Stock market
Food sector shares are valued far differently at the start of 2018 than was the case a year ago or several years earlier.

KANSAS CITY — After years of food industry share outperformance relative to the broader stock market, the sector’s reversal in 2017 was extraordinarily severe, said Brett M. Hundley, Vertical Group, Richmond, Va.

As a result, Mr. Hundley said food sector shares are valued far differently at the start of 2018 than was the case a year ago or several years earlier. Mr. Hundley was one of several food sector analysts interviewed by Milling & Baking News about the stock market outlook for the new year in the food sector generally and grain-based foods in particular.

“Since 2006, the packaged foods subindex has always traded at a premium to the market,” Mr. Hundley said. “Over the past two to three years the multiple has been 1.4 to 1.5 times. Now it is sub-1. I’d never seen that. It just shows the rotation toward industrials and tech and away from these staple names.”

Other analysts offering a market out-look were Farha Aslam, managing director, Stephens, Inc., New York; Kevin V. Dreyer, co-chief investment officer, value, Gabelli Funds, New York; and Nicholas Fereday, senior analyst, consumer foods, Rabobank, New York.

Each of the analysts cited changes in food retailing as a key market influence in 2017, notably the acquisition last year of Whole Foods Market, Austin, Texas, by, Inc., Seattle.

“A lot of (the food sector weakness) has to do with the upheaval in retail — Aldi /Lidl and Whole Foods/Amazon,” Mr. Hundley said.

Food companies and retailers will adjust to the changing circumstances, but it will take a while, he said.

He cited financial results announced recently by Kroger Co., Cincinnati, showing improved performance and steps the company is taking in response to changing consumer behavior.

“Sometimes consumers want to shop, and sometimes they want to pick up their groceries in a car,” Mr. Hundley said. “Sometimes they want to have it delivered. Those who sell food need to react, and there is a domino effect to packaged foods companies and their suppliers. Everyone is trying to find their way, and they will.”

Ms. Aslam characterized 2017 as a “challenging year” for the food sector overall but noted varied performance by sub-sector.

“There have been pockets of strengths, including the protein stocks,” she said.

Large cap packaged foods companies have had a more difficult time, she added.

“Volume growth in U.S. packaged foods has been challenged by changing consumer demographics with a growing interest in eating fresher, healthier foods,” she said. “The large-cap food companies have been facing pressure because of the retail market share wars. You’ve had the entry of Aldi and Lidl into the U.S. marketplace. You’ve had Amazon buy Whole Foods and the growth of e-commerce.”

That the acquisition of Whole Foods by Amazon sent shock waves through the food and beverage industry was strongly echoed by Mr. Dreyer. Whole Foods shares were in the Gabelli fund portfolio ahead of the Amazon move, yielding gains for fund investors. Still, he said the transaction was hardly all good news.

“We obviously benefited from the takeover of Whole Foods by Amazon, but the ramifications of that deal and negative sentiment toward food and beverage have really weighed on the stocks,” he said. “The notion is that Amazon is getting much bigger in food and will put pressure on manufacturers.”

For Gabelli, health and wellness has been an investment theme the company has pursued with success for some time. A theme that has not panned out as well has been consolidation.

“There have not been a lot of major deals,” he said.

While The Kraft Heinz Co. (3G Capital), Pittsburgh, made an unsuccessful bid to acquire Unilever P.L.C., London, the deals that were successfully completed through much of 2017 were smaller, such as the Danone S.A., Paris, acquisition of The WhiteWave Foods Co., Denver, or the McCormick & Co., Hunt Valley, Md., acquisition of the food business of Reckitt Benckiser L.L.C., Slough, U.K.

“There are a few reasons consolidation hasn’t happened,” Mr. Dreyer said. “There has been uncertainty over taxes. The market has been waiting all year for a tax deal. Whether you get a deal or not, uncertainly has caused a certain amount of reticence among c.e.o.s and boards to do transformational transactions.”

His thesis, shared in an early December interview, appeared to be borne out by the sudden wave of transactions announced in the final weeks of the year, coinciding nearly perfectly with congressional passage of tax reform legislation.

In any event, Mr. Dreyer said the market reaction to the Amazon/Whole Foods transaction appears to have been excessive.

“After the deal, you’d see headlines about how large Amazon is getting,” he said. “That hasn’t been borne out. Mondelez has posted strong results. Conagra has as well. Campbell and General Mills have had choppier results. This notion that it is Amazon exerting pressure on industry, it’s not in the numbers yet. Whole Foods had 450 stores. That’s less than 1.5% of the food market.”

Meanwhile, Amazon has retrenched in other parts of its food retail initiatives, exiting Amazon Fresh in several states.

“They’re still trying to figure out the right formula,” Mr. Dreyer said.

Mr. Dreyer noted sales of large brands over-index in e-commerce versus performance in traditional brick-and-mortar stores. Still, the shift in focus toward e-commerce represents a cost for large food companies presently.

“Companies are investing in online promotion and display,” he said. “They’re trying to figure out how they are going to compete in e-commerce, but they are going to do it.”

Looking forward to trends expected to emerge in 2018, Mr. Hundley said efficiency will be a major theme for food and beverage companies in 2018.

“Broadly, I think it’s going to be another year of s.k.u. (stock-keeping unit) rationalization,” he said. “That has been a major storyline between 2017 and 2018. All major companies have talked about becoming more efficient. That is playing out against a situation among retailers in which grocers are starting to alter their assortment in stores. Target and Kroger are starting to minimize linear square footage for soup and increase linear square footage for product categories like beverages.”

More generally, supermarkets may downsize in the years ahead, Mr. Hundley said.

“I think grocery stores are way too big,” he said. “I foresee in coming years that U.S. grocers are going to trim the amount of in-store space devoted to food and beverage. That will have consequences for food and beverage producers. As retailers shrink space and potentially devote space for fulfillment centers for pickup delivery or potentially introduce clothing lines like Kroger is set to do or team up with electronic retailers. Or share space with a gym. I think you’ll see grocers get creative with how they utilize space. I see that with potential to pressure distribution for some packaged food and beverage producers in the United States.”

The rate of change in the food sector has accelerated to an extraordinary pace, said Mr. Fereday. Food companies are scrambling to make acquisitions to realign product portfolios to meet the changing taste of consumers for products such as plant-based protein, he said.

“There are companies being bought today that didn’t exist three to four years ago,” he said .

Emblematic of the pace of industry change is the fact that the banner event of the year — the Amazon acquisition of Whole Foods — was unexpected in the industry.

“How is it possible no one in the food industry saw that coming?” Mr. Fereday said. “It creates a series of ‘what’s next?’ scenarios.”

Many key forces at play going into 2018 were prominent features a year ago, Mr. Fereday said.

“Top-line growth is still a struggle,” he said. “Food companies are still trying to renovate. Cost cutting is a factor with 3G pressure hanging over them. There is interest in small companies to shift the gravity in line with consumer trends, and valuations are rising. In the past, companies talked about how they like to get to know a company before considering an acquisition.”

Meanwhile, innovation coming from within large packaged foods companies has been scant, Mr. Fereday said.

“We are waiting for some brilliant ideas from large companies, wondering whether companies will surprise us,” he said. “Have they given up on internal ideas? Is it a cost consideration?”

He said the days of an army of research and development staff appear over in the world of 3G Capital, New York. He described a struggle between meeting near-term (shareholder) goals and long-term objectives.

“This represents an existential threat to large food companies,” he said. “A clock is ticking. At what point do we ask, ‘Have these investments (in small companies) made any returns for us?’ At what point do you start giving them a scorecard? How much time do you give them?”