Better near-term outlook, many challenges seen for food sector

by L. Joshua Sosland
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While 2012 appears to be beginning on a bright note for grain-based foods companies, the footing may be shaky ahead, according to Wall Street analysts. Coming after a year of better-than-market performance, on average, for shares of the packaged foods industry, major challenges facing a range of companies may come to the fore in the new year, they said.

Profitability generally is expected to improve in the near term, the analysts said.

“Most of the companies I follow have unique drivers of their businesses affecting their stock prices, and fundamental industry trends often do not apply individually,” said Mitchell B. Pinheiro, managing director, equity research, Janney Montgomery Scott, Philadelphia. “But I think you will have a much better year on average.”

In terms of share price performance, outperformance of broader market indices will not be easy to achieve in 2012, Mr. Pinheiro said. As mature a business as food does not tend to outperform the market year after year, particularly in periods of market appreciation, and current valuations give investors cause for caution in approaching the food sector, he said.

“From a broader market perspective, the average food company is trading at 15 times earnings,” Mr. Pinheiro said. “The S&P 500 is trading at 12. That’s a premium of 25%. Normally, food company shares trade between a 10% discount and a 10% premium.

“Depending on the broader market, whether we are trading out of a recession, it could be another so-so year for the packaged foods stocks. If we remain mired in this very sluggish economy, investors will probably stay somewhat heavily in staples as a defensive measure, and you might have a better-than-average year.”

Eric Katzman, an equity research analyst with Deutsche Bank, said food companies “performed extremely well” last year, an achievement the sector is unlikely to repeat in 2012.

“They did what they’re supposed to do in a volatile and tough market,” he said. “The defensive characteristics of the stocks, including good dividend yields and reasonable if modest earnings growth resulted in the outperformance.

“We’re relatively cautious on the group’s ability to outperform this year. The defensive nature of the stock market has already played out in our view. It’s hard to see how food stocks outperfom from here.”
Grain-based foods companies and packaged foods companies in general enter 2012 with momentum in certain important areas that is likely to flag as the year progresses, said Robert Moskow, senior equity analyst, food, Credit Suisse, New York.

“Many packaged foods companies took pricing in 2011, and it’s spilling over in 2012,” he said. “As the year progresses, you’re going to lap those increases. So from a top-line perspective, you’ll have decelerating top-line growth as the year progresses. Packaged foods companies have found it easy to get the increases through, but elasticity of demand has been sharper than expected, especially in breakfast cereal but other categories as well.”

Elaborating on his concern about the ready-to-eat cereal business, Mr. Moskow said the “value proposition for consumers looks weaker and weaker.”

“Boxes are getting thinner,” he said. “Consumers don’t have a lot of choices for a value breakfast. But they are making tougher and tougher decisions about how much they are going to load up their pantries and how much they are going to eat. They are forced, too. Economics are definitely factoring in.”
Mr. Moskow said he is less concerned about bottom-line prospects in the food industry than about the likely pressure on sales comparisons later in the year.

“From a profitability standpoint, the outlook is okay,” he said. “That’s because they’re all continuing to focus on productivity, restructuring, still generating good trends in emerging markets.”

The same set of factors identified by Mr. Moskow takes on a slightly different aspect in the analysis of Mr. Pinheiro. In his view, 2011 was a difficult year for food companies and “2012 is looking a lot better.”
“Pricing has been implemented,” he said. “Wheat prices have come down more than a touch. You are probably seeing a drop of greater than 20%. If pricing holds, margins should recover.”

Commenting on major themes in the food sector, Mr. Katzman said two — food inflation and demand elasticity — already have played out consistently over the last two years.

“There are two others,” he continued. “First is restructuring. As the volumes have been weak across the industry because of pressure on the consumer, there is coincident pressure on companies to keep fixed costs low. So you’re likely to see more restructuring announcements like the one just from Kraft. Most companies believe consumer changes will be a long-term affair. The new normal is resulting in the companies looking at their portfolios and brands and positioning them to this new normal. That will result in more merger and acquisition activity, whether it’s ConAgra becoming more of a private label company or Kraft splitting in two. There is a whole host of possibilities.”

While it hardly has been flying beneath the radar screen in recent years, attention toward Grupo Bimbo S.A.B. de C.V. is heightened going into 2012.

While currently rating Grupo Bimbo “neutral,” an analyst at J.P. Morgan is very upbeat on the company’s longer term prospects.

“In the short term, though, there are a number of things playing in their favor,” said Alan Alanis, executive director, senior analyst, Latin America food and beverage, at J.P. Morgan, New York. “But, also a number things that are not.”

On the plus side, Mr. Alanis said he was “very excited about the lower price” Bimbo was able to pay for Sara Lee with the Justice Department settlement and said the acquisition of Sara Lee’s assets in Spain was completed at a very attractive price. Additionally, the company’s Mexican baking business continues to perform solidly. On the negative side of the ledger have been costs from hedge positions and an expectation that margins may be under pressure in the next few quarters.

Mr. Alanis said that while uncertainty prevails about a number of prospective developments affecting Bimbo, the company’s strategy in North America is not uncertain.

