Analysts see variety of effects on food sector from globalization
January 25, 2011
by L. Joshua Sosland
The globalization of the world food business, and its impact in the United States, stood out as a principal if wide ranging trend affecting U.S. food companies in
interviews conducted recently with Wall Street analysts. Whether investment by U.S. companies in the food sectors of emerging markets worldwide or the acquisitions of U.S. companies by global food giants, globalization was identified by several analysts as playing a pivotal role in how the food business will evolve in the months and years ahead.
For the U.S. food industry overall and grain-based foods, the analysts emphasized the importance of being able to raise food prices in 2011 as costs escalate and were guided in their investment opinions toward companies they saw possessing the greatest ability to pass along the higher costs.
Among the most prominent ways the U.S. grain-based foods business has witnessed the globalization trend has been the emergence in U.S. baking of Grupo Bimbo S.A. de C.V., Mexico City. From a negligible presence in the early 1990s, Bimbo today is a U.S. baking powerhouse, poised to hold a larger share of the U.S. baking market than any
company has ever held before.
Bimbo driving optimism on baking
Upbeat on the outlook for the baking industry in 2011 was Alan Alanis, executive director/Latin America food and beverage analyst for J.P. Morgan, New York. Central to his optimism is the larger position of Grupo Bimbo in the industry, even though his own rating on Bimbo is neutral.
“I doubt that the companies in the packaged bread business will make the same mistake they made in 2008 when they went for market share and didn’t fully pass along higher costs,” Mr. Alanis said. “It’s particularly a problem for companies that have a higher amount of leverage. I think there is more willingness to take pricing in 2011.”
Consolidation in the industry, notably the pending acquisition of Sara Lee by Bimbo, helps set the stage for more rational pricing, Mr. Alanis said.
“I’m more optimistic about profitability of the bread business,” he said. “If you ask whether I am optimistic about top-line growth, I’m more cautious. Yes, these are staples, but we have 10% unemployment. We need to see purchasing power strengthen before we see volume growth above G.D.P. growth next year.”
Less sanguine was Mr. Alanis’ view of global food issues in the new year.
“I am concerned about food inflation in 2011, as early as the first quarter,” he said. “Food companies around the world are trying to take pricing. If you notice seriousness in my tone, it is a matter of concern for many people around the world.”
Asked whether he expects civil unrest in the new year, Mr. Alanis said he didn’t see such problems as inevitable, but he said the seriousness of the threat was being masked by weakness in the value of the U.S. dollar.
“I don’t want to take it that far (predicting civil unrest), but there is a risk,” he said. “As long as the dollar remains weak, part of what has been offsetting the higher costs has been the ability of people to counter higher dollar prices with higher valued local currencies. But beef is at record prices on a nominal basis. Chicken prices are going higher. If we see weaker local currencies, we will be talking about the risk you just mentioned (of civil unrest).”
Turning to his neutral rating for Bimbo, Mr. Alanis said he downgraded the company shortly after the Sara Lee transaction was announced. His move was a reaction to appreciation in the company’s stock price rather than a dim view of the pending transaction. To the contrary, he described the deal as “a very attractive price.”
He said he does not recall seeing another significant acquisition in baking in which the buyer was paying the same EBITDA multiple (8.5, in this instance) as the buyer’s share price was trading on the stock market.
Mr. Alanis views Bimbo’s investment in the U.S. baking business as indicative of a larger trend playing out, which is foreign investment in the U.S. food and beverage business. Significant beer, quick-service restaurant and chicken businesses have been acquired in recent years, driven by inexpensive access to credit with a weak U.S. dollar as well as a “a sense of fragmentation in many industries around the world and the United States,” Mr. Alanis said. “It’s attractive to buy in the U.S. because valuations are cheap and the dollar is weak. If the dollar turns around, it will be harder for the companies to come in.”
While margins of U.S. food and beverage businesses tend to lag those in other countries, theoretically making U.S. companies less attractive, Mr. Alanis said the stability of the U.S. market is viewed as a draw.
Exposure to emerging markets vital
Eric Katzman, an analyst with Deutsche Bank Securities, New York, also brought an international perspective, together with other factors, to his analysis of U.S. food and beverage companies that may be attractive in the years to come.
“When it comes to the names we are recommending, there are a couple ways to look at the group,” he said. “You want companies that have emerging market exposure because that’s where there is volume growth. You want companies that are No. 1 or No. 2 in a category that is very rational. And you want companies able to adjust their portfolios to growth areas in food — health and wellness and ethnic.”
In terms of gauging what kind of year 2011 will be for the food industry, Mr. Katzman said new product efficacy, price increases and moderation in promotion will offer good measure of whether companies and the industry more generally are succeeding.
