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The equities outlook is iffy for 2017 and even iffier for packaged foods companies.

KANSAS CITY — Notwithstanding, or perhaps because of, the post-election stock market surge, the equities outlook is iffy for 2017 and even iffier for packaged foods companies. That was the conclusion of investment analysts interviewed recently.

Brett M. Hundley, an equity research analyst with Vertical Group, Richmond, Va., expressed concern the market’s idealized vision of an impending Trump administration may not match up with the ultimate reality.

Brett M. Hundley
Brett M. Hundley, an equity research analyst with Vertical Group

“I’m torn,” he said “I think an incoming Trump administration throws a lot of uncertainty into the equation. On the surface, the ideas he has put forth should spell out continued gains for the stock market, but I think a lot of people are questioning whether he will follow through on the ideas.”

Mitchell B. Pinheiro, a senior vice-president and senior research analyst with Memphis, Tenn.-based Wunderlich, said the stock market has gotten ahead of itself in the face of a potentially promising economic outlook.

“I am cautious on the market only due to the fact this large run post the election has borrowed some of the performance for next year and moved it into 2016,” he said. “I think it could be rough sledding not because the economy isn’t okay but because of valuations already anticipating the potential positive fundamentals.”

Those positives don’t necessarily extend to the environment for the food sector, Mr. Hundley said.

“On a more micro level, when you begin getting into sectors like packaged foods and consumer staples, I think it will be a difficult overall environment,” he said. “Growth remains hard to come by. A lot of companies have been manufacturing earnings growth through internal cost cutting, share repurchase and debt retirement. It remains a tough overall market for growth.”

Mr. Hundley’s concern about the food sector outlook was colored by what has been a more difficult year than expected in 2016.

“I would say the revenue dynamics are probably weaker than we had anticipated,” he said. “We have been in a deflationary commodity environment for a while. We were not expecting much from pricing to drive top-line growth, but the volume side has been somewhat surprising, somewhat more negative than anticipated. I had thought with the falling unemployment, the consumer would get back on his feet and drive greater growth.

“Food and agribusiness companies have done a good job of removing costs from their businesses. From an earnings standpoint, the industry has performed as expected, with more cost cutting and less sales growth than expected.”

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John J. Baumgartner, a vice-president and senior analyst with Wells Fargo, New York, also highlighted the persistent lack of sales volume growth as a red flag for the food sector.

“For the food sector specifically, fundamentals are pretty poor,” he said. “Volume has been down for five straight years. Companies are not getting a pricing contribution of growth, and that’s been driving them to cut costs to grow profit given they can’t count on sales growth. I think that’s going to be the issue across the board.”

Volumes since December 2015 have drifted downward, and Mr. Baumgartner said “it’s tough to see” where growth may come from moving forward.

“A lot of people in the industry have wrestled with why volume is down,” he said. “What we’ve found is that since the credit crisis about a third of consumers say they use weekly grocery savings to pay other household bills. It blows me away that this far into a recovery you have people using food savings for household working capital.”

While acknowledging some move of shoppers toward the perimeter of the store, Mr. Baumgartner said the focus on this as a principal factor weighing on center-of-store sales is overblown.

“There has been some migration to packaged fresh categories, but my issue is, eating that way, trying to shop the perimeter is not cheap,” he said. “The number of households that do that is fairly limited. Most of the volume decline is from wasting less.”

Still, Mr. Pinheiro said food companies might benefit from a proposed cut in the corporate tax rate to 15%.

“Corporate tax rates are fairly high, so this group will definitely benefit if corporate tax rates fall,” he said. “Most companies are not highly leveraged, so the lack of an interest exemption will not be as painful. Capital spending isn’t that high, so the tax changes could be positive for the sector.”

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With the extended period of historically low interest rates apparently coming to an end, Mr. Pinheiro said the food sector stocks will be facing multiple headwinds. He described food stocks in recent years as “surrogate corporate bonds” generating a 2% dividend with 2% to 3% growth/inflation generating a 4% to 5% total return. More recently, there has been a rotation out of the sector by investors, he said.

“I don’t think we will see any change in the first half of 2017,” Mr. Pinheiro said. “I think early in the year, the group will be out of favor. The valuations having been adjusted, I think we will see a fundamentally good year for the food group. I think it will play out the second half of the year in the stock market. It will be a good environment for raw material costs. The question is whether they will hang on to pricing for some margin expansion.

“As always for the food sector, it’s about sales growth and volume growth. Without real growth, it’s hard for food companies over time. So volume growth is at a premium. Those are the companies we’re focused on.”

Still, for one such company, The Hain Celestial Group, Inc., Lake Success, N.Y., it is profound difficulties that he sees that makes the company Mr. Pinheiro’s top investment pick for 2017. Nearer term, he said investors have been left waiting for Hain to release fiscal 2016 (year ended June 30) results, delayed because of revenue recognition and other problems.

