At a time when the outlook for food and beverage companies seems brighter, the business agenda for leaders in the industry continues to grow more complex. Tax, regulatory and business uncertainties and concerns loom, with issues such as changing tax regulations, health care reform, the proposed FDA Food Safety Modernization Act, ingredient tracking requirements, inspections, food safety and carbon footprints adding to the challenges facing company leadership. It's no longer enough to develop safe, high-quality products and deliver them to market; executives must also navigate an increasingly strict regulatory environment, pursue growth through mergers and acquisitions, and leverage government incentives and credits.
What are food and beverage manufacturers doing in the face of these challenges? How are they achieving growth? This survey examines a number of key strategies food and beverage leaders are pursuing as they guide their companies through today's unique challenges and opportunities.
Grant Thornton LLP, an audit, tax and business advisory firm, collaborates with Food Processing magazine on a series of industry surveys — Fast Facts on Food Processing — to offer perspectives on performance trends, challenges and opportunities in the food industry. This edition — Food company leadership and outcomes — examines how companies are growing their organizations and leveraging government incentives. Responses were received from 116 companies (see the participant profile at the end of this report) in August and September 2010.
Emerging lean and ready for post-recession growth
Cost cutting has been on the minds of food and beverage manufacturers for some time. In fact, many were already somewhat lean heading into the recession, spurred into efficiency by spiraling raw material prices during 2007–2008. "Companies went through a process of reducing staff and capacity at that time to cope with high ingredient prices," explains Dexter Manning, national Food and Beverage practice leader. "By the time the recession began, ingredient prices had become more moderate, but many companies continued to hunker down and cut costs.
Consequently, many food and beverage companies had better profitability in 2009 despite lower sales," explains Manning.
But by a number of indicators, the worst is over. Consumer spending has remained strong. People are dining out again. More importantly, many of the food and beverage companies that have cut heavily over the past few years are actively looking for growth, both through capital investments and through M&A activity.
"Companies are recognizing that they've got to start growing and are slowly beginning to increase capacity and make capital investments in property, plant and equipment," says Manning. "Not only are these changes overdue since they have been put off for some time, but companies can now take advantage of government credits and incentives to retrofit and upgrade certain aspects of their facilities and equipment, and increase write-offs for purchases of fixed assets, property and equipment. We expect to see a sustained increase in capital spending over the next 12–24 months."
Growth is particularly important now, given that for most food and beverage companies, there is little excess left to trim. "It will be very difficult to make further reductions without experiencing real pain and changes in infrastructure, such as sacrificing long-term R&D or new product initiatives. Even though companies that contracted during the recession may have increased their cash flow through reducing inventory levels and improving the collection of accounts receivable, leaders are aware that further cuts may affect the company negatively in the long term," says Audit Partner Danny Goldberger.
Savvy food and beverage executives are asking a critical question: How are we going to raise revenue and gain market share at this time? Our respondents answer this question in a number of ways: Many are engaged in M&A activity. More companies are spending on expanding capacity and investing in products. Government incentives are spurring spending on R&D and sustainability. At the same time, regulatory and tax issues remain at the forefront of leaders' minds.
Mergers and acquisitions
The food and beverage industry has witnessed an uptick in M&A activity, particularly during the third quarter of 2010. A number of factors are involved in the increase, including the loosening of the credit markets and with that, the greater availability of capital. Some M&A activity has been driven by entrepreneurs who are motivated to close deals before the 15% capital gains tax expires on Dec. 31, 2010.
"We've also seen an increase in strategic buyers holding onto cash, as well as private equity funds sitting on cash they need to deploy or return to their limited partners. So, there is a great deal of money sitting on the sidelines that we expect to see deployed in the coming months," says Brian J. Basil, Corporate Finance director. "However, there is still some uncertainty in the market holding back strategic buyers; there is also poor availability of commercial debt, but that is coming back as well."
