Mass-Market Competition Eroding Growth of Traditional Natural Products Industry, Report Says

FORT LAUDERDALE, FL—Success can be a double-edged sword and, as 1998 wanes, the natural products industry appears to be experiencing both edges.

The outcome of decades of consumer education by the natural products industry has succeeded in bringing natural products to the mainstream. But while the effort will likely benefit many of the almost $21 billion industry’s manufacturers and suppliers, it will not necessarily result in bigger profits for all industry players, especially independent retailers and perhaps even supplements makers.

So warns the “Retail State of the Union” assessment issued by Fort Lauderdale, FL-based Unicorn Trading Co.

Unless some unforeseen and dramatic circumstances arise, for the foreseeable future the natural products industry’s independent and chain natural foods grocery stores and supermarkets, health food stores, vitamin stores, co-ops, and supplements makers will be faced with increasingly stiff competition from the mass market for consumers’ dollars.

Mass merchandisers and conventional supermarkets already are competing heavily on price with traditional natural products distribution channels and may soon erode the traditionally high margins associated with natural products, particularly in supplements, the report says.

In a relatively short time, the mass market has improved its ability to emulate the “best practices” of the so-called super-naturals and has developed its own marketing systems for natural foods. Popular structure/

function supplements merchandising programs are already well established in some conventional foods and drug chains, and “suggested retailer price,” historically an important component of industry profitability, is disappearing, the report maintains. While natural products retailers’ comparative store sales continue to outperform most other retailers, percentage increases have declined so far in 1998 in most regions of the U.S., according to the report.

“Suggested retail is rapidly deteriorating. The pressure is being felt all the way back to distributors and farther,” says the report’s author, industry veteran Terry Dalton, former owner of the highly successful Unicorn Village retail store and restaurant in S. Miami Beach, FL, which was purchased by Whole Foods Market (WFMI) in February, 1995. Dalton writes: “This industry has grown because of its huge margins at every level of distribution, and those are rapidly disappearing. We have growth on the consumption side, but the industry is not expanding as fast as are the channels for people to purchase our products. The mass market is capturing more of the growth, and traditional natural foods retailers are capturing less.”

In addition, at the same time the competitive pressure from the mass marketplace is increasing, avenues for financing industry growth have narrowed, the report notes. The public market, which has been responsible for financing much of the industry’s expansion, has become volatile. At least for the short term, going public will not be a viable option for natural products companies. Several industry IPOs have been put on indefinite hold as a result.

Independent natural foods retailers in particular and small, independent vitamin stores will have to focus on service, location and value to survive, the report says.

Natural foods retailers will be competing not only with the likes of industry super-naturals Wild Oats Markets (OATS) and WFMI, but with such conventional supermarket chains as Kroger, Publix, Harris Teeter and Safeway.

At least three of the chains, Harris Teeter, Kroger and Safeway, have dedicated natural foods specialists on their payrolls.

Vitamin stores will be competing with Wal-Mart, which has nine store-within-a-store OneSource nutrition centers in Wal-Marts in the South and West and expects to open more.

Vitamin manufacturers will be competing with giant OTC-drug makers such as The Bayer Corp. and American Home Products (AHP), which bought Leonia, NJ-based Solgar Vitamin and Herb Co. this year and is in the process of merging with agribusiness colossus Monsanto. The Bayer Corp., a member of the German pharmaceutical and chemical conglomerate The Bayer Group AG, in September launched a line of herbal supplements that it expects to make up 25% to 33% of its One-A-Day line’s sales in the foreseeable future (see related stories, pgs. 5 and 15).

John Kacsan, director of trade operations for St. Augustine, FL-based Sunbelt Sales and Marketing, a natural foods brokerage, agrees that retail prices for natural products are destined to drop, but he’s not convinced that margins will drop significantly as a result of the mass market’s entry into the industry. “Conventional grocers aren’t going to hedge too much of their margin away. That’s the reason they bought in,” he says.

At least one manufacturer agrees with that assessment. “If you look at average gross margins for grocery retailers, they tend to run in the 25% to 30% range overall. That’s lower than margins for natural foods retailers. But grocery retailers don’t apply their average markup to natural foods because they look at them as specialty products, and with specialty products they look to 40% [margins], which are higher than most natural foods retailers,” says Bill Voss, CEO of Irwindale, CA-based, privately held natural foods maker Natural Nutrition Group.

