Delivering breakthrough performance for consumer products companies in Brazil

Margin unlocked

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Brazil Consumer Products sector contacts

Margin Unlocked

Sérgio Almeida Transactions Leader +55 11 2573 3086 sergio.almeida@br.ey.com

Waldyr Passetto Assurance Leader +55 11 2573 5641 waldyr.passetto@br.ey.com

Fiona Araújo Markets Leader +55 11 2573 3561 fiona.araujo@br.ey.com

Cristiane Amaral Overall Sector Leader and Consulting Leader +55 11 2573 3021 cristiane.amaral@br.ey.com

Jefferson Sanches Tax Leader +55 11 2573 3253 jefferson.sanches@br.ey.com

Delivering breakthrough performance for consumer products companies in Brazil

Margin unlocked

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Consumer products companies in Brazil face challenging times. As EY explored in its 2012 report Disrupt or be Disrupted, the industry as a whole is facing a brand new order of continuous, accelerating change and spiraling complexity in which tried and tested ways of capturing value are no longer fit for purpose.

Margin management is no exception. Although conditions in Brazil are not yet as tough as in developed economies, there are a number of specific regional factors that greatly impact the ability of local consumer products companies to grow and sustain margins. These include a heavy local tax burden, high labor costs, along with infrastructure and logistics challenges, which vary greatly from the north and south of the country.

Brazilian firms need to act now to move beyond a tactical, reactive approach to sustaining or growing margins. Incremental and localized changes focused on a specific part of the P&L or within a region, function or category will only see margins grow thinner. Some key findings from our survey stand out:

1. Three-quarters of consumer products executives surveyed from Latin America say that it has become harder to grow or sustain operating margins over the past three years. A further 52% expect conditions to become even harder in the next three years.

2. Among Latin American respondents, the biggest internal obstacles to growing or sustaining margins are a limited “margin mindset” in the organizational culture, and challenges with the operating model.

3. Companies admit that there are key areas where change is required to drive a more integrated margin management approach. Latin American respondents, in particular, report a clear lack of effectiveness at ensuring speed of decision-making to respond to margin improvement opportunities.

4. A small number of Latin American companies, however, are able to deliver “breakthrough” margin performance. These industry leaders share a number of common characteristics, including a proactive, end-to-end approach to managing margin that helps them look beyond cost reduction and price increases to drive more sustainable results.

Many Brazilian companies urgently need a new, organization-wide approach to margin management, driven by senior leadership and permeating the entire business. Putting this into practice requires companies to establish three building blocks that must form part of the DNA of the organization. Together, these building blocks comprise a framework, which EY calls integrated margin management.

About this researchIn early 2013, EY collaborated with the Economist Intelligence Unit to conduct a global survey of 183 executives from consumer products companies. Respondents represented a range of sub-sectors, including food and beverages, home and personal care, luxury, tobacco and apparel. In total, 17% of respondents were based in Latin America. Of these, 40% were based in Brazil, 20% in Argentina, 16% in Mexico, 12% in Chile and 12% in Colombia. Approximately half of respondents were C-level, or-board level executives.

In addition, EY conducted a program of in-depth interviews with senior executives from across the consumer products industry - including many in Brazil - to seek their views on current best practice in margin management. Our thanks are due to all the executives who participated in this research for their time and insight – specially the executives who participate of the qualitative interviews regarding the Brazilian market:

Claudio Nessralla VP of Operations, Morena Rosa

Gilberto Meirelles Xandó Baptista President, Vigor

Gino Didomenico CEO, Brasil Kirin

Jefferson Romanholi President, Frigoríficos Marba

José Roberto Lettiere CFO and Investor Relations Director, Alpargatas

Leonardo Senra Finance, Investor Relations and IT Director, Souza Cruz

Leopoldo Saboya Chief Administrative, Financial & Investor Relations Officer, BRF

Peter Rossbach CFO, Faber-Castell

For the purposes of this research, the term “margin” refers to operating margin, or earnings before interest, tax, depreciation and amortization (EBITDA).

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Margins under pressureIn most countries, margins at consumer products companies are being squeezed from multiple directions. Latin American companies are no exception. More than three-quarters of companies from the region say that it has become harder to grow or sustain margins over the past three years, which is almost identical to the proportion of global respondents reporting the same trend (see chart 1). Companies across the region, including in Brazil, report that margins have come under pressure from spiraling wages, commodity prices, taxes and distribution costs.

Chart 1:Has it become easier or harder for your company to sustain or grow operating margins?

Chart 2:Margin performance of the top 30 Latin American CP companies over 10 years1

16%

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76%

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The outlook for marginsLooking into the future, there are few signs that these pressures will dissipate. As a result, consumer products companies are being encouraged to think differently about how they manage margin. In the past, companies took a tactical approach, and focused on making specific improvements within geographic or functional boundaries. Many companies embarked on a series of one-off initiatives, frequently driven by market pressure, that were designed to achieve a very specific goal. For example, they may have implemented an overhead reduction programme or undertaken a consumer pricing initiative.

In isolation, these initiatives may have achieved their goals and delivered modest margin performance improvements, but they have done little to reverse overall margin pressure.