Of greater concern to Mr. Pinheiro is whether Hain management is ready to face the changing complexion of the organic/natural foods marketplace. He has concluded the business would do better in the hands of a larger owner.

“The heady days of 7% to 10% growth in Hain’s U.S. food business are over,” he said. “They turned negative last year. Now they are positive again but more like 1% to 4%.

“We take the view, management skill set isn’t aligned with where the market has moved. Much of the growth in organics is coming in the conventional channel. They grew up in the natural channel. It’s our view different skills and needs are required to tackle the conventional retail channel and Hain is lacking in that area. And they don’t have enough margin to invest in what it would take to overcame this deficit.”

As a result, Mr. Pinheiro sees Hain as a likely takeover target.

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“A larger consumer packaged goods company could add strategic value to Hain,” he said. “They would benefit from more sophisticated sales and marketing. Leveraging distribution. Certainly, the deeper pockets to support distribution growth and marketing and promotions to grow these brands would be helpful. Hain offers the buyer a diversified portfolio of strong 
brands in all the right categories.”

Hain also brings a critical mass in the natural/organic segment that other takeover targets do not, Mr. Pinheiro said.

“There are lots of small brands out there, but they are rounding errors for the large companies,” he said. “Hain has $3 billion in sales. That’s a meaningful number. They would have a large impact on the larger companies.

“Whether it happens in 2017, I don’t know. If the fundamentals don’t improve, I think the noise will grow louder.”

An extended period of flat profitability at Flowers Foods, Inc. is coming to an end, Mr. Hundley said.

“This is a company that has not grown earnings in four years,” Mr. Hundley said of Thomasville, Ga.-based Flowers. “That’s a problem of course. Alongside that it has been dealing with numerous driver misclassification lawsuits. We have long believed the lawsuits have been misplaced or would be settled. It now appears the company is moving toward settlement.

“With the legal overhang seemingly going away, the focus goes to growth and whether the company can grow again. We expect the company to grow in 2017 and 2018. A lot of that is based on Project Centennial the company has described to the Street. They will describe the quantitative aspects in the fourth-quarter call. We expect the savings to be very meaningful.”

Beyond cost cutting, Flowers should do better at generating sales growth in the years ahead, Mr. Hundley said. A starting point to this optimism is the positioning Flowers has taken in the organic baked foods space with Dave’s Killer Bread and Alpine Valley Breads acquisitions.

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“We also like what the company is doing with the Nature’s Own brand with the new Life banner,” he said. “It’s very attractive to us. These are products that are very on-trend — low carbohydrate, low sugar, ancient grains. These are products you don’t normally see in the bread aisle. We believe it will be meaningful.”

Another company Mr. Hundley sees as ready to move beyond its problems is Treehouse Foods, Inc., Oak Brook, Ill. He said the company had a “hiccup on its third-quarter earnings,” missing guidance and leading to a cut in full-year guidance.

“That came alongside the president leaving,” he said. “The stock has taken a material hit. We believe the issues that led to the earnings miss and guidance for the year, we think they are manageable and fixable. We think $5 or more earnings per share is still on the table for 2018. When you consider where the stock is today relative to the earnings the company can put up in 2018, we think there is a lot of value.

“This is a capable, experienced management team that has integrated a lot of acquisitions during its time. We expect the management team to get back on track and executing in 2017.”

A selloff in shares of Post Holdings Inc. has been overdone and leaves the St. Louis-based company’s stock attractively priced, Mr. Hundley said.

“Post has traded off with broader consumer packaged foods companies as a group, following the Trump trade toward higher risk and away from staples,” he said.

Adding to pressure on Post shares is investor skepticism over whether the company will achieve its earnings guidance for 2017 and whether the company will be able to sustain its mergers-and-acquisitions strategy in a higher interest rate environment, Mr. Hundley said.

The earnings concern is centered on Post’s Michael Foods egg business and the effects of highly depressed egg prices. Mr. Hundley said the company is “very well insulated” from low egg prices.

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As far as prospects for further takeovers, Mr. Hundley said Post has been “annoyed” with the number of other food companies in recent years seeking to make acquisitions because of the low interest rate environment.

“I think the company is looking forward to the rising interest rate market to reduce competition in the m.&a. market,” he said. “I think the company has multiple ways to raise capital, and that they are adept at navigating equity markets. They are not averse to using divestitures as a capital raising tool.”

Mr. Baumgartner ranks Post as his “favorite idea overall.”

