U.S. Food Companies Poised For Earnings Growth

by: Rick Shea

US based food manufacturers have been noticeably silent on Wall Street in the last year. Normally as market volatility increases to the downside and talk of recession dominates the headlines, interest in food companies climbs dramatically due to their predictable earnings and safe haven status. The rationale has always been "Even in a recession, people still have to eat."

Unfortunately, this time around food companies have been caught in the crossfires of unprecedented commodity inflation. Most Wall Street firms and retail investors have held off increasing their positions in food companies until they see how the companies are able to handle the double digit rise in commodities.

All this brings us to the current situation. Are food companies a good buy here? Have commodities peaked and will they return to their normal 3-5% annual inflation rate? Have food companies been able to pass through pricing to offset the increases in commodities? Are premium branded players holding market share vs. private label and value orientated products?

First, let's look at commodities. The most important ones to food companies (wheat, corn and oil) are all trading more than 20% off their highs. Daily reports suggest that the wheat and corn crops are improving and have the potential for a strong harvest that will lead to lower prices. Oil has dropped to below a $120 a barrel and likewise suggests that, at least for the short term, momentum is down, not up. This short term trend in commodities is definitely bullish for food companies.

Secondly, when we review earnings reports for Q2 2008, most companies showed a decent pass through rate on price increases vs. commodity costs. It varies by company, but in general companies were able to offset between 60-80% of their commodity increase through higher prices. Most were able to do this without losing market share. This is also a future positive for food company stocks, as it shows they can protect their margins by raising prices.

Thirdly, have consumers remained loyal to their favorite brands and avoided the trade down to private label? Here the evidence is mixed with private label shares growing in some categories. This trend towards increased value has been going on for many years. Private label products have gained market share in many categories for the last 10 years. There doesn't appear to be an acceleration of the trend, just an ongoing improvement.  However, consumers are still seeking value.

Consumers are doing three key things to stretch their overall food dollars. First, they are eating out less, thereby getting more of their total food from grocery stores. Secondly, they are shopping more at the discount food retailers. This means the sales dollars are there for food companies, just a different mix of retailers. Lastly, they are increasing the amount of food bought on deal. Many of the top categories in grocery stores already have a 50%+ on deal percentage. This means that 1 out of 2 purchases is bought using some cents off price reduction or coupon promotion. In many categories, the on deal percentage has increased by 1-3 % points over the last year.

So based on this, what food companies look attractive? My favorite picks for further research are as follows:

  • General Mills (NYSE:GIS): Strong brand portfolio, top notch management with a good mix of international sales.They should benefit nicely from the recent declines in wheat and corn prices. Their recent sale of Pop Secret also suggests that they are getting serious about divesting underperforming or non strategic businesses.
  • Kraft (KFT): Also a strong brand portfolio with an ever increasing international presence. They have made nice progress on margin improvement in the latest quarter, but have further work to do divesting non strategic brands and businesses. They need to continue efforts to streamline the company by reducing headcount and costs.
  • Ralcorp (RAH): An interesting value play based on their strength in private label. The company sells for a much lower PE than their branded competitors. They recently completed the acquisition of Post cereals, but have a long way to go to integrate the two businesses (Ralcorp's a leader in private label cereal) and drive significant cost savings. If they can drive savings in the manufacturing area and not lose sales on the Post brands, they could deliver increased shareholder value.

I would avoid Hain Foods (NASDAQ:HAIN) right now until the economy improves and consumers return to buying a higher percentage of natural and organic products. Continue to watch Whole Food's (WFMI) results, and when they start to improve it will be safe to take another look at Hain. I would also avoid meat producers like Hormel (NYSE:HRL). Corn prices have come down but they are still significantly higher than last year. With corn being the main input cost for beef, we can expect higher prices and lower margins for beef and poultry producers for the next few years. Both Conagra (NYSE:CAG) and Campbell Soup (NYSE:CPB) shares are at low PEs, but neither company has shown any catalyst for generating a higher sales growth rate and subsequently greater earnings potential. Both companies are also in need of some portfolio restructuring to drive greater growth. Both Kellogg (NYSE:K) and Pepsico (NYSE:PEP) are strong companies that also merit future research.

Overall, we believe food companies are returning to their place in investor portfolios by providing safe, stable share price and earnings appreciation. You will never get rich owning shares in food companies, but you will also not lose 25% of your portfolio value. As volatility continues and negative headlines still persist, we believe US food companies present a safe, stable alternative for investors.

In our next article we will do a more in-depth look at each food company's financials, as well as discuss future growth prospects.

Disclosure: none