Are Food Stocks Safe Havens?

To cut costs, Kraft, announced in October it was cutting 400 jobs, or 1 percent of its North American work force. Sara Lee said in December it would cut 700 jobs to bring $200-250 million in savings in the next three years.

Obviously, there’s a rough road ahead, even for food and beverage companies. Which ones are positioned to weather it better?

“Not all companies in the sector are making money now, but investors like food stocks because they're relatively immune to tough times,” says Christopher Shanahan, research analyst at Frost & Sullivan (www.frost.com), San Antonio, Texas. Fluctuating ingredient costs hampered food makers’ profits in 2008, but grocery stores had higher traffic, a trend that helped shares of some companies with private label business, a Frost & Sullivan report said.

Food companies are benefiting from economic woes as Americans eat at home more often.

Balance sheets for most are relatively strong, and falling commodity prices are a plus. The knock on the group is that it has a boring profit outlook: Analysts typically see annual earnings-per-share gains of 5-9 percent. While not stellar in most years, those look pretty attractive today.

So a little perspective is in order. U.S. food stocks lost 28 percent in 2008, according to the Dow Jones U.S. Food Producers Index. In the same period, the Dow Jones Total Market Index lost 40 percent and the Standard & Poor’s 500 lost about 39 percent.

Even though General Mills Inc.’s stock price ended 2008 at $60.75, below the year’s high of $70.06 (on Sept. 19), the Dec. 31 price was 8 percent higher than it was on the first trading day of 2008. In late December, the Golden Valley, Minn., company reported figures for its second quarter of fiscal 2009, ending Nov. 23, 2008. Despite all the bad news from Wall Street, General Mills sales were up 8 percent in the quarter (to $4.01 billion) from the second quarter of 2008, and “segment operating profits” were up 9 percent (net earnings were down 3 percent, although still a healthy $378 million).

Analysts say they  like General Mills’ focus on cost-savings and creating new products, which helps keep consumers wanting its brands (mainstays such as Cheerios, Yoplait and Pillsbury), even though they look for less expensive alternatives to many other products.

Some investors are looking harder at large-cap stocks, such as Coca-Cola and Kraft, which pay a healthy dividend yield at a low risk of being cut significantly.

Even as food costs rose in mid-2008, trends were good for food makers. As cash-strapped consumers looked to save money — grappling with their budgets amid job cuts and record-high gas prices — they turned more to grocery stores and away from pricier restaurants. The increased traffic in groceries created a bigger market for food makers expected to continue as long as consumers are trying to stretch their budgets.

Roller coaster commodity costs
Many issues marred profits for food makers in 2008. At mid-year, the main culprit was the cost of ingredients. The price of everything from corn and wheat to oil rose to record highs over the summer. Many food makers successfully raised prices to offset the costs. Some tried to hedge their ingredient purchases to save money, but that hurt in the long run, as the cost of commodities dropped in the fall.

Costs were particularly troublesome for meat producers. In the same boat as Tyson and Pilgrim’s Pride, pork producer Smithfield Foods Inc., Smithfield, Va., saw its stock value fall about 54 percent last year.

Speaking generally of commodity-sensitive food stocks, “We believe the market has unduly punished these stocks over the past four months,” says Chris Lynn, president and chief investment officer of Milwaukee-based JC Investment Management (www.jcinvests.com). “Relative to other equity sectors, the food & beverage companies are well positioned to weather what we believe will be a continued equity market downtrend.

“Year-over-year results for these companies will be favorable due to the dramatic decline in raw materials cost,” Lynn continues. “Transport costs are way, way down. Corn prices are down and we expect that they will continue to be cut in half in six months [when making year-over-year comparisons]. Packaging costs that are so heavily dependent on oil in one form or another — like cellophane and paperboard — are going to be much lower.”

New York-based Moody’s Investors Service thinks commodity prices are likely to rise this year, however. “The costs of some key ingredients — including corn, wheat and soybeans — could moderate further as farmers prepare to increase output to meet strong demand,” says Brian Weddington, vice president and senior analyst for the ratings service. He also pointed out there could be price relief from a softening global economy, which could weaken global demand for some commodities.