He explained, “We know what they will not do. They will not engage in a price war. They will accelerate capital expenditure. Their strategy is clearly laid out. The Sara Lee acquisition is not about short-term synergies. It’s about bringing the strength of Bimbo’s balance sheet into better located and higher efficiency bakeries in the U.S. It is to become the lowest cost producer in the long run because of lower cost of energy and closer distribution. We may not see margin expansion in the short term, but it makes sense in the long term. Think about what the cost of a barrel of oil was or a kilowatt hour when most of the baking plants in the United States were built. The industry was built for lower energy costs and few players have awoken to this reality.”

The decision of Kraft Foods Inc., Northfield, Ill., to split into two separate companies represents a basic shift from a foundational philosophy that has prevailed there for decades, Mr. Katzman said.

“I would say that when Kraft was part of Philip Morris many years back to its position as a public company, it’s been all about scale,” he said. “It hasn’t really worked, and the split represents a pretty big change. Not that they will be small companies, but the change will be a big strategic fork in the road. I think the growth prospects for the snack company are long-term compelling. Snacks are a good category with pretty limited competition. It’s a global business. Consumers around the world snack, which gives the snack company an opportunity to create a fair amount of value.

“The grocery company, I think it has its challenges in terms of creating value long term. It is a U.S. business in a mature industry with a lot of competition. If you look over the last 10 years, that competition has really taken it to Kraft.”

Among companies with the potential for a turn for the better in 2012 is Snyder’s-Lance, Inc., Charlotte, N.C., Mr. Pinheiro said. Because 2011 was the company’s first full year after the December 2010 merger of the Snyder’s and Lance businesses, he characterized the company and the year as a “work in progress.”
“Infrastructure investment was a big theme, route engineering, was what happened last year,” Mr. Pinheiro said. “Investors are eyeing 2012 as the transition year, when they will see the benefit of conversion of company owned routes to driver owned routes and a push of cross selling. New information technology is being introduced at the route level all the way up. We should start to see pretty positive elements of the merger come through in 2012. I think most investors are pretty optimistic, as are we.”

Mr. Pinheiro said Lance was “hurt substantially” by commodity price moves even though thoughtful risk management programs were in place.

“They were protected on commodity purchasing,” he said. “What they can’t control is whether or when customers will accept price increases. Particularly in private label, contract baking.”

Another company struggling with commodity costs in 2011 was J&J Snack Foods Corp., Pennsauken, N.J., Mr. Pinheiro said.

“It was a tough year on the commodity side for sure,” he said. “They have now passed along some of the pricing, and we’re probably getting to the end of their pain, if we haven’t already. So 2012 looks okay.”
Strategic actions taken by J&J in recent years appear promising, Mr. Pinheiro said.

“They bought the frozen handheld business from ConAgra, and it seems to have been bought attractively,” he said. “They don’t waste a lot of time when they make an acquisition before they begin working a business harder. So, I wouldn’t be surprised to see a contribution from this sector.”

Beyond ingredient costs and acquisitions, the economy factors into the prospects for J&J, Mr. Pinheiro said. He noted food service and institutional accounts represent more than 90% of the company’s business.

“They do feel the effects of recessionary trends in some of their end markets,” he said. “Meanwhile, it is not a dirt cheap stock. From a financial performance perspective, it should be a better year. We are neutral on the company, based on valuation. It is trading at a nearly 20% premium to packaged food with earnings growth somewhat in line with the group.”

Even though it retains a diverse and substantial grain-based foods business, the focus of The J.M. Smucker Co., Orrville, Ohio, has been in a different direction in recent years.

“Smucker is really a coffee company,” Mr. Pinheiro said. “Folgers dominates the company, accounting for 50% of earnings. The good news is that coffee is a very profitable business. Margins last year in the segment were 28%, versus 21% for the food business. In baking mixes, sales are up 15%, far outpacing the category.

“We’re upbeat on Smucker. One thing people forget about them is their tremendous free cash flow generation. This year we see free cash generation of $320 million, up to $470 million in the next year.”
He said this cash flow is being deployed in significant and important capital investment.

Following a “tough” 2011, Flowers Foods, Inc., Thomasville, Ga., is well positioned for significant improvement in 2012, Mr. Pinheiro said.

“In 2011 they did a good job of raising prices,” he said. “They bought Tasty, which looks like a real meaningful earnings driver for Flowers. In 2011 it was neutral to earnings. But Tastykake is now on an additional 2,200 routes. That looks solid. So when you look at 2012, there is a lot going on. Tasty should contribute 10% of earnings, just alone. If the core business can just grow 5%, you’ll have 15% growth.”
Mr. Pinheiro is upbeat on Flowers’ prospects even as he acknowledges investor nervousness over consolidation in the baking industry and the extraordinary expansion of the largest company — Grupo Bimbo S.A.B. de C.V.

