The mood of U.S. dairy executives has deteriorated, as flat growth, trade tensions and changing consumer tastes continue to dampen prospects for the coming years. With regions beyond the United States experiencing growing demand, rising numbers of U.S. dairy companies have begun to pursue exports in the past several years. Other market factors, including the move by some consumers to non-dairy alternatives, will also present challenges. New research from McKinsey & Co., New York, sheds light on the mind-sets of U.S. dairy executives and their recent evolution as they attempt to jump-start growth.

Executives on dairy exports

In 2015, several developments in the global dairy industry suggested cause for optimism. The European Union removed its milk production quotas, and observers anticipated that a growing middle class in Asia would consume more dairy products. In the ensuring years, milk supply grew faster than demand, and prices and profitability have remained depressed ever since. As a result, in 2018, 63% of survey respondents thought the downturn was not cyclical, but structural, caused by a global surplus of milk and a fast-changing consumer environment

Considering the changing landscape, U.S. dairy companies have changed their perspectives on expanding beyond U.S. borders. The importance of and participation in exports continues to increase. In 2015, 34% of those surveyed had no exports and no plans to export. In 2018, that number dropped to only 11%. The share of companies that already export but have no plans to expand and those with continued plans to expand exports also rose from 34% in 2015 to 51% in 2018. These increases likely reflect the growing importance of exports despite the current trade environment.

In the 2018 survey, opinions were split regarding how long current trade disputes would last. For instance, 53% of those surveyed believed that trade disputes were short-term in duration, whereas 47% believed they were here to stay. However, the impact of the trade disputes seemed to be universal, with 90% of the respondents reporting that they had already incurred a margin decrease between 0-10% and 95% expecting to incur a margin decrease of the same magnitude.

It is not clear whether the magnitude is low because trade disputes have a low impact or because the prices and margins were already on the decline before the disputes started. However, for those companies with significant export exposure (7-10% of respondents), the impact of trade disputes has been significant in terms of discounts or lost opportunities, with margin decreases of 10-15%.

The results show that 82% of revenues from the surveyed companies come from the U.S. domestic market, with just 18% from exports. As other countries face surpluses and focus on foreign direct investment to complement dairy exports, the production capacity of U.S. dairy companies outside the United States is also growing. In 2018, 36% of the respondents had expanded their capacity outside the United States (over the course of five years), compared with only 7% in 2015. Nearly 57% of the respondents had the same capacity in 2018, compared with 18% in 2015, and 7% reported to have less capacity in 2018 compared to 2015. This investment in foreign capacity is a hedge against the risk of losing out on the opportunity to capture more value and move away from commodity pricing and cycles. Winners in this space have transitioned from being commodity suppliers to functioning as strategic global partners.

In 2018, the results show U.S. dairy exports are mainly consolidated into two markets—Asia and Mexico—which represent 45% and 46% of the export revenues, respectively. As other countries gain access to compete in these markets, margins are expected to decline. Less than 10% of export revenues are associated with Africa and the Middle East, regions that will grow with their populations and economies and where several European and New Zealand companies already have a direct presence.

Risk and volatility management

Survey respondents also indicated a sustained concern about volatility and ways to address it. In 2015, price volatility was the third-highest concern, right after consumption decline and food safety. The number of respondents reporting the use of financial instruments to mitigate price volatility has increased. Companies securing long-term fixed contracts with vendors and customers increased as well. Demand volatility continues to be the top concern in 2018, with 47 out of 51 respondents reported being concerned, and 32 out of 51 very concerned about demand volatility. The evolution of consumer preferences seems to be connected to these concerns.

Consumer trends

The Top 4 perceived drivers of consumer demand have been stable from 2015-2018, but their order has shifted. Taste was the most important factor in 2015, and fell to No. 3 in 2018, whereas price moved from No. 2 in 2015 to No. 1 in 2018. Health and wellness also rose from No. 3 in 2015 to No. 2 in 2018. Convenience remained No. 4 in both 2015 and 2018.

The survey results suggest CEOs are reassessing their companies’ competitive advantages in a consumer landscape that is shifting toward small brands and a different set of preferences compared with older generations. In 2015, 21% of dairy CEOs had confidence in their customer service capabilities, followed by brand management. Only a minority considered customer insights to be a source of competitive advantage. In 2018, dairy CEOs had the most confidence in their operational capabilities, but very few listed brand management capabilities. Again, only a few cited consumer insights as a competitive advantage, which is surprising considering the influence of consumers on demand volatility.

The results suggest companies are responding to the new landscape by increasing the speed of innovation. The number of companies changing more than 5% of their portfolio increased from 73% in 2015 to 83% in 2018. According to the survey, new products represent 6% of the total portfolio of products for companies with growing portfolios and 3% for products with decreasing portfolios.

Milk alternatives and Millennials

Interviews with CEOs revealed a sense of frustration over the speed of change in consumer preferences, including the emergence of natural, healthy and socially oriented trends. Even so, executives recognize the necessity of listening to consumers, and are trying to adjust strategy accordingly, with some expressing the desire to enter into a business partnership with their non-dairy counterparts.

Executives exhibited moderate confidence in understanding such trends as clean labeling, which has a variety of meanings and preferences for plant protein, but not fat. As Millennials become the largest demographic in the United States, companies need more insights into these consumers, who are more diverse, more sophisticated and more demanding than other generations and prefer to shop in channels beyond the mass markets. Millennials also gravitate toward up-and-coming brands rather than established ones.

The views of dairy CEOs on the milk alternatives market has shifted significantly. In 2015, only 38% of the respondents believed that the non-dairy alternatives market would continue to grow. In 2018, this number increased to 51%. Companies can respond by understanding the areas in which dairy has an advantage and exploit those markets where nutrition is valued and price sensitivity is not a factor. Or they can invest in adding dairy alternatives to their portfolios.

Dairy-alternative products appear to be here to stay, so market insights and an openness to work with non-dairy companies will be critical elements of strategy moving forward.