🔎The death of consumer brands?💀
The entire sector is haunted by social media, AI and the success distributors have with their own labels. Many large brands are struggling. But there is hope that some of this weakness is cyclical.
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TLDR Summary
From 2010 to 2021, the median EV/revenue multiple of America’s leading consumer brand companies expanded from just 2x to over 5x. The values of large consumer brands were skyrocketing. They were ideal vehicles to push products to oversaturated consumers.
Multiples have compressed since then. Today, markets deem a consumer brand revenue Dollar about 45% less valuable than they did in late 2021. Many companies in this space haven’t participated in the latest bull market at all. Some are down a lot from their all-time highs.
Social media and AI are eating large consumer brands. Consumers often view the recommendations of influencers and chatbots more reliable than those of multinational corporations. At the same time, physical distributors have upped their private label game. Walmart WMT 0.00%↑ and Costco COST 0.00%↑ have become gatekeepers between consumer brand companies and consumers similar to how Apple AAPL 0.00%↑ acts as a gatekeeper between smartphone users and app developers.
However, there is hope for his pounded sector. At scale, consumer brands are still the most lasting and most effective way to guide consumers into purchasing decisions. They will shine again once this cyclical trough is over. When institutional investors have given up on a sector, it’s often an attractive time to buy.
To understand brand value, we first must gain an understanding how it drives the value of an enterprise.
What is the value of an enterprise?
An enterprise can be thought of as a smart combination of operating assets, the combined value of which exceeds the sum of all asset values. These assets can be tangible, such as real estate, equipment or inventory. Or they can be intangible, such as customer relationships, technology or brand value.
Tangible assets are typically recorded in the balance sheet, often with book values close to their market values. Intangible assets are often not recorded in the balance sheet. In most cases, they only get uncovered if the company gets acquired. They still exist though, whether they are recorded in the balance sheet or not.
Why is most value created in intangible assets these days?
Each industry has its own typical asset cocktail. And this asset cocktail shifts with time, based on cyclical and structural forces. Intangible assets have gained in importance over the last decades. In the past, value creation primarily happened in manufacturing processes, machinery development and physical distribution. Today, it happens primarily via customer relationships, software, data and brand.
Intangible asset-driven business models are often framed as capital-light business models while tangible asset-driven business models are often framed as capital-intensive business models. I don’t think that is the correct framing. In my opinion, there is no systematic difference in capital intensity between them. In fact, creating an intangible asset can be very expensive. You just don’t buy it from someone. You have to incur operating losses while you build it. And investors often give you a hard time for doing so because they don’t understand why you have such a low profitability.
Building/buying a tangible asset makes you incur capex. Building an intangible asset makes you incur opex. The only difference between them is their accounting treatment (capitalizing and depreciating vs. expensing).
What makes intangible assets often special is their supreme operating leverage. Intangible asset-driven business models are often much easier to scale than tangible assets-driven business models. Ford’s marginal profit on an incremental F150 sale is not much higher than the average profitability of every unit sold. They have to buy the same amount of metal and electronics for each vehicle. On the other hand, Netflix’ profit margin on an incremental subscription is near 100%. They have the content already in place. They are just unlocking it for the next paying customer.
The growing importance of intangible assets can best be observed by plotting the P/B multiple of the S&P 500 over time. It currently stands at 5x, several times higher than for most of post-WWII history.
Only a fraction of a company’s intangible assets is typically recorded in its balance sheet since most intangible assets only get uncovered subsequent to an acquisition. That’s why the market values of intangible assets are typically close to the difference between the market value of a company’s equity and its book value. Therefore, the chart above first and foremost plots the performance of intangible assets.
Why do brand values matter?
Brand values have gained in importance alongside the rise of information technology. There are several reasons for this. Firstly, the creation of goods and services has become cheaper at scale because many products don’t have to be recreated for every customer (most importantly digital media and digital services in general). Secondly, information technology has boosted manufacturing productivity. A great deal of manufacturing has been commoditized, most importantly in the extremely optimized supply chain in China.
Therefore, the most valuable skill a company can have is not anymore its ability to design and manufacture a great product. The most valuable skill is to find customers who are willing and able to pay. Willing and financially able customers are rare because the world is oversaturated with consumption. I discussed this in more detail in the article below where I framed AI primarily as a product distribution tool.
Brands are an ideal vehicle to enable that selling process. Even with very limited actual product differentiation, consumers often pay a premium for certain brands because they trust them more than others in terms of functionality and safety.
In many cases, the branding goes beyond the actual product. The perceived identity of the entire company fuses with the identity of its customers. People drink their Starbucks Latte, work on a Mac and wear their Nike sneakers because these products align with their self-perception. You consume a product not just because it’s useful for you, but because it assures you of who you are.
