stock Is Soaring”

25. The Following Reiterates Why The Prospect Of Buying Private Labels To Save Up To $3K Per Year Is So Powerful For The Average American, Particularly If He/She Felt They Could Get NBE (Or Better) In The Process: • Share of Aggregate HH Income By Quintile: 1996, 1993 and 1998 (%) 24.4 21.0 Top 5Percent 17.5 Middle 60 Percent Source: U.S. Census Bureau, Current Population Survey, March 1968, 1994, 1999

26. Factor #5 – Dilution and Erosion Of Supplier Clout And Control: • With few exceptions, the national brand supplier community is in disarray: • Has not been able to formulate a successful response to retailer consolidation or ascendancy • Spending more and getting less (TP spending now at 60%) • Focused on the wrong things – e.g., growing the category instead of own brands (!) • Characterized by unthinking and uncritical acceptance of industry epidemics such as DPP, ECR, “Partnering”, “Meal Solutions”, “Solutions Selling” and Category Management. • Meanwhile, brand loyalty continues to erode while P.L. sales grow at national brands’ expense.

27. This Is True Of P.L. vs. National Brands In All Trade Classes: • Food Sales: Private Label Versus National Brand Growth By Format Total Mass Merchants Drug Stores Supermarkets Source: Private Label Manufacturing Association

28. It Is Also True of Manufacturers Of All Sizes Except Small Manufacturers Who Either Did Not Know Enough Or Have The Resources To Get Distracted By The Latest Industry Craze: • Manufacturer Sales Growth By Channel Comparison (1998 over 1997) • DrugStores • MassMerchandiser • CombinedOutlets • Supermarkets • Top 10 Manufacturers • Next 15 Manufacturers • All Other Manufacturers • Private Label • 1.2% • 0.9% • 3.5% • 3.2% • 4.7% • 1.5% • 2.1% • 7.3% • 14.5% • 13.0% • 13.7% • 17.6% • 3.1% • 3.3% • 5.1% • 5.0% Source: IRI

29. Net Result – A Tsunami In The Making: • Kroger – #1 At $44B (1999E): • P.L. Brands now account for 25% of sales • Own P.L. manufacturing facilities • Centralized P.L. purchasing • Three tier P.L. program – premium, traditional and value • Just bought Fred Meyer where P.L. sales are 18% and mainly in G.M. versus Food

30. Kroger (cont’d) • If Kroger can get Fred Meyer P.L. food sales to 25% in three years, Kroger’s P.L. sales would be $10B and incremental gross profits would be almost $100MM. This means that Kroger’s: • P.L. segment only would be larger than Heinz, Pillsbury or Best Foods • Profits would grow from 2.8 to 4.0 or 43% • Reality is that Kroger’s P.L. sales will grow to more like 30% when Kroger shifts focus from reducing operating expenses and assumes role of marketer.

31. The Other Players: • Albertson’s-American – #2 at $36B: • American got 30% of its profits and 20% of sales from just 8% of its P.L. SKUs • This gives Albertson’s huge opportunity to grow its own P.L. sales from current levels (16.5%) to American Store’s levels (20.2%)

32. The Other Players: • Safeway – #3 at $27B: • Wins Titanium Award for developing and establishing a beautifully-packaged, quality “store brand” with Safeway Select. • Has the P.L. formula down pat: Is country leader with P.L. share at 25.5% of unit sales. • Can leverage Select brand name plus P.L. experience in Von’s, Dominick’s and Carr Gottstein.

33. The Other Players: • Ahold – #4 at $22B: • Can leverage European P.L. expertise against Bi-Lo, Stop & Shop, Tops, Finast, Cleveland and Giant, Landover. • Procure on an international level. • 37% P.L. penetration in Netherlands. • 37% becomes the floor (not the objective) in the U.S.

34. In Total, The Handwriting Would Appear To Be On The Wall: • Share of Market • % P.L. Share of Total (Units) • All need to differentiate on basis other than price. • No evidence that consolidation ambitions have peaked. • All have size, resources and economies of scale to become own marketers and take over role of “Category Captains” themselves. • Key Players • $ Sales (B) • 1993 • 1998 • 1993 • 1998 • Kroger • Wal-Mart • Albertson’s • Safeway • Ahold • Totals • $44 • 39 • 36 • 27 • 22 • $168 • 6% • 0% • 3% • 4% • 2% • 15% • 10% • 9% • 9% • 7% • 5% • 40% • 22.0% • 14.0% • 17.4%* • 20.5% • 16.0% • 17.8% • 24.5% • 16.5% • 20.2%* • 25.5% • 20.5% • 21.2% * American

35. Surviving And Thriving As A P.L. Manufacturer or Supplier

36. Threats To The Independent P.L. Manufacturing Community: • 1) Retailers developing own manufacturing capabilities as their P.L. grows and becomes cost effective to take in-house. • Kroger • Safeway • 2) National Brand manufacturers who have adopted P.L. supply as a contingency (or even survival) strategy: • Protect National Brand franchise • Cover operating costs • Already producing to NBE standards • Can leverage current I.T. and R&D to capture and maintain Private Label edge • 3) “I Saw The Enemy And It Was Us!” – Lack of size, clout, resources and information technology to deal with mega giant’s demands in what, by definition, is a low margin business.