“In terms of valuation, it trades at about a 20% discount to the food industry even though from a growth perspective they will grow as fast if not faster than their peers,” he said. “They have been aggressive to make acquisitions to diversify. That provides them both with an organic growth opportunity and growth through acquisition opportunity. And they have one of the best management teams in the industry.”

This analysis has been validated by the manner in which the company’s Michael Foods business has achieved record profits in a tough environment.

“They are battle tested,” he said.

The Post ready-to-eat breakfast cereal business is chalking up the best performance in the industry, topping General Mills, Inc. and 
Kellogg Co., Mr. Baumgartner said.

The company’s value-priced position gives it an advantage, an edge enhanced by the acquisition of MOM Brands a couple years ago.

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“They are beginning to put advertising behind MOM,” he said. “MOM is under distributed. It is a regional business they are taking national. It has pretty high customer loyalty but pretty low brand awareness. That’s a good distribution opportunity. They have begun addressing that in a small way.”

For Inventure Foods, Inc., Phoenix, 2017 will be a “binary event year,” Mr. Pinheiro said. The company is in the midst of a strategic review, and as of late 2016, there has been no end result, he said.

“We suspect they are looking at value of this company as a potential acquisition,” he said. “The company is in a bind. After the recall in 2015 in their fresh frozen business, the company had a huge setback. Now they are fairly highly leveraged. They aren’t in position to meet EBITDA covenants. They could sell a business or brand to reduce debt. They could stay within covenants, but that constrains ability to grow, a growth inhibitor. They also could either raise equity, which would be okay here, or sell the entire business.”

Choosing to ride out the storm and meet EBITDA covenants will not take Inventure where it needs to go, Mr. Pinheiro said.

“That would leave them in a very slow growth mode,” he said. “I don’t think that’s the right strategic path for this particular business. I think the board will find selling the business is in the best interest of shareholders. I think it’s worth more than $12 per share. If it doesn’t get sold, the stock has some downside.”

With prospects for packaged foods companies questionable in the new year, Mr. Hundley said he generally prefers food ingredient companies.

“The market for ingredient companies is growing and growing well,” he said. “We expect ingredient segment revenue growth of 4% to 8% on average ahead.”

Additionally, ingredient companies are generating higher operating margins — 15% to 20% or even higher, he said.

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“We think the ingredients industry is really packaged foods circa 2000 or 2005,” Mr. Hundley said. “Ingredients globally are very fragmented and very fragmented in the United States. We see a lot of consolidation potential ahead.”

Among his favorite investment targets in the ingredient space are Sensient Technologies Corp., Milwaukee, and International Flavors & Fragrances, Inc., New York.

“Those two names should benefit from what they call natural conversion — the switch from synthetic to natural ingredients,” he said. “They really stand to benefit.”

Among food companies, foundational ingredients also may affect the fortunes of investors, Mr. Hundley said. For example, sugar is “squarely in the sight lines” of regulators and activists, he said.

“We think sugar reduction will be another focus for 2017,” Mr. Hundley said. “As far as grains go, our view is that we’ve seen the worst in no- or low-carb trade. I’m increasingly hopeful consumers are becoming better educated and are reengaging with grains.”

For the most part, the analysts were not enthusiastic about the large c.p.g. companies. Commenting on a few of them, Mr. Baumgartner said Mondelez International, Inc. has performed fairly well even though the growth rate of global snacking has decelerated to 2% to 3% annually from 4% to 6% a few years ago. Still, he said Deerfield, Ill.-based Mondelez is able to generate its “own growth” by expanding into colossal markets such as China and India, where the company’s footprint remains modest.

Similarly, the Kraft Heinz Co., Pittsburgh, has “performed better than we feared out of the gate.”

“The challenge is expectations are very high,” Mr. Baumgartner said. “They have been very aggressive cutting costs. That’s embedded into the price. There are questions about what they may buy next. People are in the name for that. The stock isn’t cheap. It’s pretty expensive.”

Among the largest ready-to-eat cereal companies, Mr. Baumgartner said the long-term outlook for General Mills, Inc., Minneapolis, is brighter than that of The Kellogg Co., Battle Creek, Mich.

“With General Mills, the cost savings and profit expansion opportunity is just as good as at Kellogg, if not better,” he said. “At General Mills, we are more positive on their sales growth potential, especially global. They’re in categories that are growing and in markets like China with brands that are well appreciated. Short term, they’re both struggling. Neither one is very appealing at the moment.”

Lack of core portfolio growth has forced Campbell Soup Co., Camden, N.J., to reach beyond its core categories, Mr. Baumgartner said.

“Bolthouse (Farms) was a big one and isn’t panning out,” he said.

The company is facing pressure and investor frustration, he said. Pepperidge has been a bright spot at Campbell Soup.

“It’s just a question of how much more they can leverage that,” Mr. Baumgartner said.