FMCG CEOs: The profitability of the baby diaper category could well trend to zero in the next 5y in developed markets, here is Why/How to go about it
‘While most people understand first-order effects, few deal with second- and third-order effects. Unfortunately, virtually everything interesting in business lies in fourth-order effects and beyond’ Jay W. Forrester
Last week, we discussed exponential growth (and profit) opportunities in the mass beauty categories:
This week, that is the turn of the baby diapers category. Looking at the category dynamics, competitive situations, and exponential trends, all the conditions are now met to see the profitability of the baby diaper category trends to zero in the next 5 years in developed markets, here is Why.
All the conditions are now met to see the profitability of the baby diaper category trends to zero in the next 5 years in developed markets
1. Baby diapers: a strategic battlefield and the gate to reach the most coveted consumer group, the new mothers
All based on Nielsen reports and review of financial reports 2016:
Large category: $60bn retail sales value globally
Decently profitable: globally +/- 15% EBIT with a profitability of +/- 20% EBIT in developed markets and +/- 10% in developing markets. For perspective, 15% EBIT is roughly the average EBIT in the FMCG industry on household, beauty, personal care and food categories
Category share of revenue: 60% revenue in Europe/North America and 40% revenue in the rest of the world
Category share of profit: ~80% in Europe/North America and 20% in the rest of the world
Growth dynamics: low single digits in Europe/North America and high single to low double digits in the rest of the world. 90%+ of birth take place in developing markets. Baby diaper category is still under-penetrating in some key markets (only 7% in India for example)
Largest global players: P&G (Pampers); Kimberley-Clark (Huggies); SCA (Libero/Lotus); Unicharm; Ontex (contract manufacturer)
Diapers matter: On average a household spends around $1000 per year per baby on diapers
The gate to the ‘new mum segment’: baby diapers with baby food are the most important budget items for new mothers. So winning on baby diapers is a strategic gate to win with new mothers. For perspective,mothers take 85% of all household purchasing decisions in value
A price sensitive segment in developed markets: lower price is the #1 reason for switching diapers brands in North America (42% of respondents) and in Europe (35% of respondents)
Traffic-building category for retailers: unsurprisingly, most mothers are ready to change stores just to find the right diapers at the right prices. Consequently, retailers do not hesitate to sell diapers at cost to drive traffic in their stores and the baby diaper category is one of the retail category with the lowest average retail margin in developed markets
Consequently, retailers do not hesitate to sell diapers at cost to drive traffic in their stores and the baby diaper category is one of the retail category with the lowest average retail margin in developed markets
2. Competition in retail is intensifying and retailer driven deflationist pressure will continue
There are some paper pure players FMCG companies that are still entering the baby diaper category into new geographies. After pulling back from developing countries, and after KC itself pulled back from Europe, SCA has announced last month its intention to launch diapers under the brand Lotus in France
Irrespective of competitive activities, deflationist pressure will remain on the category as retailers in developed markets continue waging price wars and baby diaper category is seen as one of the key category to drive traffic and to build a price competitive perception among consumers. All the drivers behind retailer price war are expected to remain and even to increase over the short-/mid-term (Amazon pressure, transition to e-commerce, continuous rise of discounters. increasing competition from direct-to-consumer..)
All the drivers behind retailer price war are expected to remain and even to increase over the short-/mid-term (Amazon pressure, transition to e-commerce, continuous rise of discounters. increasing competition from direct-to-consumer..)
