Growth and value both important to food success

by Morton Sosland
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When distinctions are made by equity analysts wanting to identify companies qualifying as growth businesses and those identified for their value, familiarity with the financial performance of food manufacturers only creates confusion. Conventionally, companies categorized for growth achieve annual returns on equity of 15% or above, a rate that is high but not unusual for food. Companies that are typically considered as value investments are those with share prices judged as unusually low in price ratios to earnings, to book value and even to sales. Food companies often appear in this list. Contemplating these differences across the broad array of food companies tends to produce the conclusion that decisions about companies and their worth are best based on a combination of value and growth. In turn, this reinforces the belief that food companies emphasize the essential character of growth and value combined, not one or the other.

In this respect, it is important for food companies to appreciate the power of technology to fan growth and even to create a false impression of what it is worth. Two examples come immediately to mind. At the peak of the Internet bubble, Netscape Communications, with annual sales of $85 million, had a public offering that saw its market capitalization reach $6 billion. A much saner valuation as a growth business is Microsoft Corporation, which currently enjoys operating gross profit margins above 80% on its Office software. Its pre-tax profit margin, as the result of the acceptance of the Windows 7 operating systems, exceeds 40%. Its price-earnings ratio is 15 to 16, which is certainly not unheard of in the food business. Most important, though, is Microsoft’s return on invested capital, which is 35%, a figure to be envied, but again not unprecedented for food manufacturing.

Rather than regarding Microsoft results as unattainable, food company executives should turn their attention to the importance of combining growth and value into a single category where the food industry is king. This enviable position reflects important differences about well-run food companies. Food manufacturing is a business where return on invested capital drives capital spending decisions. Examining the financial and credit market collapses of very recent American and global experience leads to appreciation for the way that many, if not most, food companies have adhered to the simple principle of using capital raised to generate future cash flows in excess of the cost of the capital. The decision most often takes the form of measuring the prospective return from an investment against the cost of capital. Such decisions are not made without taking into account likely growth as well as returns.

Few food companies have been so short-sighted to believe investments that do not add cash flow are worth doing. Similarly, industry participants have said “no” to borrowing when equity could be raised, based on the false premise that borrowed capital has lower cost. Most food companies also have resisted revising the appearance of cash flows by changing accounting systems. Food companies for the most part also avoided the strategy at the heart of the most recent business downturn — the mismatching of short-term borrowing against long-term investing. This is not a new fault, having precipitated previous economic downturns.

Experts on the creation and measurement of value often assert that real success is possible only when a company achieves a well-defined competitive advantage. Here Microsoft is once again cited as a company whose competitive advantage is magnified by its size and by the ubiquity of its principal systems and products. Yet, food companies have proven that pursuing value in capital spending means that competitive advantage, while being important to specific markets, is not a prerequisite to business success. Companies far smaller than behemoths which adhere to quality standards to achieve an advantage have proven time after time that adhering to principles meant to conserve value is the surest road to success.

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