DEAR FELLOW SHAREHOLDERS:
LBIX MONTHLY NEWSLETTERI hope that you had a great Holiday Season and take this opportunity to wish you the best for 2004.
In mid-December we started taking down each of our major bottling lines, one by one, to fix the problems we encountered last summer. We straightened conveyors, added new and faster equipment and adjusted handling equipment. One after another, as we brought each line back up, we saw rather spectacular improvements in performance. In two instances, throughput increased more than 40%, resulting in record daily volume. Obviously, if these production levels are maintained, that translates into a pretty significant increase in plant capacity and lower average operating costs.
With these major changes behind us we can now identify additional tweaks that will result in further increased efficiencies. That should equate into reduced operating costs per case and bodes very well for the peak bottling season that commences around the third week of this month.
Additional improvement still can be obtained by tightening our operating procedures. It is important that our plant management stay focused on maintaining proficient standards for daily case output and controlling variable costs. As simple as that may sound, when the pressure of the season is upon us, and customer demand surges, the urge to satisfy customers must be properly balanced with maintaining our operating standards.
In Canada, we now have our brands listed in more chains than ever before. We spent the fall and early winter securing the final national convenience listings for TREK® and are turning our focus to grocery. Our Costco listing for that brand has now expanded across to the West. We intend to introduce a less expensive and larger size TREK® bottle this spring, to allow our customers a ‘lower price per ounce’ alternative to our now patented, premium, introductory 20.6oz format. Red Nitro ‘Turbo Berry’ is also in our distribution system. A couple of weeks ago we introduced Pez 100% Juices™ in Costco Canada.
Soy2O™ is receiving a lot of attention on both sides of the border. We have already seen repeat orders following our initial shipments. Canadian production is anticipated within a month or so. It has been relatively easy to pre-sell this unique new product and that is an encouraging sign.
We have re-focused our US operations on our brands and the hybrid distribution system that has worked so well for us in Canada. I was personally disappointed that Roth Capital chose to change their recommendation on our stock from a ‘buy’ to ‘neutral’ rating following one question on our conference call focusing on the changes we are making in our US distribution. I would therefore like to explain the reasoning behind our decisions and let you be the judge.
Over the past half dozen years there has literally been a ‘sea change’ in North American beverage distribution. Like an incoming tide, it has gone unnoticed by many and been ignored by others. As with so many other industries, success today cannot be achieved in the same way it was 20, 10 or even 5 years ago. In the beverage industry this change is directly tied to the deterioration of the ‘direct store distribution’ or DSD system that was the backbone of so many brands of the 1980s and 90s: Clearly Canadian, Snapple and SoBe to name a few. That deterioration was caused by a variety of factors, most notably:
The rise of convenience store chains, particularly in the gas channel. ‘Mom and Pop’ corner stores are being replaced in droves by slick chains with central buying and distribution. That has significantly reduced both the absolute number of customers available to direct to store distributors and the per store sales volume of the independent retailer. It is that independent retailer who is the bread and butter of most distributors. Most chain convenience stores can be serviced by lower-cost wholesalers;
The proliferation of club and discount chains that sell beverages by the case at extremely low prices. Commercial customers who in turn re-sell the product generate approximately 50% of the sales volume at those chains. The distributors must compete with that pricing while providing an additional, costly delivery service. That phenomenon has reduced both the gross margins available to the DSD distributor, the volume of each drop and consequently the overall profitability of the operation;
Sales volumes and margins on traditional carbonated soft drinks have declined this past decade, forcing DSD distributors who historically counted on that segment to support their business to try and squeeze more margin from new products, ultimately driving up prices to the end consumer to uncompetitive levels and further reducing their volumes;
DSD distributors have seen too many brands sold out from under them in recent years, before they could recoup any initial investment they had made in establishing the brand. The distributors have consequently pushed back that up-front financial commitment on the brand owners, demanding support that is often unjustified and unsustainable.
The economic downturn of recent years has put downward pressure on pricing of established products and not allowed distributors an opportunity to recover rising regulatory compliance, fuel, labor and other costs.
In many large and important markets in the US, an independent DSD system does not effectively exist anymore, making a geographic ‘ patchwork quilt’ an impossibility. Also, to assume that the ideal system to establish TREK® would be identical for a brand such as Soy2O™ is simply naïve.
In Canada, we successfully developed our Integrated Distribution System (IDS) to address this problem. At its core, our IDS means simply choosing the optimum route to market in any particular geographic location or with any particular chain. Where necessary, we supplement a channel with sales and merchandising support, but we do it where and when it makes financial sense. For example, this summer we will expand our Canadian street merchandising force to move TREK® and our other brands into more diverse accounts. It was not economic to do that in the first 18 months of the life of that brand, but it is now.
Sadly, and in retrospect, our previous US management seemed either unable or unwilling to grasp that this change was occurring. Maybe they just didn’t know any other way to go to market. Coming from Canada, it was perhaps easier for us to identify what was going on, because the difficult geography we grew up in makes distribution just that much harder and the DSD cracks showed sooner. But make no mistake, the same thing is happening in the US now. One can either choose to ignore that fact, or address it. We chose the latter approach and over the past several months have made the changes necessary to implement our IDS in the US.
There are several multi-million case-per-year beverage brands in North America that have never risen to profitability because they stubbornly adhere to a regional DSD system. They continue to throw more and more of their own resources to prop up a failing network in the hope that they will ultimately make a profit on the case they sell ‘tomorrow.’ Unfortunately for them, ‘tomorrow’ never comes. The only option they have is to hope and pray that some larger company buys out their brand and rescues them; a risky proposition in any business. We do not intend to make that same mistake. Our goal is to make a profit on every case we sell, not pretend that some unpredictable future event might save us from ourselves.
With that said, we have not wasted the past couple of years. We have numerous good distributors who understand our approach, love our brands and deserve our support. They have an important future to play in our IDS and we will continue to cultivate positive relationships where we find them. We are, however, expanding our horizons to encompass a more fulsome approach to getting our products to a broad market.
I should make one final point. In our Q3 news release I mentioned that we had re-negotiated our bank loans to re-classify $2,000,000 Cdn in operating loans to term loans. Over the past few years we had invested considerable working capital in our plants and it made sense to re-jig our financial structure to reflect that. During the past couple of weeks several people asked if that had resulted in an increase in our debt load. The answer is: No, not at all. Our net borrowing did not rise, it just changed in character from current to long-term debt, with a resultant increase in our working capital by that amount.
It is also important to put the absolute amount of our debt in perspective. It would probably cost more than $5,000,000 US to replace just one of our four main production lines. That is before the substantial land and building and infrastructure cost that may well double that number. Our total term debt is less than $5,000,000 US. None of that takes into consideration our 25 acre spring site, distribution equipment, customer base, brands, etc., etc. I hope that helps clarify matters.
Thank you for your continued support.
LEADING BRANDS, INC.
Ralph D. McRae
Chairman & CEO
We Build Brands