“Investors are always concerned, but Bimbo is acting very rationally, like a leader in the business from a pricing perspective,” Mr. Pinheiro said. “Flowers is a strong No. 2 and growing. Hostess to us looks like a liquidation. Bimbo couldn’t buy it. Flowers isn’t going to buy it. I can’t think of a company that wants in the fresh bread business. I expect the company sold in pieces, brands and plants. Whatever happens, it’s another good backdrop for Flowers. I really don’t see problems for Flowers, other than commodity costs, and those should begin to wane.”

While hardly an easy category, Mr. Katzman said there is reason to be optimistic about prospects for bread and for Flowers.

“I think the category has certainly been more competitive than Flowers management expected,” he said. “It seems every year they begin with optimism and end, over the last couple years, with pessimism. Having said that, the combination of Bimbo and Sara Lee, the opportunity for Flowers to gain share and the return to bankruptcy of Hostess argues the category should become more rational.”

In part because the company increasingly is less reliant on its breakfast cereal business, Mr. Moskow said investors increasingly are viewing Ralcorp Holdings, Inc., St. Louis, positively. After tumbling during the summer in response to a failed takeover attempt by ConAgra Foods, Inc., shares of Ralcorp finished 2011 on a strong note. Mr. Moskow said investors have taken a big picture look at Ralcorp and like what they see.

“Their pasta acquisition (American Italian Pasta Co.) has been excellent,” Mr. Moskow said. “Refrigerated dough (a business purchased from Sara Lee Corp.) promises to be highly accretive. Then you have a spin-off (Post cereals) many investors believe is going to create shareholder value.”

Ralcorp’s strong presence in the private label segment of breakfast cereal may seem a real positive for the company in a weak economy, but the reality on the ground has been more challenging, Mr. Moskow said.
“Private label gets more attention, but it hasn’t been doing well in cereal lately,” he said. “During the first part of the year, branded cereal was rather promotional, pressuring the market for private label.
“In the second half, we’ve seen private label rebound a bit because brands have taken price. But private label needs to take price, too.”

On the grain processing side, Mr. Moskow said prospects have become less promising in recent weeks. Poor earnings results at Cargill and layoffs both at Cargill and Archer Daniels Midland Co. have made Mr. Moskow wary of the near-term outlook for Bunge Ltd.

“I lowered my numbers on Bunge mostly because of weak soybean crush margin conditions,” he said. “I’m more pessimistic after going through the Cargill figures.

“There is great uncertainty around a host of questions, including when the soybean processing industry becomes more rational and the degree to which problems in the Euro zone creates agricultural market volatility and potential problems for companies like Bunge.”

While hardly bullish, Mr. Moskow’s view of ADM is less anxious. Longer term, he said the Decatur, Ill.-based company is looking to make interesting fundamental changes.

“It’s a little ‘less bad’ for ADM,” he said. “You have the benefit in the near term of good volumes in ethanol. Margins are falling there, too. Recently they pulled forward a lot of demand into 2011. Blenders were trying to get volume done before the blender credit expired. That’s happened. So there are some expectations of volume weakness.

“I think the bigger issue for ADM is they are trying to fundamentally change the culture at the company. Their strategic push is to put more capital into emerging markets, and historically, 90% of their cap ex had been in the U.S. So, the challenge for ADM is to change to a more international mindset. That will require bringing in new blood. And they’re doing that. They have a new chief operating officer, Juan R. Luciano (from Dow Chemical), and chief financial officer, Ray G. Young (from General Motors), both from the outside.“

While concerned about prospects for General Mills, Inc., Mr. Moskow’s worries about the company have far more to do with the company’s yogurt business than the breakfast cereal segment.
“It’s just a good solid company facing real challenges in yogurt,” Mr. Moskow said. “Greek yogurt has taken all the growth from Yoplait. Sales are now declining. This probably was the best part of the portfolio for many years. Their response with Yoplait Greek has been unimpressive.

“By contrast, cereal seems to be recapturing some market share.”

In the soup sector, Mr. Moskow said General Mills has been very aggressive, adding that’s not unusual for the company.

“My perception is that Campbell is trying to wean itself from deep discounts, but the retailers have maintained very deep discounts on Progresso,” Mr. Moskow said. “Whether that was the intent of Progresso (General Mills) is unclear. At the end of the day, Progresso is taking share again, in a weak category.“

Among packaged foods companies he covers, Kellogg Co., Battle Creek, Mich., stands out as facing especially serious challenges, Mr. Moskow said.

“They are going through a very challenging period,” he said. “It can be traced back to denuding their supply chain in an attempt to cut costs. They eliminated head count in key areas such as quality assurance and procurement. They weren’t fast enough in addressing some contamination issues in their Eggo plant. As a result, they now have to put big investments back into the plant for renovations and headcount innovations. There is now more scrutiny at Kellogg from the Food and Drug Administration.

“They know what they have to do, but it will take a long time before they can declare victory. It will be a significant distraction. They will be thinking about this kind of issue far more than their competitors.”
Despite its challenges, Kellogg is not without significant pluses, Mr. Moskow said.

“The brand has been very resilient from a consumer standpoint,” he said. “Market share for Eggo has rebounded. Breakfast cereal, too.”

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