Twenty percent of food and beverage manufacturers have pursued M&A activity in the past 12 months, with 15% of companies reporting that they had acquired or were in the process of acquiring another entity, and 5% reporting that they had been acquired or were being acquired (see the "M&A activity" table above). In the coming 12 months, 9% of food and beverage manufacturers expect to make an acquisition. Executives reporting that M&A activity is likely in the next 12 months cite a range of reasons for their intended acquisitions.
These reasons include corporate strategies focused on acquisitions; available cash; intent to develop a market presence; opportunities for small, selective acquisitions; and an urgent need to find knowledge and managerial skills not otherwise available.
M&A activity was substantially more common among public companies than among private enterprises or companies with other ownership structures. Of the companies participating in this survey, 42% were private equity-owned, 30% were private companies that were not owned by private equity, 24% were public companies, 3% were cooperatives, and 1% were employee stock ownership plans (ESOPs). Approximately 46% of publicly held food and beverage manufacturers report that they have been in the process of completing — or have completed — an acquisition over the past 12 months, and 22% of public companies have plans to acquire in the next 12 months. On the other hand, only 7% of private companies (meaning those under private ownership or private equity-owned) were involved in M&A activity in the past 12 months, and just 4% expect to take part in such activity over the next 12 months.
"It makes sense that public companies would be engaged in more M&A activity than private companies," says Basil. "Public companies typically have easier access to lower-cost capital and often have more flexibility with regard to deal structure than private companies. An example of such flexibility is the fact that public companies can use their stock as consideration in a transaction, which can facilitate dealmaking."
Among food processors — the largest segment of companies participating in this survey — 18% have been involved in an M&A event over the past 12 months. Among these, 12% acquired another entity and 6% were in the process of being acquired. Nine percent report that they plan to acquire in the next 12 months. No food processors expect to be acquired during that time.
But acquisition opportunities are clearly not limited to public companies or processors, especially now. "There are ample opportunities for strong companies to make acquisitions in today's market, whether to expand geographically, to add product lines or capacity, or to hire additional sales personnel. Structured properly, investments via acquisitions can require less capital than investing in existing plants and equipment. And, acquisition investments can be less risky to the core business if things don't go as planned. Also, the return on investment can be much greater and more immediate," says Basil.
Credits and incentives
Many food and beverage manufacturers are focused on becoming more energy efficient, implementing recycling efforts and investing in alternative-energy sources. Costs related to these initiatives can be significantly reduced through the use of green credits and incentives, which may be available at both the state and federal levels. These credits and incentives can help offset investment costs related to energy-efficiency efforts. For example, income tax credits, sales tax exemptions and property tax abatement programs are offered in a number of states (Arizona, California and Texas) to companies that want to install solar- or wind-powered equipment. In addition, many utility providers offer incentive programs that provide a cash grant for a percentage of the investment related to efficiency projects such as the installation of energy-efficient lighting systems. And the American Recovery and Reinvestment Act of 2009 extended income tax credits to corporations making qualified investments in equipment that uses solar and wind power and other alternative energy sources.
"Green credits and incentives, available through a combination of federal, state, local and utility-provider sources, are not the main reason companies do these types of activities, but the credits and incentives certainly improve the return on investment," says Tim Schram, State and Local Tax senior manager. "Given that costs have come down overall, it is beginning to become more financially viable for companies to achieve their sustainability goals."
Claiming federal and state research tax credits — R&D credits — for qualifying research activities is another way that some food processing companies are capitalizing on their investments in innovation and R&D. The (currently expired) federal incentive was designed to advance the competitiveness of U.S. companies in the global economy. The research tax credit has generally been available as a temporary incentive since its inception in 1981 and has been renewed 13 times during that period, often retroactively. Since its most recent expiration, food and beverage manufacturers have grown increasingly concerned about both its renewal and the timeliness of that renewal.
Recently, the president and Congress have expressed a desire to improve the research tax credit and make it permanent. Supporters estimate that the most generous proposals could lead to a $90 billion increase in annual GDP and enable companies to make long-term commitments to R&D — while keeping the United States the premier R&D location in the world.