3. Direct-to-consumer start-up new entrants will increase competition and ultimately drive also deflation
So far, the direct-to-consumer (or omni-channel) FMCG companies like Honest Beauty, Seventh Generation, Earth Best, Bambo Nature… have been focusing on premium baby diaper segment at a price in line or higher than the big brands sold in supermarkets
As of now, those DTC/omni-channel players have not been successful in capturing sizeable market share unlike on some beauty care segments (make-up, skin care…) or male grooming categories that have seen up to 30% of retail value in the US already migrating to DTC. Some points the quality of the products and quotes the challenges Honest has been facing. The price point may well even play a bigger role there
The premium price point chosen by those companies was at least partly driven by the high cost of logistics and shipping for such bulky items that required a high average transaction value to enable to sell at cost or at a small profit
To achieve a significant transfer of market share from retail to DTC in developed markets that are so cost conscious, not only quality of the products offered would have to be top-notch but prices offered by DTC FMCG companies will have to drop significantly
And this is about to happen now
To achieve a significant transfer of market share from retail to DTC in developed markets where consumers are so cost conscious, not only quality of the products offered would have to be top-notch but prices offered by DTC FMCG companies will have to drop significantly. And this is about to happen now
4. Last-Mile-Delivery-Cost (LMDC) will reduce by at least 40% within the next 5 years in developed markets creating the possibility to reduce current consumer price by 20% which is +/- 100% of current EBIT
We start being quite a few to believe that LMDC will drop significantly within the next few years. McKinsey & Co published a study end last year on the topic and forecast a drop of 40% within the next 5 years in developed markets (cf. Parcel Delivery: The Future of Last Mile – Sept 2016)
Some like the creators of the Starship delivery robot believe LMDC could be reduced by up to 90% with the use of their technology that is currently in scale-up phase in California and in some large cities in Europe
Time will tell us, what is sure, LMDC will reduce drastically and much faster than most believe. In the process, it will create a lot of space in the P&L to drive price deflation (at least 20%) and give to the DTC channel an absolute cost advantage over the retail channel
For companies that will stick to the retail channel and will be trying to compete on price with DTC pure-players, the effects could be disastrous and the overall profitability of the baby diaper category through the retail channel could well be entirely wiped out
Last-Mile-Delivery-Cost will reduce by 40% over the next 5 years (potentially more) and will create a lot of space in the P&L to drive price deflation (at least 20%) and will give to the DTC channel an absolute cost advantage over the retail channel
5. Some large FMCG companies will soon enter the baby diaper category directly through DTC to win the battle of the New Mum eco-system
Like Jon Moeller (Group CFO P&G) mentioned in Oct 2016 during a conference with financial analysts (see the below article for more details and espeically the point 7.): ‘How many people do you know,’ he said, ‘that want to satisfy their household shopping needs in a month or two by going to 40 different websites with 40 different passwords and 40 different packages that arrive at 40 different times?’
That is exactly why the companies that will succeed to assemble valuable consumer eco-system with high switching cost and with enough share of voice with the target consumer will ultimately prevail. That is exactly why Unilever acquired Dollar Shave Club to get a position on the highest penetration category on male beauty (blades & razors) to acquire critical size and to drive sales of its profitable adjacent categories that have a much lower penetration (male skin care, deodorant…). And if blades and razors have to be sold at cost or with a tiny margin, so be it. At the end of the day, there are a vehicle to drive traffic to their male beauty eco-system
Knowing that mothers control 85% of the overall household spending, it is a race worth running
Knowing that mothers control 85% of the overall household spending, it is a race worth running
Now let’s look at the potential strategies to acquire critical size on the New Mum eco-system. There are mostly two high penetration categories that could be used as a vehicle to achieve scale: baby diapers and baby food
Many FMCG companies could be interested in building a New Mum eco-system. We can well imagine companies like Unilever, Johnson & Johnson, Colgate-Palmolive, Henkel, RB, Nestle or even Danone… to consider such strategic moves
It is not a coincidence if RB announced in January to acquire Mead-Johnson, the baby milk company. Of course, there are also some other considerations like geographic synergies (especially in China) and categories synergies (OTC brands…). The bottom line is that the old way to look at synergies per category or per vertical (food vs. non-food) has become obsolete. It is all about assembling relevant eco-systems for specific consumers
It is not a coincidence also if Unilever announced 2 weeks ago the launch of a baby segment under the umbrella of its mega brand Dove (Dove Baby). Unsurprisingly, all the SKUs (baby oil, cream, wipes…) are available through retail except diapers. Why? well my guess is that it does not make any sense to go front-to-front on diapers on the retail channel that is one of the most ‘red ocean space’ in the FMCG industry but trialing a new baby product range (which is likely to be margin accretive) with the objective to make it available through DTC with a new mum eco-system and leverage the diapers business of Seven Generation that has been acquired last year. Well thatcould make a lot of sense