He gave particular emphasis to the importance of price increases.
“Those are the critical things facing us in 2011,” he said. “Given higher input costs coming down the road, we as an industry need to counter that.
“I think it’s ultimately up to the consumer. There are signs the consumer is strengthening a bit. I am cautiously optimistic the industry can navigate it, but it won’t be easy. I’m not ready to go there yet. We have a hold on the group. Let’s wait and see.”
Immediate past performance for the food industry hasn’t strengthened Mr. Katzman’s confidence in the industry.
“The way we measure it, the group has pretty significantly underperformed the S&P 500,” he said. “That’s a function of investors seeking cyclical stocks rebounding with the economy. It also reflects food price deflation and the fact that cautious consumers are very focused on not straying from particular shopping lists.”
H.J. Heinz Co., Pittsburgh, is among food companies Mr. Katzman views as holding considerable potential in the new year. The exposure of Heinz to emerging markets is helping the stock trade at a premium to the food industry generally, he said.
“Heinz has a number of opportunities, beginning with its dip and squeeze ketchup product,” he said. “It’s a new package to dispense the single serve.”
The dual-function package allows consumer to peel the lid back for dipping or tear the tip for squeezing onto foods. The package holds three times as much ketchup as traditional ketchup packets.
An appealing grain-based foods value currently in Mr. Katzman’s eyes is General Mills, Inc., Minneapolis.
“It is trading in line with the group, which is pretty unusual because they are generally viewed as one of the better managed companies in the industry,” he said. “There is concern over cold cereal, but if you look at the category over time, it’s rare you’ve seen declines two years in a row. With all the new products Kellogg and General Mills are introducing, the innovation is not factored into the stock price. That reflects widespread pessimism about the cold cereal category.”
Two companies with iffier prospects are Campbell Soup Co., Camden, N.J., and ConAgra Foods, Inc., Omaha, Mr. Katzman said. With Campbell Soup, he focused on “struggles in their core soup business.” While ConAgra has been aggressive bringing innovation to market, it has yet to bolster the company’s margins, he said.
Moskow emphasizes pricing issues
Each of the analysts emphasized the importance of raising prices for food company prospects in 2011. Robert Moskow, an analyst with Credit Suisse in New York, was particularly emphatic on the point.
“The biggest objective is to push through higher pricing,” Mr. Moskow said. “Everyone could see commodity costs are higher and hedges are rolling over. Historically, food companies have done a pretty good job of passing along costs of consumers and grocers.”
Still, Mr. Moskow said success is not a foregone conclusion in what he described as a “more complicated” situation.
“That’s because the food industry’s consumer base is very stressed financially, and the grocers have had a terrible time,” he said. “The supermarkets are nervous about passing it through and probably a little confused. They know they need price to drive same-store sales growth. On the other hand, they are nervous about taking price increases.”
Mr. Moskow said whether or not price increases take hold in 2011 will be known before the end of March.
“We will know at least half the story by then,” he said.
Mr. Moskow said his overall view of the food industry from an investment perspective has been one of skepticism, largely because earnings growth projections were higher than he thought were justified.
“Since then, companies like Campbell, Kellogg and ConAgra all have lowered their guidance,” he said. “So, the space is more investable than it was a few months ago from a stock perspective.
“Fundamentally, are these companies going to enjoy good growth? Elasticity to the price increases is going to be painful in the first two quarters. It will balance out by the end of the year. It makes sense sales should be better in 2011, when you consider how easy the comparison is to a weak 2010, in terms of price and volume.
“Operating margins reached a four-year peak in the middle of 2010, then started to decline slowly as commodity costs rose. It shows how much more important it is for the pricing to go through.”
Mr. Moskow noted that a number of industry executives have verbalized their commitments to aligning prices with costs to preserve profitability.
“Ralcorp said they are out there to protect margins with their price increases,” Mr. Moskow said. “Sara Lee said the same thing. Kraft, same thing. The ones with the most differentiated brands have the best chance to stop the margin slide.”
While offering different justifications than Mr. Katzman, Mr. Moskow also views prospects for General Mills positively.
“I think they have the best track record over the last three years introducing resonant product innovation and increasing advertising,” he said. “I trust them to be able to balance out pricing and hold margins. They figured out how to integrate Pillsbury, and they also introduced cross functional teams to gain better alignment on productivity efforts. Once they stopped the bleeding on missing numbers after Pillsbury, they could put more focus and resources on observations about consumer needs.”
A company without a track record of growth in recent years but with prospects for improvement is Kraft Foods Inc., Northfield, Ill., Mr. Moskow said. He described the Cadbury acquisition as a “unique opportunity, in part because of cost synergies that could be reinvested into Kraft to fuel growth.”