37. Given this environment, the key questions for private label suppliers is what are the meaningful ways one can differentiate oneself and create value for retailers over and above the obvious?

38. Let’s Start With The Obvious, Because This Is The Baseline: • Key Success Factors That Characterize Retailers’ “Best” Private Label Suppliers • Very Important • Important • Not Important • Consistent Product Quality • Complete/Timely Deliveries • Promotional Support • Flexibility On Price • Innovative Product Ideas • Below Average Product Costs • In-Store Sales Service • 100% 0% 0% • 98% 2% 0% • 52% 36% 11% • 49% 51% 0% • 49% 49% 2% • 44% 42% 14% • 14% 44% 42% Source: PLMA, “Blueprint For Growth” Current Salmon Associates, 1998 Based On Responses From 45 Leading Retailers

39. How Independent Private Label Manufacturers Stack-Up Against National Brand Manufacturers In Meeting These Needs Suggests That “Pricing Flexibility” Is Currently The Independents’ Strongest Selling Point: • Which Type of Supplier Is Better Equipped In Regard To The Following Factors? • Private Label Suppliers • National Brand Suppliers • Performance Measures • Retail Margins 96% 4% • Pricing Flexibility 84% 16% • Ability To Work With 69% 31% • Product Quality 39% 61% • Consistent Delivery 34% 66% • Promotional Support 22% 78% • Packaging 21% 79% • Equipment & Technology (Plant/Machinery) 20% 80% • Category Management 9% 91% • EDI 9% 91% • Product Innovation 2% 98% • ECR 0% 100% Source:

40. With Regard To Price: • Low price is NOT a viable or sustainable strategy for P.L. manufacturers long-term: • Anyone with deep pockets can emulate low prices and outlast you • Perrigo and Paragon are not the lowest cost suppliers in their categories and did not build their businesses slowly on price

41. With Regard To Price: • Price IS a major component of the P.L. sales mix but must be balanced with other factors to provide you with a signature reason for being – for example: • Identifying new product opportunities and developing new products to meet them • Consistent quality • Consistent delivery • Promotion support • All of the above

42. It Is Obviously Impossible In A General Meeting Like This To Address Each Supplier’s Particular Issues, But Here Are Some Guidelines Which Will Help You Survive and Thrive In The New Environment: • 1. Do not try to be all things to all retailers: • Different retailers have different definitions of “value-added” and even these may vary in degree. • Know how each retailer defines value-added and target those retailers whose definition most closely approximates your core competencies.

43. Guidelines, (cont’d) • 2. Be able to say who you are what you stand for in one (short) sentence: • For example: • “One-stop shopping for high quality store brand products” • Do one thing right and build your reputation on it

44. Guidelines, (cont’d) • 3. Understand what you are good at and be honest with yourselves about what you are not good at: • Do not expand into areas outside of your core competencies as this will only dilute your image and drain your resources

45. Guidelines, (cont’d) • 4. Know your costs: • If you do not yet have an activity-based costing (ABC) system, get one • As chains get bigger, P.L. margins will go down • Success or failure may be a matter of pennies – as it has been for years in the supermarket business

46. Guidelines, (cont’d) • 5. Avoid making promises you cannot fulfill: • “If you take us on, we’ll put one person on-site to manage the business.” • “We can process and deliver within 7 days.”

47. Guidelines, (cont’d) • 6. Hire the best people you can afford but stay lean: • Particularly important with those who represent you on the front line • Leverage big company training and expertise

48. Guidelines, (cont’d) • 7. Do not build in unnecessary quality: • Once NCE is past, you are back in a price game • Better to devote the funds to new product innovation or operational improvements

49. Guidelines, (cont’d) • 8. Dig for the details that will make a difference and set you apart. For example: • Most supermarkets are leaving millions on the table because the price gap between P.L.s and national brands is too big vs. consumer expectations • All of this is carefully detailed and publicly available in a nifty little report from Wharton. Using information like this to help your key accounts increase profits is far more powerful than cutting your costs another 10¢.

50. Death Strokes: • In the future, if your answer to, “why should we buy from you?”, is: “Because we are the lowest cost brand” – you are committing suicide. • “We’re just as good as the supplier you are using” – provides no real point of differentiation (and pisses off the buyer). • “I’ll match anybody’s price” – indicates that the supplier does not understand his own costs and is potentially unreliable as a long-term source. • “Just tell me what you want and I’ll make it for you” – conveys the message that you are not much more than a street walker.