Voss also says that while expanding channels of distribution generally help manufacturers, they can be a mixed blessing. “It creates opportunities to increase sales, but the biggest risk is indiscriminate distribution. Natural products are still most popular with people who have a high degree of education and an interest in health. The worst thing a manufacturer can do is to have lots of product in stores where such customers aren’t shopping,” he says.

Chain vitamin stores such as General Nutrition Cos. (GNCI), which saw its stock nosedive on the announcement that it would lower prices on certain commodity products, will continue to face strong competitive pressure from mass merchandisers, which now are selling not only through traditional retail outlets but also via the Internet. Kmart (KM), for example, just launched an on-line shopping site, www.familyandfitness.com, to sell vitamins, herbs and homeopathic products, as well as other merchandise.

Super-naturals like OATS and WFMI, while creating their own highly successful competitive niches, will face increasing pressure from almost all food-retailing sectors: conventional supermarkets, gourmet and specialty chains such as South Pasadena, CA-based Trader Joe’s, and the Kmarts and Wal-Marts that sell those high-margin supplements.

Conventional supermarkets also expect the so-called Whole Health category, a concept already embraced by the natural products industry through GNCI’s recent launch of it’s 42,000-sq.-ft. Nature’s Northwest “lifestyle” store, to become the largest growth sector in the conventional grocery industry (see Natural Business, September 1998, pg. 7).

The report also notes that convenience stores are becoming a ripe channel for natural products distribution. Dalton notes that convenience stores, among others, already sell functional-foods beverages and energy bars.

Drugstores and independent pharmacies also are new channels for natural products sales but have been slower on the uptake than mass merchants and conventional supermarkets. A shift in this go-slow strategy may be in the making, however, the report says (see related story, pg. 7). This year, for example, pharmacists for the first time were allowed to obtain continuing education credits for attending nutrition classes at New Hope Communications’ Natural Products Expos.

In addition to these natural-products distribution channels, the report lists mainstream network marketers such as Amway, which already sells a limited amount of Westbrae-, Hain- and Estee-brand products for Hain Food Group (HAIN), along with its own supplements offerings. It also lists as “distribution channels” vending machines, which can sell energy bars and other functional foods in high-traffic areas; fitness centers and spas; and doctors, HMOs and hospitals—all of which are beginning to sell supplements and some of which offer coverage of alternative medical treatments.

Trying to determine the best survival strategy in this newly expanded marketplace may fill many an hour in boardrooms across the natural products industry, however Wall Street analysts are confident about the long-term health of the industry.

“The industry is still growing at a rapid clip and will continue to grow at about 15% for supplements and 20% for foods,” says Adams, Harkness & Hill Managing Director Matthew Patsky. “Expanding distribution channels are positive for manufacturers and consumers, and specialty retailers will remain competitive.”

He agrees, however, that significant competitive pressure will continue from the mass-market channels and the “mom and pops” of the industry.

Bill Steele, senior VP of Buckingham Research Group in Novato, CA, sees significant competitive pressure ahead, not only for the “mom and pops,” but also for some natural products supplements manufacturers.

“You are seeing the results of it now in the performance of some of the supplements company stocks. Investors are taking a look at the end gain. They’re asking who will be the survivors in a shakeout in this very fragmented industry,” he says.

Steele says an appropriate competitive step for natural-products supplements makers could be to develop proprietary products. “When you look at the VMS [vitamin, mineral and supplements] industry, none of the technology is proprietary. There will be a steady stream of new products over the next 10 years, and natural supplements makers could develop proprietary delivery systems, such as timed-release, for them. There also needs to be a significant increase in research and development and perhaps some more patented processes.”

While Steele agrees with Patsky that the long-term growth prospects for the industry are strong, he is convinced that a shakeout, at least in the VMS industry, is inevitable in the short term. “At what profit level will these companies be over the next five years?” he asks. “I’m staying on the sidelines for now.”

Dalton’s state-of-the-union report concludes that as long as positive research and innovative product development continue, nutritional products should maintain their high growth rates.

But Dalton’s report also issues a cautionary note. The direction and leadership of this traditionally environmentally oriented and socially responsible industry appears currently to be almost totally exposed to market forces, it says. Exactly how the natural products industry will be changed by the mass market and the consumer-direct retail revolution will begin to come into focus in the coming year.

For more information on this report, fax Terry Dalton at 954.467.3745 or e-mail twd@sprintmail.com.