Knowing that PepsiCo (PEP) had experienced a bit of weakness during recent weeks, I was looking forward to the company’s earnings release today. I already own shares of this giant food and beverage company, but I’ve been considering adding more as the yield approaches the 3% threshold. When thinking about this purchase, I wanted to take a look at the food space as a whole to see where PepsiCo stacked up against its peers that also offer respectable dividend yields. In the coming days I plan on putting together a piece focused more directly on PEP’s most recent quarterly earnings, but in the mean time, I hope you all enjoy this view of the food space through a broader lens.
To me, the economy looks strong. Sure, there are issues (there always are) but I expect the FED’s to maintain a hawkish stance moving forward. I expect that interest rates will continue to rise as the FED attempts to normalize its balance sheet. I think another quarter point increase in December makes sense right now and I wouldn’t be surprised to see this followed by another two or three increases in 2018 as well. Because of this I’m a bit bearish on consumer staples stocks right now.
These stocks, oftentimes considered to be “bond equivalent” equities, aren’t likely to outperform in a rising rate environment. What’s more, many of them are facing fierce competition and potentially disruptive threats as consumers move away from branded names in favor or cheaper alternatives as quality improves in the generic space. The large cap food space has seen tremendous pressure as of late as sales fall, threatening margins. This has led to very low share prices and above average dividend yields across much of the food space.
Deals (and yields) like this catch my attention and I’ve struggled in recent weeks as I’ve browsed the food space, attempting to weigh potentially secular threats of changing consumer sentiment and a bearish shift in the bond market against my desire to bolster my portfolio’s yield with companies historically known for their reliable cash flows. In preparation for potential purchases in the food space, I put together these comparative graphs, trying to make sense of the recent destruction.
As you can see below, only two of the food stocks that I track from a DGI perspective, McCormick (MKC) and PepsiCo (PEP) have posted positive returns on the year. I own shares of both companies, but this relative strength to their peers is little solace to latch onto because even the best performing food companies on this list are significantly underperforming the S&P 500, which is up 14.49% YTD. I know investors look to names like these when they’re interested in low beta, defensive stocks with reliable dividend yields; however, the 2-4% yields that these companies offer hardly compare to the relative underperformance compared to the broader market.
|Company||Price||YTD performace||Relative performance to S&P 500||Dividend yield|| |
Annual Dividend Increase Streak
|Campbell Soup (CPB)||$46.56||-23.62%||-38.11%||3.03%||1 year|
|General Mills (GIS)||$52.01||-16.92%||-31.41%||3.82%||14 years|
|Hormel (HRL)||$31.76||-8.70%||-23.19%||2.14%||51 years|
|Kellogg (K)||$62.42||-15.86%||-30.35%||3.48%||13 years|
|Kraft Heinz (KHC)||$77.77||-10.88%||-25.37%||3.21%||5 years|
|McCormick (MKC)||$99.77||5.09%||-9.40%||1.92%||31 years|
|Mondelez (MDLZ)||$41.02||-7.65%||-22.14%||2.15%||3 years|
|J.M. Smucker (SJM)||$105.02||-18.56%||-33.05%||2.99%||20 years|
Now, obviously the past is in the past. Right now, when looking at the space, I have to try and figure out if this basket of stocks will continue to underperform the SPY or if recent weakness has pushed valuations down to the point where future projections start to look more attractive from a total returns standpoint. In this next graph you’ll see the current valuations of the companies on the list versus their 10-year normal P/E ratios, according to F.A.S.T. Graphs as I attempt to find undervalued names in the space.
|Company||current P/E|| |
10 year average P/E
Only Campbell Soup, General Mills, Kellogg, and J.M. Smucker have valuations in the present that appear to be discounts relative to their 10 year historical norms. It was a surprise to me that after such significant weakness more of these companies weren’t trading at similar discounts. This speaks towards the overvaluation we saw in the space in prior years as investors reached for reliable yields. Out of these three companies, I’m probably most interested in adding shares to J.M Smucker to my portfolio. Now I know I’m over simplifying things here as these companies have all taken measures to diversify their product portfolios over the years, but at the end of the day, I’m just not very bullish on the future of the cereal/canned soup industries.
Prior to 2017’s cool down, some of these companies traded with valuations that similar to high growth tech names. Hormel and McCormick traded for nearly 30x earnings in early 2016 while KHC exceeded that 30x threshold for much of the year. Many of the other stocks on this list traded for ~25x earnings in 2015/2016, which is simply too much for companies posting top-line growth in the low single digits.
I think that moving forward, investors should expect these companies to trade more in-line with their historical norms, in the high teens and low twenties in terms of P/E ratios. These are still premium valuations, which are well deserved due to the reliable cash flows and dividend yields previously discussed, but anything much more than that represents overvalued territory, if you ask me. Now that we’ve experienced an industry wide correction, I expect for future returns to be based upon EPS growth with multiples back in-line with historical norms.
My biggest issue with the food space is that I cannot figure out whether we’re witnessing a true change of the competitive landscape right now in terms of consumer sentiment and the aforementioned shift from quality (brand names) to value or if this is simply a short-term issue of negative sentiment that will turn out to be false. This could be a secular headwind for all of these packaged food plays if my generation as truly lost interest (or trust) in the quality of the brand names compared to cheaper generic options. And speaking of quality, I wonder if sales of packaged foods in general will continue to suffer as consumers stick to the outside isles of the grocery stores where fresh and frozen goods lie rather than the middle isles full of packaged goods and preservatives.
But then again, maybe I’m wrong. Maybe the health foods trend isn’t as strong as I think it is; after all, GIS recently added artificial dyes back into their Trix cereal due to customer demands. I think these companies are finding that there is a fine line between healthy and the tastes and prices that we’ve come to expect. This is surely proving to be a difficult line to toe. PepsiCo management touched on this during their recent conference call regarding their marketing budget and decline sales of their soda business. In the age of big data and algorithms, it seems that management teams are still finding that there is more art than science to proper ad spending in the face of constantly changing trends.
|Company||TTM sales growth|| |
TTM EPS growth
I’m always happy to invest in companies when I believe they’ve sold off on an isolated instance, but in the case of the packaged food names, I’m truly concerned about their problematic trends they’re facing being of the secular variety. In the graphic above, we see that just about every company in this space has struggled to grow their top line during the trailing 12 months. Several of them have posted strong bottom line results, though I believe this sort of performance is unsustainable over the long-term. Cost cutting and efficiency measures can only impact a company for so long until it requires higher sales to grow. I’m impressed that so many of these companies have been able to carve out profits in this difficult environment, but as a long-term investor, I’m much more interested in the overall health of the business and management ability to grow sales and increase consumer demand for its products/services rather than its ability to squeeze a bit of profits out of an otherwise troubling situation.
So, with this isolated issues versus secular trend question still weighing heavily on my mind, I hope to open up the discussion to the SA community in hopes of gaining a bit of clarity of the subject. What do you think? Are we looking at a potentially lucrative opportunity here with many of these well known brand names trading at multi-year lows or will these names continue to be value traps for investors as they struggle to produce top-line growth? At what point do their dividend yields become too high for you to ignore any longer? Do rising interest rates effect your outlook when it comes to the packaged food/consumer staples space? These are all questions that I continue to mull over and I sincerely look forward to seeing what everyone else has to say.
Disclosure: I am/we are long PEP, MKC, SJM.
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.