“But I think, especially in North America, the organization is not where it needs to be in terms of business momentum or having the right team,” Mr. Moskow said. “A lot of their problems were cultural years ago. It was very bureaucratic with way too much analysis, not enough action. Years ago they were still cutting the quality out of their products and running it like a financially driven organization rather than a marketing driven organization. Now, I’d like to think there is a different operating philosophy in place. The results have been spotty.”
Mr. Moskow’s managerial criticism does not extend to the company’s chief executive officer, Irene Rosenfeld.
“I am very impressed by her,” Mr. Moskow said. “I think she understands the consumer, and she is a very effective leader internally. But integrating this Cadbury business is going to take longer and have more bumps along the road than they probably realize.”
Internationally, Mr. Moskow said the importance of international exposure has been heightened by domestic conditions. Beyond the perennial difficulties squeezing growth from a U.S. population expanding ever so slowly, Mr. Moskow sees additional difficulties.
“Food stamps have gone from 5% to 10% of food expenditures annually,” he said. “For food companies to grow, they need to become more exposed to emerging markets.”
Mr. Moskow also identified H.J. Heinz for its exposure in emerging markets.
“Heinz has done a very good job with a handful of regional jewels,” he said. “Their track record had been spotty internationally until the last couple years. They have better management in place in China, India and Russia.”
While St. Louis-based Ralcorp Holdings, Inc. has struggled to achieve success with its venture into the branded ready-to-eat cereal business, Mr. Moskow said the company has done better and is on more familiar turf with American Italian Pasta Co., Kansas City, acquired in 2010. Still, even a modicum of success going forward with Post is possible and may be highly beneficial to shareholders, he said.
“I think AIPC is doing well,” Mr. Moskow said. “Post Cereal is the problem there. It has been two years. They underestimated what it would take to run a branded cereal business. They are a private label company. Now they are launching new products, and I like the new management they are hiring. So, if they can get Post to what it was when they bought it, there is a lot of value to be unlocked.”
Mr. Moskow said Ralcorp, General Mills, Inc., and Kellogg Co., Battle Creek, Mich., all would benefit from higher pricing and innovation in 2011, and he said management from each company appeared committed to both.
Focused on and wary of U.S. picture
More focused on domestic food companies and perhaps warier about the industry’s prospects than the other analysts going into 2011 was Mitchell Pinheiro, with Janney Montgomery Scott, Philadelphia.
“I think it’s going to be a challenging year for grain-based foods stocks as they face a new round of commodity cost inflation and continued uncertainty about the consumer’s ability to absorb higher costs,” he said. “So, the companies that will fare better will be those that have pricing power. Those with brand strength and that cater more to retail channel than food service.”
Mr. Pinheiro said he is very positive about prospects for Flowers Foods, Inc., Thomasville, Ga.
“It is my favorite name in the group, as a case in point,” he said. “We think Flowers stands to benefit from inflation in the bread category. It could be counterintuitive since their costs are going up, but I think the grocers learned that deflation in bread is bad for everyone. It’s a staple, a regularly purchased staple with few alternatives.”
Mr. Pinheiro said Flowers already has shown pricing leadership in bread. While he said competitors have yet to follow, most will.
“They don’t have a choice,” Mr. Pinheiro said. “Either raise prices or see significant margin declines.”
Another promising company in grain-based foods is Snyder’s-Lance, Inc., Charlotte, N.C., Mr. Pinheiro said.
Following a complicated 2010, he foresees an “interesting 2011” because of the merger between private-held Snyder’s and Lance.
Before the merger, Lance appeared to be struggling last year, having announced depressed earnings and cost-cutting moves. The company’s share price suffered.
Mr. Pinheiro noted, though, that while first-quarter earnings “dropped a bomb on investors” by falling far shy of guidance, second-quarter earnings were dramatically higher than guidance. Mr. Pinheiro said it was hard to parse out which part of the share price recovery was attributable to the better earnings and which part to the merger announcement.
“Lance has a very strong partner in Snyder’s, one of the best in the salty snack industry,” Mr. Pinheiro said. “The ability to leverage both distribution systems with each others’ brands has a significant revenue potential.”
The ability to consistently deliver double-digit earnings growth has made J&J Snack Foods Corp., Pennsauken. N.J., a favorite of Mr. Pinheiro. While impressed by the company’s performance, particularly in recent difficult times, he is cautious about the company’s prospects in 2011. Still, he has a buy rating for the company, with snack products that include soft pretzels and funnel cakes sold at specialty venues.
“More than anything, I think J&J is subject to consumer discretionary consumer trends,” he said. “I’m not optimistic on the consumer in 2011. Conditions will hurt companies dependent on theme parks, baseball stadiums and supermarkets. We have a buy rating on J&J, but we are cautious.”