Unbeknownst to many consumers, the supply chain that facilitates the delivery of those delectable heart-shaped chocolates is facing significant challenges.  Should these challenges go unresolved, the future of chocolate may not be so sweet. The large majority of cocao is grown on small family farms that often use unsophisticated, labor-intensive farming practices.  Poor yields are demonstrative of poor or inexistent educational systems and inadequate knowledge of modern farming techniques.  Even if farmers do possess the knowledge necessary to improve operations, it’s likely they lack the financial wherewithal to support productivity investment.  As the industry adjusts to the demands of an evolving supply chain, it may be worthwhile investigating the business model of Rausch, a private German chocolatier.  The company works with all stakeholders – governments, brokers, cooperatives, and individual farmers – to establish reliable supply but also to “help the farmer have a better life by earning enough money so that he can enjoy and provide a future for himself and his family.”

This past month on February 14, people around the world exchanged gifts with their significant others in celebration of Valentine’s Day.  Some couples prefer elaborate displays of affection whereas others favor a more low-key approach.  Regardless of how people approach the day, it’s likely that everyone has at some point given or received the gift of chocolate.  The popularity of chocolate at this time of year is underscored by Nielsen’s research which estimates that U.S. chocolate sales during Valentine’s week account for over 5% of total annual sales.1  Unbeknownst to many consumers however, the supply chain that facilitates the delivery of those delectable heart-shaped chocolates is facing significant challenges.  Should these challenges go unresolved, the future of chocolate may not be so sweet.

Cocoa, the basis of all chocolate, is derived from the beans of the cacao tree.  Cacao trees flourish exclusively in the hot and rainy tropical areas around the Equator.  West Africa is the key growing region and accounts for 70% of global cocoa cultivation, with two countries, Cote d’Ivore (Ivory Coast) and Ghana, producing over 50% of all traded cocoa.2  The large majority of cocoa is grown on small family farms that often use unsophisticated, labor-intensive farming practices.  Oxfam International estimates that farms in Ghana and Ivory Coast harvest an average of 300-400 kilograms of cocoa beans per hectare per year, a yield that is 30-50% below potential.  These poor yields are demonstrative of poor or inexistent educational systems and inadequate knowledge of modern farming techniques.  The World Cocoa Foundation notes “challenges that limit productivity include ageing trees that are past their peak cocoa production, soil fertility that declines over time when nutrients are not regularly replaced, and pest and disease that attack cocoa trees.”3

Even if farmers do possess the knowledge necessary to improve operations, it’s likely they lack the financial wherewithal to support productivity investment.  In direct contrast to the fragmented nature of the cocoa farmers, a concentrated number of chocolate and confectionery companies and grinders dominate the supply chain.  ADM, Barry Callebaut and Cargill control the grinding market (further concentration may be afoot as it’s reported that Cargill is negotiating the purchase of ADM’s cocoa business) and Mars, Nestle, Hershey, Kraft Foods and Ferrero dominate the chocolate and confectionery manufacturing market.  Converging with headwinds of an asymmetrical supply chain are government policies that tax exports and depress the prices that farmers receive.  Despite cocoa prices hitting a multi-year high amidst growing emerging market demand “growers in West Africa are likely to receive just 3.5-6.4% of the final value of a chocolate bar…compared with 16% in the late 1980s.  By contrast, the manufacturers’ share has increased from 56% to 70% and the retailers’ from 12% to 17% over the same period.”4

With this understanding, the unsustainable nature of the situation becomes apparent.  The cocoa farmers’ diminishing value capture combined with rising costs prohibits investment into more efficient operations, thus perpetuating the cycle of low productivity and incomes.  The inauspicious environment is taking a toll on broader cocoa industry as impoverished farmers abandon their farms and move to urban areas in search of more profitable work.  These developments now have the industry questioning its ability to meet future demand, which is projected to grow by 30% by 2020, particularly due to strong demand growth from emerging markets.5  The gravity of the situation (along with efforts from NGOs, activists, media, etc) is driving the industry to re-evaluate the policies and economics of the cocoa supply chain.   For instance, several chocolate producers have established goals concerning sourcing certified cocoa and others are investing in traceability efforts.  Other stakeholders advocate the need for investing in local infrastructure and introducing access to credit to small cocoa farmers.

As the industry adjusts to the demands of an evolving supply chain, it may be worthwhile investigating the business model of Rausch, a private German chocolatier.  While industry competitors sought sales growth in the bulk chocolate market, Rausch pursued the premium market.  The company developed a product line called Plantagen-Schokolade (Plantation Chocolate) which is produced from 100% pure single-origin plantation chocolate.  Compared to bulk cocoa, it is far less common and more expensive, but Rausch’s impressive sales growth and a partnership to produce under the J.D. Gross brand for Lidl, a German global discount supermarket chain, has validated the strategy.

As Rausch’s business has grown, it has not sacrificed its commitment to the cocoa farmers.  The company works with all stakeholders – governments, brokers, cooperatives, and individual farmers – to establish reliable supply but also to “help the farmer have a better life by earning enough money so that he can enjoy and provide a future for himself and his family.”6  Rausch also tries to eliminate the middlemen, ultimately shifting more of the value capture to local farmers.  Looking forward, Rausch is striking deals with governments to develop company-owned cocoa farms and is investing into logistics, both of which are aimed at enabling bean-to-bar traceability.  Admittedly, Rausch is still significantly smaller than the industry’s largest players, but the company’s success is encouraging as it provides a “road-map” on building a profitable yet sustainable chocolate business.

Michael Shavel, CFA is a Research & Business Analyst at Cornerstone Capital Inc. and a former Research Analyst on AllianceBernstein’s Global Growth & Thematic team.

1 http://www.nielsen.com/us/en/press-room/2009/nielsen_u_s_consumers.html

2 Oxfam International Research Report (2008). Towards a Sustainable Cocoa Chain: Power and possibilities within the cocoa and chocolate sector