This becomes evident when we look at the margin performance of leading Latin American consumer products companies over the past decade. Most have managed only to deliver modest margin growth, with the overall average margin for the largest 30 consumer products companies decreasing by 200 basis points over the 10-year period (see chart 2).

* Latin American respondents only

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•19,2%

18,9% 19%18,8%

18,3% 17,1%16,7%

17,1% 17,2% 17,2%20%

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0%2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

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1Source: CapitalIQ. Chart shows unweighted EBITDA performance of the top 30 Latin American headquarted CP (Food, Beverage, HPC and Tobacco) companies as ranked by revenues in 2012

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In Brazil, some companies are already trying new approaches. Gino Didomenico, CEO of Brazil Kirin, Brazil’s third largest brewery, emphasizes the importance of focus to achieve consistent profitability. “Our mantra is to have a very clear strategy and defined priorities, with a focus on profitability,” he explains. “We apply a ‘must win battles’ approach at Kirin. Priorities and tradeoffs are clearly defined: which categories, brands, geographies and projects are key for the development of the brand and the team.”

Claudio Nessralla, VP of Operations at Morena Rosa, a Brazilian clothing manufacturer, also emphasizes the importance of having focus, but highlights that this should not mean restricting the company’s offering. “Focus for us does not mean cutting something altogether and looking at only one aspect,” he argues. “It is important to re-invent and have direction. We need to focus on what is important without isolating ourselves from the context.”

Large discount retailers, for example, put so much pressure on consumer goods suppliers that some have been forced into whole new channel strategies: shifting to service five or ten times as many smaller customers as a way of building and gaining control

over margins. But as Jefferson Romanholi, President of Frigorífico Marba, a food company, explains, this then creates new problems: “As we changed from a larger centralized model to a decentralized model, there were many logistics and transportation impacts. Before we could enter São Paulo city with large trucks and one truck could deliver to 30 clients, now we can only use small trucks and need 10 trucks with 10 drivers and 10 helpers to do the same job.” As in this case, while new strategies are necessary for long-term survival, they don’t always transform margins. It is also essential to embed operational excellence in everything the company does.

Another strategy that is increasingly common in Brazil is an up-scaling or de-commoditization of products in order to exploit new demographics with higher incomes. “We have focused on having overall better quality products and have tried to avoid low margin products with low EBITDA,” says the director of large Brazilian consumer products company. “As part of this strategy, we have reduced 40% of our low margin SKUs. We believe we have been effective here by analyzing cost reduction, costs of SKUs, conducting factory benchmarking and conducting product management reports.”

Chart 3:Distribution of operating margins for the top 30 Latin American CP companies 2

“Companies that deliver break-through margin performance approach margin holistically and embed integrated margin management into the DNA of their organization”

Cristiane Amaral, Consumer Products Lead Partner, EY Brazil

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2012 operation margin

Operating margin growth vs 2003

• 2012 weighted average operating margin

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2Source: Capital IQ Chart shows unweighted EBITDA performance of the top 30 Latin American headquarted CP (Food, Beverage, HPC and Tobacco) companies as ranked by revenues in 2012 Excludes companies which did not report data in 2003

Ambev’s parent company ABI, for example, has an operating margin of 32%, ahead not just of global beer companies but also premium spirits brands. ABI’s simple, focused and clear approach to its business and margin, heavily influenced by ambev, has had a significant impact, consistently delivering increasing EBITDA margins since its formation in 2008. The ABI way comprises four key strands: a lean cost structure (including zero-based budgeting); being in the right markets; focusing on the right brands; and a pursuit of price leadership.

Chart 4:the ABI way

Breakthrough performanceDespite these challenges, our research provides encouraging evidence of a number of Brazilian companies that have delivered “breakthrough” margin performance over the past 10 years, surpassing the results delivered by their peers. Chart 3 maps the operating margin and change in operating margin for the largest consumer products companies. The results are diverse, but those positioned towards the top right-hand corner – including ABI’s subsidiary Ambev and Souza Cruz – are achieving best-in-class margin performance. Not only are they delivering margin at the top of their industry group, they have also delivered consistent increases in margin over the past five years.

Our research and experience of working with companies across the consumer products industry points to a number of key features that are common to the way in which these “breakthrough” companies view and manage margin within their organizations.

In particular, they take an active approach to breaking down barriers across the organization and apply innovative, non-traditional thinking to improve margin performance. By managing margin end to end, they look beyond cost reduction and price increases to find a more integrated way of driving overall results. This puts the company in the best possible position to drive margin improvement across the entire organization.

ABI

32%• ABI generates

impressive operating margins of 32%

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An integrated approach to margin management, driven by senior leadershipApproaches to sustaining or growing margins that worked well in the past are now failing to deliver. We believe that consumer products companies must look at margin more holistically and consider opportunities for driving performance across the entire P&L (see chart 5). This means working more collaboratively with both internal and external stakeholders as a single organizational unit rather than as a collection of functions, partners and geographies.