Although the federal credit is currently not available, several states have permanent R&D credits that are available. Most notably, California has a 15% R&D credit, and with the recent extension of the net operating loss (NOL) suspension by the California Legislature, R&D credits will be very beneficial for companies in that state that may not have benefited from the credit in the past.
"The R&D credit offers a dollar for- dollar offset against a company's tax liability. Although the federal credit expired on Dec. 31, 2009, many companies are claiming the credit for prior years. Manufacturers that are in a tax loss situation or are subject to the alternative minimum tax can carry any unused R&D credits forward for 20 years," says Stan Babicz, Corporate Strategic Federal Tax Services director.
While it may make good financial, tax and business sense to do so, the majority of food and beverage manufacturers have not taken advantage of green/ sustainability credits or R&D credits during the past 12 months, and many don't intend to tap into these credits over the next 12 months either (see the "Taking advantage of credits" table above):
- Green/sustainability credits — Just 22% of companies took advantage of green/sustainability credits in the past 12 months, and 26% plan to use these credits over the next 12 months.
- R&D credits — A mere 25% of companies have used R&D credits in the past 12 months; 29% expect to use them in the next 12 months.
In the past 12 months, just 12% of food and beverage manufacturers made use of both green and R&D credits. Not knowing what incentives are available can also be an issue, and it appears to be a common one. For example, 59% of survey participants were not aware of state or local tax incentives available to their company if it expands; only 41% of respondents were aware of them.
"While certain state and local tax credits and incentives such as those noted above can be beneficial, state and local tax related issues may also be adding to costs incurred by certain states," notes Scot Grierson, State and Local Tax principal.
"Due to the revenue environment, a number of cash-strapped states have withdrawn, suspended or limited the use of certain credits and incentives that food and beverage companies have relied on to structure their costs. For example, California suspended from 2008-2011 a federal rule it had adopted allowing businesses to carry forward NOLs from a prior year to apply against future income. New York recently adopted legislation requiring a temporary deferral of many of the state's credits to the extent they exceed $2 million in 2010, 2011 or 2012, and other states are also considering limiting the use of certain state tax credits and incentives," notes Grierson.
Additional challenges facing companies are increases in sales tax rates, the expansion of the sales tax base, targeted taxes on alcohol and liquor, and stricter scrutiny in the form of audits by many state tax authorities. A number of states are hiring additional auditors and taking more aggressive positions in making assessments against food and beverage companies. At the same time, the increase in sales tax rates raises the overall cost of doing business and increases costs to consumers, which can affect sales.
The regulatory environment
Government regulators play a large role in the activities of food and beverage companies — and not surprisingly, many executives wish that role were more limited. A majority of food and beverage manufacturers (59%) expect the regulatory environment to affect their business, and 46% see that effect as negative:
- Yes — some negative impact: 32%
- Yes — very negative impact: 14%
- Yes — some positive impact: 10%
- Yes — very positive impact: 3%
Many companies cite the negative impact that regulations have on their cost structures, pointing to taxes, ethanol policies, health care, government-mandated paperwork, labor and resources required to adhere to government specifications, and food safety regulations and guidelines, including emerging regulations targeted at obesity (see "Food for thought: Health care reform implementation" at right). As one executive summarizes, "Increased regulatory pressure and oversight are likely to increase the cost of doing business."
Executives cite negative effects not only on costs, but also on business functions: "[Regulation] further slows down the release of product batches until you are assured that you have complied with ever-changing regulatory requirements," writes one participant. Offers another, "The increasing amount of bureaucratic involvement in small business is the largest deterrent to product development."
Many Fast Facts participants specifically complain about food safety regulations, with one executive claiming that more food poisoning arises from home-cooked foods than from commercial products. Others believe that "nutritional guidelines will affect some retail companies, which will lose sales" and that "additional food safety testing will cause higher prices [among larger processors], because smaller [ones] will not be able to absorb the increased costs and cannot pass along price increases to cover the extra testing."
