Caution Advised For Investors Exposed To U.S. Food Companies

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 |  Includes: CAG, CPB, DF, GIS, K, KHC, MDLZ, PEP, PG
by: Equity Watch

The U.S. food industry has been experiencing difficulties in improving volume trends and organic sales in recent times, due to sluggish economic conditions in the U.S. and a slowdown in emerging markets. I believe 2014 will not be much different than 2013, as top and bottom lines' growths will be difficult to achieve. In 2013, U.S. food companies delivered total returns of 22%, lagging behind the S&P 500's return of 30%. Valuations for U.S. food companies also remain unattractive given the prevailing difficulties in expanding volumes; approximately 15% of the returns of U.S. food companies in 2013 came as a result of price multiples' expansion.

As we move into 2014, I believe this year will be a difficult one for the U.S. food industry. Sales volume growth has been decelerating, high growth expectations are priced in and valuations remain stretched. Also, companies in the industry might not be able to benefit from falling costs of ingredients and may not achieve the desired level of gross margin expansion in 2014 due to sluggish volume growth and high fixed costs. Companies in the industry might also not be able to increase prices to drive sales growth due to the cautious consumer spending environment; the industry might have to offer price discounts to force sales volume growth.

Despite the fact that the inflationary environment has eased for the industry, sales volume growth has been hard to find. The industry is expected to experience a sales volume increase of only 1.3% and price increase of 0.5% in 2013, resulting in organic sales growth of 1.8% for the year. Also, organic sales growth is not expected to accelerate much in the near term and is expected to be 2%-2.2% in 2014.

The industry is counting on cost savings and restructuring efforts to achieve earnings growth in the near term. Companies within the industry are registering charges, consistent with their cost saving efforts. The industry's cost saving efforts include lowering headcounts, improving distribution and supply chains, improving manufacturing facilities, and lowering operational and overhead cost structures. Cost savings, which are expected to be achieved in the near term, are intended to be invested back into businesses to encourage growth. Some of the recently announced cost saving efforts are as follows:
- Campbell Soup Co. (NYSE:CPB) announced administrative restructuring, which is expected to result in savings of $40 million,
- Dean Foods (NYSE:DF) is aiming to close its unproductive plants, which will result in productivity savings of $80 million; DF closed 8 plants in 2013,
- Kellogg (NYSE:K) is targeting savings of $425-$475 million by reducing headcount by 7%,
- Mondelez (NASDAQ:MDLZ) and Kraft Foods (KRFT) announced to take charge of $925 million and $575 million from 2012-2014, respectively, which will result in margin expansions,
- ConAgra (NYSE:CAG), last month, announced to optimize its facilities and improve efficiency and take a charge of $200 million,
- Procter & Gamble (NYSE:PG) in 2012 announced to register a $3.5 billion charge over four years to cut 5,700 jobs, and achieve expected savings of $10 billion by 2016. Also, in 2012, Procter & Gamble sold its Pringles business to Kellogg in an effort to focus on its core businesses,
- PepsiCo (NYSE:PEP) is working to reduce its global force by 3% taking a $100 million charge from 2013-2015, which will help the company improve its organization structure and earnings growth,
- General Mills (NYSE:GIS) is targeting to reduce 850 jobs globally and register asset write-downs, under its cost savings plan.

Private label food makers pose a threat to top and bottom lines' results of branded food companies. As ingredient cost inflation is likely to ease in 2014, it will allow private label makers to reduce prices, which will result in a higher market share for private label makers and will adversely affect the performance of branded food companies. Therefore, I believe lower input cost inflation will benefit private label food makers in 2014.

In recent years, consumer stocks experienced notable multiple expansion. Valuations for the industry remain high, which is why I believe that the U.S food industry remains unattractive for 2014. Current expected benefits of easing input cost inflation are aggressive, and gross margin expansion will not be significant in 2014, as sales volume growth will stay weak. Also, I believe high growth expectations are priced in, and missing earnings growth projections will pressurize valuations. Moreover, rising interest rates and sector rotation into more cyclical sectors will not portend well for the industry's valuations. The following table shows that valuations for U.S. food companies remain unattractive.

 

2011

2012

2013

K

15x

20x

23.5x

CPB

14x

15x

22x

PG

20x

17x

21x

GIS

17x

15x

19x

HSY

22x

25x

28x

CAG

15x

18x

22x

MDLZ

18x

29x

23

KRFT

-

16x

18x

Average

17x

19x

22x

Click to enlarge

Source: Morningstar and Calculations

Conclusion
2014 is likely to be a difficult year for U.S. packaged food companies, as the sales volume trend remains weak. Moderating input cost inflation in 2014 will prove to be less of a benefit for the industry margins due to high fixed costs and weak sales volume. Moreover, valuations for companies are currently stretched and unattractive, which does not portent well for the industry, as aggressive growth expectations are priced in. Recently, companies in the industry took corrective measures by lowering their growth guidance for the near term, consistent with the prevailing market conditions, which will help ease valuations. Therefore, I recommend investors with exposure to U.S. food companies to be cautious in 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.