Analysts generally guarded toward grain-based foods shares going into 2015

by Josh Sosland
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While shares of many grain-based foods companies climbed impressively to new highs in 2014, investment analysts were hard pressed to paint an optimistic picture for the segment when considering the stock market outlook for the new year. Viewed from a number of perspectives, the analysts interviewed by Milling & Baking News said headwinds facing many companies in the industry created investment risks that overshadowed the attraction that lifted the group for several years, a longer period than many on Wall Street had expected.

A consumer migration away from carbohydrates and toward protein, a trend that has shifted in style and emphasis over the years, continued in 2014 and will persist in the new year, said Rob Moskow, an analyst with Credit Suisse, New York.

Mr. Moskow and the other analysts said companies most able to understand and meet consumer demand for products viewed as “healthier” stand the best chance of prospering ahead. The shift has been particularly difficult for leading makers of ready-to-eat cereal, Mr. Moskow said.

“People are eating less breakfast cereal in the morning and are eating more protein,” he said. “They believe lower carb, lower gluten diets are healthier. Consumer packaged foods companies are trying to figure out how to adjust to that.

“When I look at my coverage list of 15 companies, about 10 missed their expectations for the year. That included most of the blue chip branded companies. Protein companies did better, exceeding expectations. I think it’s no accident that Hormel and Tyson both had very strong years. In the case of Tyson, top-line success was a key. Chicken demand was very strong. Hormel experienced the same thing. The companies would not have been able to achieve their bottom-line results without having solid supply and demand economics.”

Many of the companies that struggled were described by Mr. Moskow as “carb heavy.” Additionally, major consumer packaged foods companies are losing ground in competition with natural and organic companies.

“According to Nielsen data, the top 25 food and beverage companies have lost 420 points of basis share to entrepreneurial competitors,” he said. “A lot of the brands are losing their resonance with consumers at a slow but steady pace.”

The steady erosion of share of food sales enjoyed by traditional supermarkets and the shift toward other channels will continue in 2015 and will factor in the investment prospects of consumer packaged goods companies in the new year, said Mitchell B. Pinheiro, senior vice-president, Imperial Capital L.L.C., New York.

“Customers are moving toward the club, dollar and the natural channels,” Mr. Pinheiro said. “This will continue at a slow but measurable rate. And it will help determine which companies have success or struggles.”

Among the growing channels, Mr. Pinheiro is focused in his practice with Imperial on the natural segment, or health and wellness more generally, for investment opportunities. The profile of the leading natural foods retailer underscores his point, Mr. Pinheiro said.

“You see Whole Foods, Sprouts and Natural Grocers growing at a 15% to 20% clip,” he said. “Well those stores don’t have your typical brands. Some food companies do a much better job than others in getting into these stores. General Mills, Inc. and Kellogg Co. are doing a great job with Cascadian and Kashi, respectively. General Mills just bought Annie’s, which is another example of a company upgrading its portfolio. I think we will see more of this in 2015. We think the larger, more mature companies will struggle from the sucking sound of the channels where these companies don’t have a presence. As a rule, companies that are not burdened by legacy brands will perform better.”

Similarly, Mr. Moskow said the path chosen by large packaged foods companies saddled with product portfolios losing consumer favor has been the acquisition of smaller companies with rapidly growing sales.

“That’s the solution thus far,” he said. “General Mills bought Annie’s and Food Should Taste Good, looking to expand its Small Plant Foods division faster. Campbell Soup bought Bolthouse Farm and Plum Organics. At Kellogg Co., Kashi has contracted, and they are now regrouping. I expect more acquisitions across the packaged foods sector.”

For traditional food companies, the news going into the new year is not all bad, Mr. Moskow said.

“You have lower gas prices, and you are lapping the cut in SNAP benefits,” he said. “The backdrop is a little better than it was a year ago.

“That’s the case in general when consumers feel more confident. For lower and middle income consumers, the drop in gas puts as much as $700 into their pockets on an annual basis. That’s very meaningful for a lower income consumer. There is some discretionary nature to how consumers spend in a grocery store. This will make them feel a little more confident.

“The improved economic conditions are not going to cure everything. It’s probably for the companies I cover — it’s going to be less bad. I think this year was pretty extraordinarily bad.”

While financial results of the largest packaged foods companies have been disappointing, Mr. Moskow acknowledged that the share price performance has been strong.

“I think it is a little paradoxical that the fundamental performance of these companies has been very subpar by their own metrics in three of the last five years,” he said. “But valuation multiples of the stocks keep going higher. I don’t think that’s happening because investors love these stocks. I think it’s happening because the market loves yield. Investors are treating these companies shares like quasi bonds. If interest rates rise faster than expectation, this could change rapidly. There would be rotation out of this sector.”