Taking Defensive action “If you’re going to stay invested, you should look to defensive sectors,” Ron Rowland and Brandon Clay, growth stock advisors, suggest in their Invest with an Edge newsletter. “Perhaps the best way to do this is with Consumer Staples Select Sector SPDR XLP, the most liquid, exchange-traded fund (ETF) in the sector. Regardless how the economy acts, people still eat. Consumers may not shop at Whole Foods, but they’ll still buy groceries. Companies like Wal-Mart and Safeway will continue to rake in revenues from hungry customers. Coca-Cola and PepsiCo will still sell products during a prolonged downturn. Americans also still want their beer at football games and NASCAR races.”

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Looking abroad France’s Group Danone is looking to wring increased profits from its yogurt. “They open new countries every year, and that is going to continue, the question is where,” Marco Gulpers, an analyst with ING Financial Markets, told Forbes.com. “They will be looking into emerging markets, particularly in Asia, which offers a huge potential for growth, and they are already well placed in Latin America. And Eastern Europe will be a later option as they are waiting for those countries to develop further,” Gulpers said.

Retailers are more receptive to passing on price hikes from suppliers, and consumers have become more conditioned to paying those higher prices, said Weddington.

“While most investment-grade food companies should be able to sustain fairly stable earnings [this] year under moderate commodity inflation, most other companies will have a tough time passing on rising costs, and all are likely to see profit margins contract.” And he added, “If commodity prices rise more sharply than expected, some weaker packaged foods companies that lack sufficient pricing power with customers could come under significant pressure.”

Not every analyst welcomes dramatically lower commodity prices. “We believe the recent, high-profile easing in many commodities may take away from the likely viability of pricing remaining an ongoing part of the growth algorithm in food,” says Andrew Lazar, analyst with Barclays Capital (www.barcap.com), London.

Maintaining brand loyalty is key

In November, Lazar lowered his rating on the packaged food industry to neutral from positive. He cited “muddied visibility” for earnings acceleration in 2009, exacerbated by the fact that consumers are choosing less expensive foods at the supermarket.

“These are all good companies, but you see their weaknesses when costs were high as they were in 2008,” interjects Shanahan. “This year should show improvement, but the issue now is that although costs are down, customer income is also down and many are trading down to private label.

“That could result in a weakening of brand loyalty for all the national brands,” Shanahan continues. “We are going to see marketing campaigns that promote and build brand awareness, reminding consumers that Campbell’s soup and Kraft brands are still around.”

“Supermarkets are investing heavily in their own private-label products. The quality of these products has vastly improved over the past few years,” adds Lynn. “Because the recession is causing the consumer to be increasingly cash-strapped, private label prices, which are up to 40 percent lower, will present a compelling choice in supermarket aisles.”

“There’s gong to be an interesting battle between grocers and food companies in 2009,” predicts Morgan Stanley analyst Mark Wiltamuth, quoted on Forbes.com. “Commodity prices have fallen, so grocers are going to pressure food companies to come down on their pricing, but packaged food companies want to keep prices high. At this point, I think inflation will cool but not disappear. I don’t think we will get into a deflation scenario in 2009.”

Sure, many companies provide generic products to these big retail chains. “However, margins are lower,” says Steven Ralston, senior analyst for consumer staples with Chicago-based Zacks Investment Research (www.zacks.com).

“Wal-Mart’s entrance into the grocery channel has and will lead to even greater consolidation among retailers, shifting purchasing decisions to a few powerful chains and limiting pricing leverage for branded food producers,” Lynn warns.

But there also are signs that consumers will not give up their favorite brands … although second- and third-tier ones may drop off the shelves in favor of store brands.

General Mills gained market share last fall, even though its prices were higher. Meanwhile, ConAgra Foods Inc. learned a tough lesson in pricing and branding as its consumer foods volume slipped in the second quarter, which ended Nov. 23, reports The New York Times. Quoting Edward Jones analyst Matt Arnold, ConAgra Brands such as Banquet, Hebrew National and Slim Jim don’t appeal to consumers as strongly as General Mills’, which is why ConAgra’s price increases didn’t hold up as well.

Shanahan points out that in the 2002 and 2003 recessions, innovation and new product development were hampered. And he fears the same may happen this year.

“There will be some innovation, but it will be well thought out,” he believes. “This year there will be a bit more dramatic innovation on shelves and more marketing efforts to basically maintain brands. [Product] innovation will be relatively flat for some, but profitable companies such as Coca-Cola and PepsiCo rely on innovation to maintain profitability. The industry is still somewhat recession-proof, but maintaining brand loyalty is the key in 2009-2010.”

