June 15 2016 08:00 AM

Exports, ingredients, innovation, and operational excellence are opportunities for the U.S. dairy sector. Achieving these mileposts will come with challenges.

Carbonneau is a partner in McKinsey's Washington, D.C. office, Meilhac is an associate partner in the Stamford office, Modi is a consultant in the New Jersey office, and Pflugfelder is a consultant in the Minneapolis office.

dairy case

The U.S. dairy industry promises exciting opportunities.

That message may sound surprising amid the gloomy data seen in recent years.

Lately, growth in milk production has closely mirrored population growth, indicating essentially flat per-capita consumption. Amid rising consumer concerns over health and wellness, environmental sustainability, and animal welfare, dairy products increasingly vie with alternatives for share of the stomach.

In January 2016, the International Dairy Foods Association (IDFA) invited McKinsey & Company to share our research with the Dairy Forum’s audience of more than 1,000 dairy executives from across North America. We presented our views on how U.S. dairy manufacturers can reignite growth for the industry via four possible bold moves that could drive milk production higher:

  1. Global growth: Fulfill demand beyond U.S. borders.
  2. Business-model growth: Expand beyond traditional products into newer lines such as dairy ingredients or adjacent food categories.
  3. Insight-driven innovation: Grow domestic consumption by uncovering new needs and designing new dairy product portfolio offerings.
  4. Operational excellence: Improve the bottom line by developing a competitive cost advantage.

It will take vision

In order to make these moves work, dairies must understand the underlying strategic choices they need to make — and the resulting implications throughout their businesses.

1. Despite recent volatility, international markets show promise.

Over the last 15 years, the United States has steadily grown its total dairy exports across several subcategories. In cheese alone, exports have grown a surprising 20 percent annually since 2007. Nevertheless, U.S. exports still lag behind the EU’s total. We therefore believe that U.S. dairy producers and manufacturers are only just starting their journey to capture their share of the global dairy market.

But growing U.S. milk production, by sourcing demand from abroad, will require both producers and manufacturers to build new capabilities: to navigate complex regulatory environments, manage market volatility, and understand market-specific consumer behaviors. Meanwhile, EU dairy companies appear to be investing more heavily in developing international capabilities. An analysis of the top five EU dairy producers reveals that they generate at least 50 percent or more of their total revenue outside of the EU. By contrast, for the top five U.S. processors, overseas sales account for less than 15 percent of total revenues.

Moreover, production costs and prices must remain competitive against international milk sources . . . despite volatility around the world both in commodity prices and currency exchanges. Yet, the U.S. industry’s lower cost of production and farm-gate price suggest that these conditions could hold true, and overall growth in U.S. exports could drive significant growth for U.S. milk production.

2. Dairy ingredient consumption is growing faster than world milk production.

Over the last several decades, dairy by-products have evolved into high-value ingredients with large markets, measured in both volume and sales. Two dynamics have contributed to this development.

First, on the manufacturing side, sophisticated and cost-effective new technologies allow milk and cheese processors to develop high-functional products by fractionating milk components at a micronutrient level. More and more, food makers are using dairy ingredients for their physical characteristics as well. Second, on the consumer side, high protein content is increasingly attractive in everything from snack bars to supplements — even baking mixes.

These forces mean that world production of dairy ingredients is expected to grow two to three times faster than world milk production. For U.S. dairy producers, the demand for dairy ingredients can be a significant source of growth if U.S. dairy manufacturers invest the appropriate levels of product development and research to complete with peers.

3. Consumer insight-driven innovation can spur future growth.

Several factors underlie the need for U.S. dairy manufacturers to introduce a constant stream of novel products. Diversifying consumer needs, growing granularity of segmentation, and intensifying price competition all drive the need for product innovation. In fact, as a category, dairy is one of the most prolific in terms of new product introductions, particularly in the cheese and yogurt categories.

Yet, we suspect that innovation in dairy has not reached its full potential. Categories other than cheese and yogurt have seen comparatively few launches, and almost 70 percent of new products are changes in flavors and packaging. Store-brand penetration also has been high, rising to 68 percent of the market in 2015, up from 64 percent in 2010.

More encouraging, however, is that some of dairy’s more successful and innovative launches — such as in high-protein or lactose-free products — have resulted from deep understanding of consumer insights. Advanced data and analytic tools promise still more opportunities to find untapped potential. We believe that product and formulation innovation together will be a meaningful source of growth for the U.S. dairy market in the next few years.

4. Continuous improvement of the bottom line will remain critical.

Given the unique challenges the industry faces, such as short shelf-life products, frequent direct-store deliveries, and seasonality mismatch between supply and demand, continuous improvement has long been top-of-mind. But a major complication is the sector’s legacy of mergers and acquisitions, leaving widespread under-optimized manufacturing capacity.

Our experience in working with dairy companies suggests that many have an operational improvement opportunity of 10 percent or more. This can be achieved though a comprehensive transformation ranging from optimization of purchasing spend and logistics networks to greater use of predictive analytics.

In the short term, cost-plus contracts may also help manufacturers maintain stable milk prices from partner producers. We believe that, if done right, these arrangements can be beneficial to both parties.

Conclusion: Growing the future dairy industry will require strategic focus and alignment on industry objectives.

We believe the future is vibrant for the U.S. dairy industry, with growth fueled by exports, ingredients, innovation, and operational excellence. Manufacturers and producers both stand to gain by working toward the same objective of growing the U.S. market.

This article appears on page 387 of the June 2016 issue of Hoard's Dairyman.

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