by Sithembile Bopela
"Life is like a [smaller] box of chocolates ... you never know what you're going to get." - Forrest Gump
The average chocolate treat is not the same as it was a few years ago - most are now smaller in size or have a slightly different taste. Our treats have been subject to a phenomenon termed 'shrinkflation'. Also known as package downsizing, or price pack architecture, shrinkflation is the process of shrinking items in size or quantity, while holding prices constant. The slight changes in taste are due to producers swapping out more expensive ingredients for more economical alternatives.
Over the past few years manufacturers have had to manoeuvre through tighter supply markets coupled with demand challenges, including tighter regulations (anti-deforestation, sustainability and fair practice, sugar tax), met with changing consumer behaviour (towards healthier lifestyles and healthier snack options), and more recently, shortages of a key ingredient - cocoa.
What is cocoa?
Cocoa is derived from cacao beans that are harvested from cacao trees. These unrefined beans are then fermented, dried, roasted, cracked, and winnowed (removing the outer shells) before the remaining cacao nibs can be sent for grinding into a thick paste of cocoa liquor or mass. It is from this liquor that cocoa powder can be made, and ultimately, the chocolate slabs, beverages and confections enjoyed around the world.
A byproduct of this cocoa processing, cocoa butter, is made by extracting fat from the cocoa liquor, after grinding and pressing. This butter is used in chocolate production but also has uses in hair and skincare as well as pharmaceuticals.
Why is there a cocoa shortage?
While the cacao plant is native to South America, this brown gold is now produced in several countries situated along the equator or 'cacao belt' of tropical regions including the biggest global producers, Cote d'Ivoire (Ivory Coast) and Ghana, as well as Indonesia.
Cacao is especially vulnerable to its natural environment. Many of these countries, particularly the major West African regions, have faced decades-long effects of climate change that has resulted in hotter temperatures and altered rainfall patterns, and in turn, lower harvest yields. The industry has also been impacted by slower economic growth, seasonal weather-related disruptions (El Nino/ La Nina cycles), and crop disease, coupled with chronic underinvestment in cacao farms, tighter regulations against unsustainable farming practices, investor speculation, and the market influence of 'Big Chocolate'. As such, cocoa prices have increased meaningfully over the past decade, and even more so over the past year.
The cocoa shortage has posed challenges for stakeholders across the value chain, from farmers to chocolatiers.
Chocolate demand/supply mismatch
After a strong start to the year, with peaks in April and June, cocoa prices are back to (still high) March levels due to an improving production outlook from the world's largest producers. According to Bloomberg Intelligence, the Ivory Coast is projected to harvest 2 million tonnes (Mt) of cocoa in the 2024/25 season that begins in October 2024, above earlier production estimates of 1.8 Mt. Improved weather conditions are also expected to drive a better-than-expected increase in Ghanaian production to 700 Mt from a weaker base (2022/2023: 425 Mt). Still, prices remain elevated on a year-on-year (y/y) basis as global production is expected to stay subdued, with the issues in West Africa now systemic and unlikely to find a near-term quick fix.
At the same time, the near-term demand outlook has also had a slightly dampening impact on cocoa prices as higher chocolate unit prices and broader consumer pressure is expected to dampen consumption. Nestle SA (NESN SW) recently joined a chorus of chocolate makers including Chocoladefabriken Lindt & Sprüngli, commonly known as Lindt (LISP SW), who anticipate lower sales volumes. Still, based on data from the International Cocoa Organisation (ICCO), global cocoa demand has remained resilient despite these record prices. The ICCO projects that demand will outpace supply by 439 kilotonnes (kt) this year (2023/2024), upwardly revised from 374 kt, driven by higher cocoa grinding activity in importing countries. This increase marks a third straight year of a supply deficit, evidence of the relative low elasticity of chocolate demand.
Where do the chocolate fountains flow?
Surprisingly, besides being among the biggest cocoa producers in the world, West Africa, Indonesia, and even South American countries are very low on the list of global chocolate consumers. In fact, Europe remains the largest consumer by region, specifically Switzerland which holds the record for the highest consumption per capita at ~8.8kg, which is roughly three 57-gram chocolate bars a week per person.
In this context, producers with high European exposure and with significant cocoa-product concentration in their portfolios may be worst hit on lower volumes and softer margins despite perhaps having strong sourcing capabilities or pricing power, given the surge in chocolate prices in this environment. For instance, leading Swiss-Belgian cocoa processor and chocolate manufacturer Barry Callebaut's (BARN SW) exposure to chocolate and cocoa processing activities accounts for >90% of total sales, as do similarly exposed dominant market players like Lindt and US-chocolate giant, Hershey (HSY US).
The potential substitution effect may favour more diversified beverage and snack food companies. However, diversified players like Nestle (NESN), with significant exposure to coffee (~27% of sales) through its headline brands like Nescafe, Starbucks, and Nespresso, are facing a particularly challenging environment amid tighter supply markets for coffee beans as well. While confectionery accounts for only ~9% of reported sales revenue, the group's exposure (undisclosed %) to chocolate also encompasses its beverages, milk products and ice-cream segments.
Ultimately, the benefactors of this industry shift are companies that can adapt their products quickly (without compromising quality and consumer satisfaction) and reduce or eliminate their dependency on cocoa-based chocolate altogether. Some companies are, therefore, instead using 'chocolatey' - lower cocoa concentrations or cocoa-free - alternatives made with ingredients like carob, oats, sunflower or grapeseed oil, and even faba beans among other more sustainable inputs.
Several innovative start-ups like German-based Plant A Foods, Voyage Foods (US), as well as the UK's Nukoko have developed cocoa-free concentrates and butters that are readily available on the market to reduce pressure on cocoa supply chains. These private companies are likely to benefit as key suppliers in the cocoa industry, as well as being potential M&A targets given their advanced R&D capabilities.
There are only few such names in the listed space, but companies like AAK AB (AAK SS), a leader in the plant-based oils and fats industry, provides attractive exposure to this segment of the alternatives economy. The company has developed specialised fats to supplement or completely replace cocoa butter, while improving the texture, shelf life, and taste of chocolate and confectionery products. The group also supplies bakery, dairy and plant-based food solutions as well as non-food applications such as cosmetics and medicinal formulations, while maintaining a focus on ensuring ethical sourcing of raw materials and reducing its carbon-footprint
On a 22.3 times forward PE, the share trades at a premium relative to its peer group justified by its fundamental growth prospects. However, it is now trading below its own long term average rating.
A word of caution - analysts remain widely split on new generation products, and we would suspect consumers as well. Incumbents like Lindt and Hershey's have indeed embraced long-term industry trends like shrinkflation and have worked hard on pushing efficiency gains to support margins. Additionally, Lindt has done well to 'premiumise' its product - making it easier to push through price increases. Macroeconomic tailwinds like lower general inflation and lower interest rates could also offer demand support and continued good (seemingly structural) growth in travel will also help protect volumes over time.