On the subject of organic foods, Shanahan thinks they’ve plateaued under current economic conditions. Erin Ashley Smith, analyst at New York’s Argus Research Co. (www.argusresearch.com), thinks consumers are becoming more mindful of what’s in their food.

“Since food companies have been raising prices to offset commodity and currency-related effects, the pricing gap between regular and organic products is closing, which may make organic products more popular to consumers.”

Through adversity, opportunity will come. “The silver lining to the recent decline is that it has created tremendous buying opportunities,” said Gregory Dorsey, contributing editor to Leeb’s Income Performance Letter (www.leebincomeletter.com). He thinks consumer staples will perform well in a tough economy.

“Safe haven” is a term heard often when analysts discuss food stocks. But Ralston of Zacks Investment thinks the safe-haven thinking will be short lived. “I’ve been bullish on the food industry for the last three years. Despite rising commodity costs, which began in mid 2004, these stocks have been outperforming the market. But I’ve followed the industry for a significantly long period of time, and noticed when they start to outperform the market it’s for about a three year period. So, on a macro level and stock performance level, I think food industry stocks will begin to underperform the market.”

Ironically, an economic recovery could contribute to this underperformance. “What we are going to see in the market is the hope of a recovery in the second half of the year,” Ralston continues. “Somewhere in the first quarter, when the figures come out, portfolio managers will sell their consumer defensive staples like food companies and will buy economically sensitive stocks.”

PICKS AND PANS

General Mills
+ “Walk down any aisle in the grocery store and you will see GIS [its stock symbol] products on the shelves. From a top-down viewpoint, the appeal of this company is clear. If the economy weakens substantially, GIS should perform better than others as their business is recession-proof.” (Sean Hannon, president of Epic Advisors LLC)
+ “With a 3 percent yield, great management, an ability to raise prices in this environment without losing a substantial market share to the private label brands, all with tempered expectations, will allow for strong performance in the next 12-18 months.” (Chris Lynn, JC Investment Management)

Campbell Soup
+ “I really like Campbell Soup; they have a very wide products line, they control their category well, are proactive in their marketing and have no qualms attacking their competitors.”  (Christopher Shanahan, Frost & Sullivan)

Kraft Foods
+ “Kraft Foods is close to a 4 1/3 percent yield and their debt level isn’t onerous.” (Steven Ralston, Zacks Investment Research)
+ (In December, The Motley Fool upgraded Kraft Foods to its highest-possible rating, five stars.) “Kraft …has taken steps to cut costs and spend more on advertising to attract customers. Price hikes have also helped improve revenue, and Kraft's sales rose 19.4 percent to $10.5 billion in the third quarter.” (Dave Mock, The Motley Fool)
+ “Kraft Foods had a few issues last year, their margins shrank a bit and they won’t be growing too much, but they have strong brands.” (Shanahan)

Sara Lee
+ “Our top pick of the year. They are going through a dramatic restructuring and, historically the management at Sara Lee has been adept and professional and able to accomplish their plans.” (Ralston)
+ “Sara Lee has strong growth in European countries and Latin America.” (Shanahan)

Hormel Foods Corp.
+ “Hormel represents real quality in the packaged foods sector. Products are well-positioned to deliver unit volume growth in FY09 and FY10 as they are on trend with a consumer that is spending cautiously – and a consumer that more and more shops at Wal-Mart.” (Timothy Ramey and Theresa MacPherson, D.A. Davidson Co.)

PEPSICO
+ “From Gatorade and Tropicana to Frito-Lay and Quaker Foods, PepsiCo has built a $42 billion global empire marketing drinks and snacks that consumers are likely to buy through thick and thin, making PepsiCo the classic consumer staples company. Over the next several years, we expect PepsiCo’s earnings to grow at an average annual rate of 10 percent or more.” (Gregory Dorsey, Leeb’s Income Performance Letter)
+ “Pepsi has been gaining share from Coca-Cola in key noncarbonated beverage categories.” (Alton Stump, Longbow Research)

H.J. HEINZ
+ “In times of economic uncertainty, consumers take solace in comfort foods. With consumer spending weak, people increasingly are eating at home instead of out. H.J. Heinz is a good way to capitalize on this trend.” (Dorsey)