Food for thought: Health care reform implementation
Almost every food and beverage company is affected by health care reform, and now is the time to get down to the business of incorporating into their employee benefit plans the myriad and complex provisions of health care reform. Failure to do so will bring about costly consequences. An employer who does not comply with health care reform is fined a whopping $100 per day, per employee. Clearly, no company can afford to take a passive attitude regarding compliance.
Below is a list of the major new requirements for health care benefit plans, along with other new rules related to plans, such as reporting and penalty rules. (Note: numerous additional rules that are not listed here apply to new plans that go into effect after March 2010, as well as to existing plans that are modified in certain respects after March 2010.)
2010:
- Small employers (employers with fewer than 25 full-time equivalent employees with average wages less than $50,000) receive tax credit for providing coverage
Plan years beginning after Sept. 23, 2010:
- Must cover children until age 26
- For children under age 19, no exclusion from coverage due to pre-existing conditions
- No lifetime maximum on benefits
- No rescission of an individual's coverage
2011:
- W-2 reporting of the cost of health care benefits (optional for 2011, mandatory starting in 2012)
- No reimbursements in a health care flexible spending account for over-the-counter drugs unless prescribed by a physician
2013:
- Employee contributions to health care flexible spending accounts limited to $2,500 per year
2014:
- No exclusion from coverage due to pre-existing conditions, regardless of the individual's age
- No annual dollar limits on benefits
- Large employers (employers with 50 or more full-time employees) pay penalties for providing no coverage or inadequate coverage
2018:
- 40% excise tax on high-cost plans (plans with a cost in excess of $10,200 for single coverage and $27,500 for family coverage)
To illustrate what is involved in implementing health care reform, below are a few decisions food and beverage manufacturers will need to make related to the requirement to cover children until age 26 (just one of the many new requirements):
- Decide whether to exclude from the plan a child who is eligible to enroll in another employer-sponsored plan (allowed only until 2014).
- Decide on the specific date the plan will stop covering children (e.g., the day the child turns age 26, the last day of the plan year in which the child turns age 26 or some other day beyond age 26).
- Decide whether to increase the employees' share of the cost of covering children in order to minimize the impact of this change on costs. But be careful: This could create a plan modification that causes additional health care reform rules to apply (rules that otherwise don't apply to plans that were in existence when health care reform was enacted).
- Adopt a written amendment to the cafeteria plan before the first day that the plan is required to provide the coverage. (Health care plans are almost always part of a cafeteria plan. The amendment to the cafeteria plan must be made to preserve the tax-free status of the plan to employees.)
- Given the potential increase in costs related to dependent coverage, consider conducting periodic dependent eligibility audits to ensure that the plan is covering the appropriate individuals.
Health care reform will require many changes, but food and beverage companies are no strangers to change and the challenges it brings about. The time to get started is now — especially for the provisions that go into effect next year!
While food safety has always been a priority for food and beverage companies, recent incidents of contamination involving peanut butter and eggs have resulted in greater scrutiny by regulators. Many food processors have had to increase their capital spending on quality control and technology solutions.
The U.S. government is clearly intensifying its efforts to improve food safety, as evidenced by the record number of food safety bills currently working their way through Congress. If passed, these new laws and regulations will add a new layer of compliance costs for food and beverage companies.
Certainly, not all executives view food safety regulations and guidelines as negative: One executive observes that more inspections should result in more sales of products. Another executive hopes that better restrictions will mean more attention to food safety.
Looking ahead
Even with the challenges, there is quite a bit of optimism across the food and beverage industry. Companies are engaged in more M&A activity. They are also investing in new products and expanding capacity. While industry leaders continue to exercise restraint because of uncertainties related to tax law changes, health care reform and food safety issues, there are many positive signs.
"This may not be a strong recovery yet, but it is a recovery," says Manning. "Moreover, this industry is poised for more growth over the next one to two years."
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