Embedding a pervasive culture of margin management starts with the vision and urgency

Chart 5: Functional interventions are making way for an end-to-end approach

Improved insight on margin performance to drive better, faster decisionsAn integrated margin management approach requires companies to make step changes to the visibility into the performance of the business, and the velocity with which they are able to use that information to make decisions. Driving breakthrough margin performance requires companies to “get granular” and focus on the details so that they can access, monitor and act upon information both confidently and in a timely manner.

This is an evolving area in Brazil - and around the world - and one where many companies are still finding their way. But among our Latin American survey respondents, for example, 20% say that they are very effective at leveraging data and analytics to inform margin decision-making. This compares well against just [13%] globally.

As one director told us: “We do not have the optimum level of business intelligence that can be achieved from our SAP system. We conduct our analysis by sector, sales numbers, people, SKU, clients, etc. We do not have a data problem. Our the challenge is turning data into usable intelligence.”

In our view, using driver-based analytics mathematically to link outcome metrics with the forces that drive margin is fundamental to good decision-making. Decision-makers can prioritize actions on the highest impact drivers. EY’s recent publication Making better decisions faster outlines further the case for employing a Driver-based Analytics Approach.

for change articulated by senior leadership. By working from the very top, companies can embed a new ethos deeply in the business and make it part of the fabric of day-to-day decision-making. “A culture and metrics around margin must permeate the company,” says Gilberto Meirelles Xandó Baptista, President of Vigor, a Brazilian dairy and food company. “Initiatives around pricing that are embedded across the whole value chain should be closely linked to sales team metrics, not only based on volume but also on bottom line results.”

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An operating model with margin at its coreTo ensure that integrated margin management delivers the intended results and is sustainable, Brazilian companies needs to break down a number of key barriers to facilitate a whole new way of operating. There are four key priorities that they need to consider:

Transcend traditional barriers with margin orchestrationEmbedding a culture of margin management requires companies to ensure that the right accountability is in place to drive the right behaviour. By making an individual or team responsible for margin management, companies are better able to prioritize opportunities and allocate resources.

For example, at Alpargatas, the Brazilian footwear giant and producer of the Havianas brand, this begins by spreading responsibility and accountability for margin throughout the key areas of the business. All managers are then trained to focus on the same overall operations plan. “An overall operational plan indicating a focus on contribution margin maintains our focus,” says José Roberto Lettiere, Brazil CFO and Investor Relations Director at Alpargatas. “Through the plan, all company managers have the same historical data, future targets and levers. The operational plan works clearly and shows how each area must act to achieve their contribution to margin.”

In geographically aligned organizations, the value chain is more fragmented and multiple P&Ls are impacted to reach end-to-end margin optimization. This makes margin orchestration more difficult to achieve. Faber-Castell, the German multinational stationery company whose biggest global market is Brazil, has a proactive way of dealing with this. “We have a network of Global Insights and Best Practice directors, managers and specialists,” says CFO, Peter Rossbach. “There is a common exchange between Germany, Brazil and Indonesia. We take a lead from the competency leader in a certain area: i.e. plastics in Peru, wood technology in Brazil, premium production technologies in Germany. At the same time we are always aware of regional specifics and that not all knowledge and practices are transferable.”

Increase awareness, motivation and organizational capability at every level of the companyUltimately, margin needs to be the responsibility of everyone in the organization. Constant communication reinforces the message about the importance of margin management, and embeds it in the culture.

Chart 6: Total margin management

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“We always seek to communicate and explain our strategy and direction,” says Leonardo Senra, Finance, Investor relations and IT Director at Souza Cruz, a Brazilian tobacco company. “This requires a great deal of functional discipline, effective budget management, accuracy and solid action plans to execute well. We have also embedded a controller function in each department to demonstrate the importance of costs, create discipline and build internal awareness of costs and margins. As such, the functional areas expect costs and margins to be continually assessed and reviewed. It is part of the day-to-day culture.”

Creating the motivation for change and build new capabilitiesPart of the shift to an integrated margin management approach requires companies to incorporate margin targets into the annual target-setting process for the next year, as well as the strategic planning horizon. Targets then need to be cascaded through the organization and incentives aligned to ensure that integrated margin management comes to life in day-to-day execution.

Chart 6: Total margin management

Strategic Planning

Innovation & Portifolio Management

Sales & Operations Planning

• Strategic business planning

• Category / brand planning

• Annual planning• Customes planning

• Ideation• Development• Launch• Phase out

• Sales forcasting• Inventory

management• Supply planning• Materials

planning

Total margin management

Margin Unlocked

In addition to building basic awareness and education, companies need to develop a deeper skillset to analyze margin leakage and define action that is needed to make improvements. In many cases, companies may need to recruit or develop these skills because they are not already present within the key functional areas where margin improvement opportunities need to be identified.

Some leading consumer products companies are responding to the need for greater expertise by expanding the role of commercial hubs and creating global centers of excellence (CoEs) that can bring together best practice on margin management and ensure that it is applied consistently across the entire company.

Make margin management sustainable by embedding it into business-as-usualFrom the annual strategic processes through to day-to-day execution, a consideration of margin must be built into the formal processes and policies of the organization.

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