We will see an increasing number of companies leap-frogging to baby diaper category directly through DTC and at such competition on baby diaper will only increase dramatically
I am not in the secrets of the gods in the two above companies but what is clear is the battle to win on the New Mum eco-system has started and it will be a fiercely one and the first casualty will be the diaper category
We will see an increasing number of companies leap-frogging to baby diaper category directly through DTC and at such competition on baby diaper will only increase dramatically
6. Over-capacity in developed markets as a result of declining birth rates and volume loss (driven by increase in competition) will push companies to price at marginal cost and fuel price war
Baby diaper (like most paper segments) is a rather capital intensive category with long investment and pay-back cycle. Manufacturing units are costly (in the hundreds of millions) and manufacturing fixed cost as % of revenue is much higher than on other household (laundry, cleaners…) or beauty categories (hair care, skin care…)
The challenge is in an environment of increasing competition (from the reasons stated above) and expected decline in number of birth in developed countries, baby diapers plants in developed markets will lose further volume. As a result unit cost is going to rise, margin is going to deteriorate and some players might be tempted to price at marginal cost to recover their fixed costs. Which is going to fuel further price war until the over-capacity issue is addressed
Looking at the financial reports of some of the largest branded baby diaper manufacturers in developed markets, unit revenue has been the key growth driver over volume increase. So although capacity utilization data are not available, it will not be surprising to see that capacity utilization has already dropped at some large key players
7. The space left at the bottom of the market could well become a profitable multi-billion $ revenue opportunity for a low cost entrant and trigger unprecedented deflation for incumbents that fail to adapt
I did not believe it until I read it. In 2017, in the US, 30% of mothers cannot afford diapers. 30% according to study done by the Yale university (see article below):
Some charities are even solely focused to make diapers available to the poorest in the US like Baby2baby
In other words, almost a third of the consumption in the US, that is also the largest and most profitable baby diaper market in the world, is constrained by affordability
Let’s not explore the Why of this situation as all the facts are not easily available. It can well be technological and supply chain challenges, strategic considerations, fear to cannibalize the rest of the business, years of innovations over-shooting consumer needs, premiumization/trade-up strategy… the bottom-line is 30% of mothers in the US would like to use diapers or would like to use more diapers but simply cannot
So let’s assume that the average retail price for a diaper is +/- 25 cents today. If a new entrant will focus on the bottom of the market and succeed to design a value diaper that could be cheaply manufactured and distributed cost effectively through DTC with very low last-mile-delivery-cost (let’s say by 2019-20) and sold at maximum +/- 10 cents each while still making a 10-15% EBIT (no marketing expenses as the product and the prices speak for themselves, bare mimium packaging cost as it will not have to stand-out on shelf). Could you imagine the damages that such business model could make in developed markets to existing large players? but also in developing markets? We could talk billions $ revenue impact
And that will trigger unprecedented deflation for sure. Not the Carrefour or Walmart type of yearly negotiation deflation FMCG companies are experiencing every year but double digit deflation.Exactly like when Dollar Shave Club, Harry’s and Co proposed a product that is ‘good enough’ for half the price and oblige Gillette to cut prices across its range of blades to restore its price competitiveness
That is how an incumbent with products that over-shoot the needs of some of its consumers base end up discounting heavily its products to remain competitive with ‘good enough’ products
That is how an incumbent with products that over-shoot the needs of some of its consumers base end up discounting heavily its products to remain competitive with ‘good enough’ products
8. The temptation for contract manufacturers to start their own DTC business
We talked about DTC start-ups, large FMCG leap-froggers but a critical player will be contract manufacturer especially on baby diaper, here is why:
i. They have manufacturing capacity and baby diaper manufacturing remains a capital intensive affair
ii. They have the technical know-how required to design a no-frill cost-effective diaper
iii. It has never been so easy to start-up a brand and sell directly to consumers through DTC
iv. Although they have relationship to manage, they have comparably less to lose than the current large players and could set-up a DTC business in one of their white spaces to avoid going head-to-head with current business partners
v. At a time when pressure on margin will become unbearable for everyone (retailers, manufacturers…), setting-up a DTC business will be the way to access (comparatively) a strategic ‘blue ocean’
Naturally, contract manufacturers would have to learn to become a FMCG company in their own right, to build a brand, to build direct long-term relationships with the consumers… but if there is one category where it could be worth making this jump, that might well be baby diapers. Some companies with no preexisting assets and knowledge of the baby category are launching start-ups, why a contract manufacturer would have not higher chances of success?
