Lean times ahead for UK food and drink sector

QBE-Credit-Lines-Underwriter-Steve-Roberts

By QBE Credit Lines Underwriter Steve Roberts

Food is clearly a product where demand should not be an issue. However, the food and drink sector is under considerable pressure, and some sub-sectors face credit risks every bit as challenging as high profile sectors like retail and construction.

From farm to mouth, the industry that puts food on our plates is as impressive as it is large. The UK agri-food business is worth round £113bn and employs 3.9 million people, according to UK government data. UK consumers spend a whopping £219bn while producers export a further £22bn of food products each year.

But the UK food sector is in a tight spot, squeezed by rising costs and Brexit.

Perfect storm

Take food manufacturing. The sector is dealing with labour shortages, poor harvests and uncertainty from Brexit. Unsurprisingly, insolvency rates have increased among food manufacturers, with more to come, whatever the outcome of Brexit.

Food manufacturers’ costs have been increasing on a number of fronts. The UK’s late cold snap ‘The Beast from the East’ and unusually dry summer affected yields and prices. The price of dairy products, for example, rose in 2018 with increased wholesale rates and the effects of unseasonal weather in Europe, while the cost of potatoes also rose in 2018 following a poor harvest.

Margins in the sector are thin, and there is limited scope to pass on higher expense to retailers and consumers. According to the British Retail Consortium, UK food prices in March reached their highest rate of inflation in more than five years, the effect of extreme weather and global food commodity price increases.

Labour costs are also under pressure, with a rise in the national minimum wage and constraints on labour. According to ONS data, the UK unemployment rate dropped to 3.9% at the end of 2018, the lowest since February 1975, while wage growth held at 3.4%. Britain’s fruit and vegetable sector employs up to 80,000 seasonal workers from the EU each year, but Brexit has led to some staying away.

Over capacity

At the other end of the food chain, the restaurant and food-to-go sector is having a torrid time.

The sector faces many of the same challenges as food manufacturing, including wafer thin margins, higher costs and waning consumer confidence. Even successful restaurant and pub chains have reported reduced profits as higher labour cost and food prices hurt margins – a £33m higher wage bill ate into the profits of pub chain Wetherspoons in 2018.

The sector is also suffering from overcapacity and reduced demand for eating out. According to accountancy firm Moore Stephens, Brexit uncertainty and rising business rates helped push over 1,200 restaurants into insolvency in 2017/18, up 24% on the year before and nearly double the rate seen in 2010/11.

Research from analyst CGA, found the managed restaurant sector is now in ‘modest’ decline, with further closures and CVAs expected in the course of 2019. Having grown 27% in the past five years, the casual dining sector contracted 0.1% in 2018, its first reduction in nine years. Restaurant chains such as Carluccio's, Prezzo, Jamie's Italian and Strada have closed outlets in the last year, while Cafe chain Patisserie Valerie went into administration in January.

Brexit

Leaving the EU was always going to be a material event for UK food producers, manufacturers and retailers. The UK only produces around half of its own food, while 70% of imported food comes from the EU, according to National Statistics. The EU is also the biggest export market for the UK food industry – almost 72% of UK food and non-alcoholic drinks exports go to the EU, worth almost £11bn, according to the Food and Drink Association (FDA).

The fall in the value of the pound against the Euro has increased the cost of imported raw materials and food products. According to PwC, Brexit price inflation is likely to bring an end to the recent deflationary food environment.

Brexit also has implications for the availability and cost of labour. The number of EU workers in the UK has been declining – there were 61,000 fewer EU workers in the UK at the end of 2018 –while there are now more people from Central and Eastern European countries leaving the UK than arriving, according to ONS data.

The food sector is particularly dependent on EU workers, especially for food production, crop picking and packing, as well as logistics and warehouses. According to the FDA, 30% of workers in food and drink manufacturing, 18% of food wholesale, and 12% of food services industries are from the EU, making the industry overall one of the most vulnerable to a tightening of migration rules for European workers.

Cost of uncertainty

Uncertainty about when and how the UK will leave the EU is also adding cost to food producers. In addition to the effect of exchange rate volatility on imports, many food companies are stockpiling ingredients as part of contingency plans – one cup-cake baker, for example, stockpiled 10 tonnes of cream cheese to avoid disruption. Uncertainty over the UK’s departure date will mean many companies in the sector will have capital tied up in extra stock for the foreseeable future.

Although a no-deal Brexit is not considered a likely outcome, it remains a theoretical possibility. Such a scenario is thought to be particularly challenging for agriculture and food production, with implications for tariffs and supply chains. In particular, importers and food manufacturers are concerned about customs and transport delays at ports, which could severely disrupt the supply chain for perishable goods.

Changing tastes

Consumer trends are another factor that can put pressure on margins. Concern for the environment, health and animal welfare have been driving demand for meat free foods and environmentally friendly packaging. Such trends are an opportunity for some the food industry, but they are also a challenge, adding costs or resulting in changes to demand.

For example, one in three people in the UK have stopped or reduced their meat consumption, according to a report from retailer Waitrose, which suggests a revolution in eating habits may be underway. One in eight people are now vegetarian or vegan, while a further 21% claim to be flexitarian, the study found. Online food delivery service Just-Eat says it has seen demand for meat-free food increased by 987% in 2017 and demand for healthy options grow by 98%.

Waste is also becoming a bigger issue for the food sector - a campaign to reduce plastic use has seen a number of food retailers commit to recyclable or compostable packaging. The UK government’s recently published waste strategy would push the full cost of recycling and disposal of packaging onto manufacturers. The strategy also seeks to tackle food waste – the UK wastes an estimated 10 million tonnes of food and drink annually, worth around £20bn.

Health and allergy concerns are also shaping consumer tastes and regulation. Research suggests consumers are growing more conscious of what they eat, while the government wants to tackle high rates of obesity and diabetes. In 2018 the UK introduced a tax on high-sugar drinks, while there are now plans to tighten up food labelling laws around allergies.

Outlook

Brexit has dominated the agenda for the food and drink sector. Depending on the form of Brexit, the UK’s departure from the EU would have big implications for labour supply, supply chains and the cost of commodities. Many food and drink companies will be able to successfully adapt to Brexit, but a number may not have the financial strength to withstand a hard Brexit or prolonged uncertainty.

Food and drink supply chains are already under pressure, where costs are being squeezed and where large retailers exert considerable power over suppliers. Many companies are dependent on large contracts, and sudden changes in contracts can put margins under increased pressure, or even put a manufacturer out of business. Labour shortages, volatile weather and Brexit uncertainty only add pressure to the supply chain, especially room for manoeuvre is constrained by fixed price contracts.

Trading conditions are tough, but companies with strong management continue to thrive, even in sub-sectors like food manufacturing and restaurants. By actively meeting management at companies throughout the food supply chain and keeping a close eye on supply chains, our underwriters are able to use their off-balance sheet knowledge to maintain levels of cover and expert support for this key sector.

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