Even more cautious about the operating environment for consumer packaged foods companies going into 2015 was Erin Lash, senior equity analyst for the sector at Morningstar, Inc.

“There are a couple obvious headwinds they continue to face that we don’t think will abate,” she said. “The consumer remains very selective in purchase decisions. Making sure a company’s products are resonating with consumers and making sure consumers know about your new products are key. While consumers continue to maintain a bent toward health and wellness items, they are not looking for products that give them a sense they are on a diet. Companies need to be sensitive, especially in the domestic market.”

A second trend identified by Ms. Lash poses challenges to many grain-based foods companies.

“Shoppers continue to shop the perimeters of the store,” she said. “Getting product in front of the consumer is key. That’s a challenge because consumers are still operating on a budget.”

No meaningful relief is expected for the food sector regarding overall commodity input costs, Ms. Lash said.

“We still expect commodity cost inflation will persist across the basket of goods,” she said. “We aren’t anticipating a material tailwind from a retreat in commodity costs. Right now, we view the sector as modestly overvalued. Consumer defensive names are perceived as products consumers use on an everyday basis and they are sources of income for investors.”

On a company by company basis, major moves into health and wellness do not represent the only approach needed for success in the coming year, Mr. Moskow said. Changes of a different kind under way at Mondelēz International Inc., Deerfield, Ill., are brightening prospects for that company, he said.

“I like Mondelēz primarily because they have the best opportunity for self help,” he said. “They are changing the culture internally to change their cost controls and expand profit margins. Their margins are well below their peer group. There is a huge opportunity. This isn’t the solution to long-term success, but I think it helps bridge the gap until emerging market rebound.

“Irene Rosenfeld (chairman and chief executive officer) has responded to the change in the environment. The environment is slower growth. It makes sense to focus your attention internally. I think they had been negligent in that regard for too long.”

An ingredient supplier Mr. Moskow sees with a promising outlook is Ingredion, Inc., Westchester, Ill.

An expectation the company will raise high-fructose corn syrup prices significantly in 2015 is among his reasons for optimism.

“They and ADM have more pricing power this year,” he said. “The United States has limited some of the sugar imports from Mexico as part of the agreement with Mexico. Ingredion is an international company. Some of their markets have slowed, like Argentina and Brazil. Eventually some of those markets will come back.”

Longer term, growth at Ingredion will be driven by the company’s specialty starch business, Mr. Moskow said.

“It’s about 15% of the business now but its growing at a high single digit pace, it’s margin accretive and helps participate in health and wellness area these companies are pursuing. In Mexico, for example, the government is putting more pressure on food companies to reduce sugar content and calorie content and fat content. Specialty starches can be used to replaced some of these ingredient while maintaining the texture of the original products.”

A company struggling with forces beyond its control in Mr. Moskow’s view is The J.M. Smucker Co., Orrville, Ohio.

“It’s a very good company, but I have been cautious on them,” he said. “To get the stock right you have to time the coffee bean market and buy it when the inputs are falling. Right now they are having trouble passing through full impact of cost increases they took. Prices haven’t fallen enough to make the stock interesting to me.”

Mr. Pinheiro focused on players in the health and wellness segment, including major players beginning or about to make a move toward grain-based foods. A case in point is The WhiteWave Foods Co., Denver, Mr. Pinheiro said.

“WhiteWave is the largest player in three natural/organic categories — produce, with Earthbound Farm; dairy, with Horizon Organic; and plant-based beverages with Silk, So Delicious and alpro,” he said.

“What the larger packaged foods companies are doing, Annie’s for instance, are developing brands that are cross category, say into mac and cheese, frozen pizza and snacks. WhiteWave, with the Horizon organic brand, is beginning to expand from dairy into some of these kinds of products. They also are cross channel. You can find Annie’s in Wal-Mart or Target and you can find it in Whole Foods. Same with Horizon. You can find it in Target and in Whole Foods.

“Horizon is an interesting little brand I think will grow under the radar. It will grow in grain-based areas. They have snacks and cheese crackers, cookies and mac and cheese. I think they will take share from traditional leaders — Kraft in mac and cheese and Pepperidge (Goldfish) in snacks.

“In produce, Earthbound Farm is barely able to keep up with demand. We’re also seeing them expand into different areas, tangential to produce, like salad dressing or maybe into croutons.”

Another company focused on health and wellness but with a very different profile than WhiteWave is Hain Celestial Group, New Hyde Park, N.Y.