Some companies with no preexisting assets and knowledge of the baby category are launching start-ups, why a contract manufacturer would have not higher chances of success?
9. Expected retailers response and retail price matching initiatives
It was surely not a simple discussion at a time for Gillette to announce to its retailers that it will open an online DTC subscription service
Now imagine the same type of discussion but on one of the largest FMCG category in the world (baby diaper is roughly 6 times the size of the blades and razors category – although the trade margin is much lower) and on a critical traffic-building category that is a key driver in shaping consumer price perception. Those are tough discussion in perspective
What is sure is retailers are not going to let it go and will price-match versus the lowest prices off- and on-line (incl. DTC pure players). In other terms, they will force down deflation on current players and protect their foot-fall/traffic on the highly strategic new mum consumer segment
Retailers are not going to let it go and will price-match versus the lowest prices off- and on-line (incl. DTC pure players). In other terms, they will force down deflation on current players
10. Bringing it all together: a unique and unprecedented situation that could well end up with the fastest decline in structural profitability of a category in the history of the FMCG industry
It is a rather unusual situation to have a large category that has been growing in its largest and most profitable markets mostly through premiumization, with quite a significant part of the population that is constrained by affordability, with a DTC business model that is now coming at maturity with drastic LMDC reduction and that is the gate to the most coveted consumer group (new mum) in the whole FMCG industry
Taking all those ingredients, adding competitive moves expected from some other FMCG companies that will likely leapfrog, new start-up that will be funded by hyper-abundant capital with a high tolerance to losses (at least over the short-/mid-term) and retailers that are desperate to keep this strategic category in their backyard and you obtain a unique and unprecedented case that could well end up with the fastest decline in structural profitability in the history of the FMCG industry
You obtain a unique and unprecedented case that could well end up with the fastest decline in structural profitability in the history of the FMCG industry
If what I am writing has any merit, there are 5 actions any current (and potential future) players in the baby diapers category should focus on:
1. Address the affordability barriers to non-consumption in developed and developing markets
Companies that will succeed to deliver a ‘good enough’ diaper at a rock bottom price (10 cents or even potentially lower) will be rewarded with high penetration across markets, will achieve an absolute cost advantage and will enjoy critical size on their ‘new mum eco-system’ that will put them in a position to monetize it with complementary products and services.
In developed markets, a dedicated DTC value-chain with a drastic design-to-value approach, no marketing spend and basic secondary packaging specifications could work best
In developing markets, a DTC peer-to-peer model with strong word-of-mouth and peer recommendation to drive trials and educate new mothers could be the best business model
In both cases, companies that will succeed to crack this affordability challenge will likely achieve market leadership over the mid-term especially knowing that 90%+ of new birth take place in developing markets and that cracking affordability will be critical to unlock the Growth in those markets
Companies that will pass on this will be exposed to dramatic volume loss and deflation. Knowing the capital intensity of the category, the downward spiral will likely be fast and will lead to loss of market leadership
Companies that will fail to address the bottom of the market will be exposed to dramatic volume loss and deflation, jeopardizing over the mid-term their market leadership
2. Build a valuable New Mum eco-system with high switching costs that could be profitable even with diapers sold at (near)-cost
Companies that will succeed to build a valuable eco-system solving valuable problems for consumers will likely prevail:
i. Products: a range of diapers from entry-level to premium segment; adjacent segments: oil, cream, powder, wipes… all with a subscription model and with profitability coming mostly from the other (non-diapers) segments
ii. Connected objects: device to monitor baby sleep (e.g. Mimo by J&J) and baby activities (Aristotle by Mattel)
iii. Apps: e.g. to help new mums staying fit during and after pregnancy (e.g. the Johnson & Johnson’s 7 Minutes Fitness for Expected and New Mums app), to monitor and store baby’s sleep data (e.g. the Johnson’s Bed Time app)….
