Do you know the definition of a cake? How about yoghurt? What qualifies as low-fat versus non-fat?
At first glance readers may stifle a yawn, but seemingly banal definitions can reach into the heart of a company’s business model, ultimately hitting its bottom line. The financial implications can run into the millions and, for consumer staples stocks, can constitute barriers to entry for smaller players, giving incumbent corporates a potential advantage.
Our interest in this topic was piqued by a snippet in an NPR article detailing how the US government had decided that French dressing (a misnomer as it’s an American invention,) no longer required certain regulations.
One might naturally think competition regulation, or perhaps food safety. But actually, the regulation of said salad dressing went as far as the ingredients list: 35% vegetable oil was a must, tomato paste and spices were optional extras.
This regulation had held uncontested since the 1950s, but after an explosion in appetising alternatives, such as ranch and Italian, the US Food & Drug Association (FDA) agreed to revoke the ‘standard of identity’ for the product in 1998, on the basis it no longer promoted fair dealing in the interest of consumers.
Another dietary revocation was for the identity standards for yogurt, low-fat yogurt and non-fat yogurt. Under the latest rules, the latter two are covered by the FDA’s general definition, which allows modified versions of traditional foods, such as those sweetened by agave rather than sugar. It also establishes the minimum amount of active cultures yogurt must contain to bear the ‘live’ label.
The consequences of these seemingly trivial matters can have huge and long-lasting financial implications for corporations, and therefore their shareholders.
For example, the FDA’s announcement of the Nutrition Innovation Strategy in 2018 was a significant shift in direction, with a new focus on nutritional science while simultaneously trying to allow flexibility for innovation. It prompted major strategic shifts at a management level.
While we may not see these shifts immediately reflected in a company’s share price, the longer-term impact on profitability, and consequently a company’s ability for capital expenditure and/or distribution to shareholders, all feed into its profile for prospective investors.
For example, the matter of whether a baked good is a cake or a biscuit might superficially appear to be a debate limited to a peculiar British obsession. But it warranted a longwinded legal dispute in the early 1990s. A court was required to settle whether McVitie’s Jaffa Cakes were indeed cakes not biscuits.
Why does it matter? The ruling would have margin implications to the sum of £200 million for McVitie’s[1].
Biscuits were deemed a luxury item under UK law, so full VAT would be levied at 20%, whereas cakes were regarded as a staple food, with a zero-rate VAT applied. UK tax authorities argued that Jaffa Cakes were biscuits but the case was ruled in McVitie’s favour as it highlighted how cakes harden when they go stale, while biscuits soften. The result is that £1.19 billion worth of Jaffa Cakes made every year are free of VAT.
Unfortunately for Procter & Gamble, the manufacturer of Pringles, it saw a similar ruling go in the government’s favour after arguing passionately that the snack was not a crisp (potato chip) in an attempt not to attract VAT. The ruling left Procter & Gamble facing a tax bill of millions and the court case also had the unfortunate result of the public discovering that Pringles are made from less than 50% potato.[2]
The regulation of such matters isn’t limited to the world of consumer goods. In the 1890s, the US Supreme Court altered the definition of the tomato when it ruled that importers were required to pay the port duties as if it were a vegetable (even though botanically it is a fruit). In the UK, tax authorities ruled in 2014 that bridge was a game and not a sport, so clubs could not reclaim VAT on contest fees.[3]
While perhaps curious from a trivia perspective, the reasons for this level of regulatory scrutiny are well founded. They facilitate a well-functioning market economy, keep consumers safe, labelling honest and ingredients lists from becoming opaque.
The reason this is important for investors, is that keeping up with regulation can be an expensive business.
There are direct costs associated with product categorisation, as well as indirect ones in the form of safety and registration requirements, and implications for how a product is marketed. Therefore, it is vital for companies to be up to date on these matters and to be exceedingly sure-footed in how they navigate the landscape.
This regulatory complexity can create barriers to entry for new players, while the larger incumbent leaders typically benefit from having legal and product development structures in place to keep abreast of regulatory changes. When the implications of falling foul of a definition can result in a £200 million tax bill, this is something that shouldn’t be underestimated by investors.
Please read the full piece here.