“Where WhiteWave has three or four major brands, Hain has 20 large brands,” Mr. Pinheiro said. “On the grain-based side, they have Arrowhead Mills. It’s a terrific mix brand. DeBoles Pasta. They recently bought Rudi’s bakery. Rudi’s is mostly a bread baker, but they are moving into gluten-free items. Rudi’s was an interesting acquisition for Hain. What you’re seeing, if you look at the bread aisle in a Whole Foods is that there aren’t many recognizable breads. What’s interesting is that there may be some shelf space up for grabs. I think Rudi’s can grab share. Fresh bread in the natural channel is not dominated by a single brand. Hain may establish some hierarchy in the sector.”

With its focus on gluten-free products, Boulder Brands Inc., Boulder, Colo., is another company that bears watching in the health and wellness segment, Mr. Pinheiro said.

“Boulder owns Udi’s and Glutino’s,” Mr. Pinheiro said. “Consumption of gluten-free bread is still growing annually in the 20% area. Some of the supermarkets are beginning to add it to the deli area of the bakeries. They are even developing specialty items for the in-store bakery, like different loaf shapes.

“Again, what makes some of the brands interesting is the ability to take them across categories. The brands are so new that consumers are willing to accept their presence in different categories than they are with older brands.”

While fad diets may come and go, gluten-free dieting has not yet passed, Mr. Moskow said. Recently conducted research largely debunking the effectiveness of gluten-free diets for individuals who do not have celiac disease, reported in The New Yorker magazine, does not change this view.

“I think the gluten-free movement still as legs to it,” Mr. Moskow said. “Scientifically I agree with that article. Emotionally, consumers think they feel better when they don’t eat a lot of gluten. If you look at the New York Times best seller list for diet books, I think basically 7 of 8 talked about reducing carbs.”

Mr. Pinheiro mused about whether different health and wellness companies could, like Annie’s, be attractive as an acquisition candidate.

“Boulder to me is an interesting small brand, and it also could be interesting to larger consumer packaged goods companies,” he said. “They have started brands and grown them the old fashioned way and they have purchased existing brands.

“One of the issues for Hain, is that they are so diversified, I can’t imagine another company buying them. It’s a cool portfolio, but all over the map.”

If gluten-free has been a driver of consumer demand in 2014, so has the avoidance of foods containing bioengineered ingredients, Mr. Pinheiro said.

“It’s the other big trend right now,” he said. “A lot of these companies are championing the non-G.M.O. issue. They are not making a statement on whether they are good or bad, but labeling plays to their mission statement. They are all supporters of those various bills that would require labeling. Whole Foods will basically remove any product with G.M.O. It’s tough. If you label it, you won’t get sales. You don’t label, and you’re out.

The avoidance of G.M.O.’s may be viewed as part of a trend toward avoidance of a wide range of undesirable ingredients or qualities.

“G.M.O. is part of the big ‘free’ movement,” Mr. Pinheiro said. “Trans fat, preservative, artificial flavor/coloring, dairy, gluten, G.M.O., fat, sugar, antibiotic free.”

Against a backdrop of outsized growth in health and wellness food products, Mr. Pinheiro follows a number of retailers in the sector.

“I love Whole Foods,” he said. “They are the leader. The one underneath the radar screen is Natural Grocers.”

Formally known as Natural Grocers by Vitamin College Inc., Lakewood, Colo., the company operates 91 stores — 15 in western states other than California.

“Natural Grocers is for hard core consumers who believe what you put in your bodies directly affects your health,” Mr. Pinheiro said. “If the meat department is 4 feet wide, I’m exaggerating by overstating the size. They sell very little red meat. They will sell buffalo. Better-for-you meats.

“They just kicked out any dairy products that come from confined dairy cows. They offer certain egg products with especially interesting nutrition aspects to their eggs. Nothing artificial in any products. All produce is organic. No advertising a low price for a fruit or vegetable that isn’t organic. I think as more people enter the natural and healthy living category, a certain percentage will drop to the hard core area, and Natural Grocers is a natural fit for them.”

In December, Natural Grocers acquired Nature’s Pantry in Independence, Mo., and began operating the store as Natural Grocers. The company said the acquisition was one of 18 stores to be opened in fiscal 2015 (year ending Sept. 30). The company’s other stores in the Kansas City metropolitan area include one less than half a mile from a Whole Foods Market.

“Locating near Whole Foods has been very effective for Natural Grocers,” Mr. Pinheiro said. “It is less expensive and less fancy. There is a health coach in every store. It’s a great concept — very sticky, loyal customer base.”

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