iv. Consumer communities: e.g. an artificial intelligence powered consumer community that will enable to answer every questions mothers have before and after pregnancy
3. Continue to invest in product innovation
Product innovation will remain important but alone (especially incremental product innovations) will not be enough to make the difference
4. Resist the temptation to buy manufacturing capacity with the objective to shut it down to prevent deflation and re-create barriers-to-entry
That sounds terribly like a strategy straight from the 19th century and remind of the times of what Rockfeller did in the US to build the Standard Oil Company, And it could well be an effective strategy to buy time in some critical geographies like the US. Especially knowing how critical is a near-sourcing strategy on this category to make the overall numbers work. The big question mark is how the standards of manufacturing will evolve, at which price can such assets be acquired and how does the price tag compare to the profit at risk
If it could be a temptation, in the end, no one can really prevent the pace of progress, buying manufacturing capacity to close it down will only buy time and it will be a rather poor use of capital over the long-term. Investing a comparable amount in R&D or in a brand new business with the objective to disrupt the baby diaper category will yield better returns over the long term
5. Adapt organization and culture to drive (self)-disruption at scale and at pace
Strategy will be the easiest part. Execution will be the most difficult bit. Having in place the right governance, organization design, people and fostering the right culture will be more than ever the make or break of such a transformation.
Many dilemmas will have to be overcome
Bringing it all together:
The battle of the New Mum eco-system has started and the first casualty is going to be the diaper category
The battle of the New Mum eco-system has started and the first casualty is going to be the diaper category. That is the irony of strategy in the digital disruption age where the largest categories with the highest penetration become also the most vulnerable ones, where barriers to entry are falling and traditional competitive advantages are becoming increasingly obsolete
The most important is not to determine whether the entire profitability of the category will be wiped out or not. The question is whether we can afford working on only one strategic scenario, completely ignoring the above and not hedging our bets. That is the exciting challenge on offer on this category
The most important is not to determine whether the entire profitability of the category will be wiped out or not. Maybe the structural profitability will drop only by half down to 5-10% EBIT. No one can predict with precision the future and time only will tell us. The question is whether we can afford working on only one strategic scenario, completely ignoring the above and not hedging our bets. That is the exciting challenge that offers this category
In the end, the winners will be the players that will display humility, accept that a variety of strategic scenarios are possible and act with a sense of urgency to address them
In the end, the winners will be the players that will display humility, accept that a variety of strategic scenarios are possible and act with a sense of urgency to address them
As often, I will close this article with the opening quote:
‘While most people understand first-order effects, few deal with second- and third-order effects. Unfortunately, virtually everything interesting in business lies in fourth-order effects and beyond’ Jay W. Forrester
If you are interested in discussing more on the above, you can reach out at: frederic@fredericfernandezassociates.com
Frederic Fernandez does not own any stocks or financial instruments of any FMCG companies or companies mentioned in the above article. All the above information are public information.
About the author:
Frederic Fernandez is an expert and thought leader in the FMCG industry. He is the Managing Director of Frederic Fernandez & Associates a bespoke Strategy Consulting Firm exclusively focused on the FMCG industry. Before joining the world of management consulting, he worked with Fortune 500 companies like Procter & Gamble, Reckitt Benckiser, PriceWaterhouseCoopers and Societe Generale in leadership positions across Europe (France, UK, Nordics, Germany, Switzerland, Austria), Central Africa and India. His focus areas are mainly growth and profit turnaround, corporate strategy, direct-to-consumer and business model innovation in the FMCG industry. His passion is to help FMCG leaders co-creating the future of the industry and to develop, achieve and exceed the potential of their business. He spends his time advising Fortune 500 FMCG senior leaders globally. He is based in Zurich, Switzerland. He is also a sought-after speaker and speaks across the globe at trade associations and for corporate clients (CEO strategy meeting, yearly strategic reviews, senior management events) about the FMCG/Retail industry.
