Pricing: 'Power' or 'Poof'

by Josh Sosland
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In the words of Robert Moskow, a food industry analyst with Credit Suisse, New York, pricing "is the single issue investors will most worry about in 2009." In particular, Wall Street is wary of whether food companies will be able to maintain the food price increases instituted amid the commodity price surge of 2007-08, whether companies will be able to push through another round or whether price cuts could be in the offing.

The ability to raise prices was a significant contributor to the relative outperformance of food industry companies in 2008 versus the broader market averages. The packaged foods and meat sector of the S&P 500 declined 15% in 2008, a far narrower decline than the 39% drop in the S&P 500 and the 34% decline in the Dow Jones average of industrial shares.

While a normal tendency of investors is to embrace food companies during periods of economic insecurity, food price increases helped the industry’s companies minimize the negative effects of highly volatile ingredient markets.

Largely because of the pricing question for 2009, Deutsche Bank AG is neutral about the sector at the moment, said Eric Katzman, a New York-based analyst with the company.

"Packaged foods names performed quite well in 2008 versus the market," he said. "But the industry is in a position in which it must prove it will be able to keep pricing that it has put in place over the last 18 to 24 months versus a publicly stated intention of retailers to bring prices down.

"Private label is retailers’ weapon to push that agenda. At the same time you have the consumer under pressure because of recession. So until the consumer packaged goods industry can prove pricing is solid, we believe stocks are in a show-me mode."

More optimistic going into the new year is Mitch Pinheiro, an analyst with Janney, Montgomery, Scott, Philadelphia. Mr. Pinheiro is hopeful based on what he perceives as common interests among the various parties.

"Except, perhaps, for the consumer, it really is in no one’s best interest to reduce prices," he said. "For the manufacturer, higher prices allow them to take normal profit allowing them to reinvest in research and development, innovation, new products and opportunities to lower costs. On the retailing side, the margins are thin enough. I can’t see what would motivate retailers except to gain market share, but that’s ultimately a losers’ game, with everyone at the same competitive position with no long-term gain.

"We believe prices will hold in 2009, and where you’ll get price reductions is through promotion. I’m not talking about promotion for promotions sake but promotion that drives demand longer term and has a return to both parties — retailers and manufacturers are smarter about promotion these days."

For much of the year, 2008 was a pleasant surprise regarding packaged foods company performance, Mr. Moskow said.

"Fundamentally, at least through September, packaged foods companies put up better results than we expected," he said. "Sales growth was robust because consumers were eating at home more and restaurants less. Volume was okay, not great, around 1%. The pricing did get pushed through, especially on companies with good brands.

"Some of that pricing dropped to the bottom line."

While the overall results were better than he had expected, Mr. Moskow said one major trend fell in place as expected — companies with strong brands and marketing programs in good categories did considerably better than companies in weaker categories or portfolios of brands.

"The companies we were worried about were exposed to highly commoditized categories and volatility," Mr. Moskow said. "Milk had another tough year. Branded cheese (Kraft) lost market share. Several of ConAgra’s brands lost market share. High quality portfolios with low exposure to commodities did better.

"The meat business, protein processors, had too much capacity, especially in chicken. They weren’t able to pass on the impact of higher grain costs."

Looking back at 2008, Mr. Pinheiro said it could be seen as surprising that food companies did not perform worse.

"It was a very difficult year operationally for many food companies, dealing with unprecedented volatility in commodities combined with trying to pass on these costs to consumers as fast as they could," he said. "Despite this difficult operating environment, they outperformed. Yes, it’s a safe haven, but in a year in which food companies could have been treated harshly by investors, they were given a reprieve."

He continued, "It’s true in other categories as well. Wal-Mart has done a great job over the years of identifying the top two brands, offering them and then Sam’s Choice. We like variety, but there is a price you pay for that because it makes retailers more expensive to run."

As a result, Mr. Pinheiro and other analysts said that brands that are neither the No. 1 nor the No. 2 selling products may be in danger. The vulnerability extends beyond tertiary brands to certain overall categories, Mr. Pinheiro said.

"I definitely believe commodity oriented products are at risk — cooking oils, processed cheese, white bread and canned vegetables are examples," he said.

Mr. Moskow said considerable uncertainty exists over how financial results for the fourth quarter will turn out, given the difficult to assess impact of the rapidly deteriorating U.S. economy.

"The fourth quarter is a big question mark," he said. "We expect to see some aberrant consumer behavior because the headlines were so bad about the financial crisis. We wouldn’t be surprised to see another drop-off in volume in even traditionally stable categories such as cookies, crackers and breakfast cereal.

"I believe some of that is temporary. Consumers will return to the grocery store in 2009. Still, I think we have another year of this structural shift toward consumers saving more money. That means fewer trips to restaurants and more trips in the grocery store. Also we will see a continuation of the channel shift toward stores such as Wal-Mart and Costco and away from high end supermarkets and specialty stores."

Tougher to evaluate for 2009 is whether the share price outperformance of the year before will be repeated. Essentially, analysts agreed that the sooner the economy and the broader market begin to recover, the sooner the food sector will begin to underperform.

Mr. Katzman agreed that the relative performance of the food sector will be dependent on whether the overall market recovers, possibly quickly.

"If we get some incredible snap back and it’s suddenly euphoria rather than Armageddon, food stocks would have a hard time keeping up," he said. "That’s putting the cart before the horse. Deutsche Bank is calling for a challenging year for the market in 2009."

At least in terms of relative performance, Mr. Pinheiro said good news for the economy is bad news for food industry shares.

"If investors get a sense that the broader market and economy will recover, the food sector will suffer as investors move into early cycle and less defensive sectors," Mr. Pinheiro said, adding that the food sector goes into the new year with reasons to be hopeful about its fundamentals.

"The food industry has weathered the (commodity price) storm," he said. "Some companies have passed on the higher costs and are poised to see some margin recovery. If prices hold and the economy still stinks, they’ll have a very good year relative to the rest of the market. If the economy starts getting better, which looks unlikely in the face of what seems to be a protracted recession, it will hurt the stocks relative to the broader market, no matter how the companies’ fundamentals perform."

Beyond the question of whether food companies will be able to sustain price increases is uncertainty over whether a new round of commodity storms could be forthcoming.

"I don’t think we are out of the woods on the commodity issue," Mr. Pinheiro said. "The story in 2009 could be just as bad as good. We dodged a bullet in 2008. There is still that element out there."

Barring a worst case scenario for the U.S. economy, Mr. Moskow too is pessimistic about the investment performance prospects for consumer packaged foods companies in the year ahead.

"The answer is they will underperform," he said. "The overall market is depressed enough that the first dollar that goes back will be in higher beta sectors that are early in the cycle. My expectation is that will happen in 2009. They don’t pay me to forecast the overall market or economy, but there is risk.

"If the government fiscal stimulus falls on its face and people lose faith in the U.S. dollar or taxing authority, these food companies again will be the defensive category for 2009. Right now, though, investors are looking for early cycle names."

This article can also be found in the digital edition of Food Business News, January 20, 2009, starting on Page 1. Click here to search that archive.

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