Successful branding allows companies to earn a superior profit on their revenues. They enjoy higher margins than undifferentiated competitors. And the more profit you make for every Dollar of revenue earned, the higher the market value of your equity for every revenue Dollar. For brand-heavy business models, the EV/Revenue ratio offers direct insight into the value of their brand.
What has been happening to US brand values lately?
To figure that out, I have identified a number of major brand-driven companies in the US, i.e. I have searched for companies with B2C businesses where customers are willing to consider more than just price when they select their vendor. This filtered out most financial services businesses which I consider commodity businesses. I also filtered out pure distributors (Walmart, Costco etc.) because these are currently subject to market forces that are distinctively different from consumer brand companies. In fact, they are part of the problem for consumer brand companies as you will see further below. I will likely elaborate more on that in a future article.
In total, I came up with the following 43 companies:
This is a highly heterogenous group of companies. But looking at the median allows to filter out company-specific noise and enables telling a story that impacts most of them.
From 2010 to 2021, the median EV/Revenues multiple of this consumer brand basket has risen from 2x to almost 5x.
By 2021, markets deemed every revenue Dollar from these companies more than twice as valuable as ten years earlier. This multiple expansion is suggests rising brand values as discussed earlier.
Since 2021, valuations have come down. Many of these companies have not participated in the bull market at all. Take a look at the P/S ratio for the S&P 500. It has kept advancing beyond the peak in 2021.
Some of consumer brand companies are down significantly since November 2021.
The relative performance is even worse. The S&P 500 is up 45% since then.
The median EV/Revenue multiple is now 2.9x. This means markets deem a consumer brand revenue Dollar about 45% less valuable today than they did in late 2021.
Some of this rerating is a normalization from inflated valuations during the pandemic when consumers carried their stimulus money to their favorite brands in boatloads. But even in 2019, the multiple was 45% higher than it is today.
This begs the question: Why are brand values under so much pressure?
Is the pressure structural?
In my opinion, there are several reasons why someone might choose to be bearish consumer brands and expect further weakness.
Firstly, to some extent brand values require customers to do no or very limited shopping around. They default to their favorite brand without checking alternative offerings. The internet, most importantly social media and AI, dropped the cost of getting the information needed to make the switch. In fact, influencers and chatbots directly compete with the promises of a major consumer brand. And they are often viewed as more credible and independent with their recommendation than the multinational corporation selling its own product.
Secondly, distributors have upped their private label game, esp. the large ones that can afford it. Walmart and Costco match the quality of dedicated consumer brand names at a significantly lower price and while controlling the shelf-placement. They are gatekeepers between consumer brand companies and consumers similar to how Apple acts as a gatekeeper between smartphone users and app developers. I discussed Apple’s gatekeeping in more detail in my Meta META 0.00%↑ article in 2021:
The value of this gatekeeping seems to have risen rapidly in the last few years. Nike NKE 0.00%↑ is currently paying a huge price for learning that lesson.
Thirdly, when I wrote about Garmin GRMN 0.00%↑ a while ago, I argued that consumers are fragmenting into micro-economies. In the past, everybody consumed the same media. There was a much more dominant lead culture. Digital distribution, social media and algorithmic feeds have changed that. As a result, numerous echo chambers have formed. This makes it challenging for big consumer brands to succeed. It might not be that consumers don’t care about brands anymore in general. They might simply be more interested in niche brands rather than the multinational corporations in the sample above.
Or is it cyclical?
Firstly, yes, media preferences have changed drastically after the pandemic. But some of the structural bearish arguments above were already around in the late 2010s when consumer brand revenue multiples were expanding. There are clearly positive forces beneath the surface that may shine again once the consolidation is over. Consumers are saturated and they want guidance about which products to consume. At scale, consumer brands are still the most lasting and most effective way to guide consumers into purchasing decisions.
Secondly, branding is still scalable even with the emergence of micro-economies. There are still ways to capture and monetize the attention of large audiences. Nike might have to share more their revenues with influencers. But they still matter as a factor in product distribution. It would be hard for LeBron James to establish his own shoe brand. Leveraging Nike is the much more logical path. Athletes rise and retire. They won’t be popular forever. Corporate brands have an indefinite lifespan. Successful ones will be those that manage to form synergistic partnerships with influencers.
Thirdly, the weakness of consumer brands right now is related to an overall weakness of discretionary consumer spending, both in the US and globally. I discussed that in more detail in my Nike article. This clearly smells cyclical which will have to mean revert eventually. I find it encouraging that institutional investors have capitulated on this sector.
Sincerely,
Rene