High hurdle seen for successful '09 investing in grain-based foods

by Josh Sosland
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KANSAS CITY — Heightened selectivity will be required for investors seeking success in owning grain-based foods shares in 2009. While a number of industry companies have promising outlooks this year, Wall Street analysts interviewed by Milling & Baking News seemed warier than usual of the sector.

In what is as difficult an economic environment as experienced by anyone working today, food companies face a number of specific challenges that have changed the relative fortunes of many businesses in the industry, the analysts said.

From an investment perspective, many questions hover over the grain-based foods industry and the food industry generally, and two of these questions were reviewed by the analysts in the first part of this annual assessment, published in the Jan. 20 issue of Food Business News (see story on Page 1 of that issue). The first challenge relates towhether companies will be able to sustain price increases taken in 2008. Retailer consolidation in the 1990s put considerable pressure on food companies to keep prices low, pressure that was alleviated somewhat in 2007-08 with soaring commodity prices. Whether the subsequent retreat in commodity prices and the weaker, potentially deflationary, economic environment would undo food companies’ pricing gains stood as a major concern going into the current year.

Second and independent of the industry’s fundamentals, analysts expressed the observation that in the event investors see an impending economic recovery, shares of food companies could lag the performance of the overall market, particularly shares of cyclical sectors, e.g. housing and manufacturing, and others that have been battered in the current bear market.

Separate from whether or not the food sector will outperform the overall market is a more important question of whether any given food company is positioned as an attractive long-term investment, said Eric Katzman, an analyst with Deutsche Bank AG, New York. A few companies successfully measure up against this fundamental standard, he said.

"The average company in the industry is expected to grow earnings at around 7% to 8% per year and offer a dividend of 2% to 3%, giving a low double-digit return," he said. "Over history, that is a competitive performance, and companies should be able to do at least that. So there are still companies worthy of investment, including such large cap names as General Mills, Inc., Minneapolis, and Campbell Soup Co., Camden, N.J.; and such mid-cap names as Dean Foods Co., Dallas, and The J.M. Smucker Co., Orrville, Ohio."

At Deutsche Bank, potential investments are measured against three themes in the current environment determining whether or not a company is positioned to grow, Mr. Katzman said.

"The first is pricing power in the face of input cost inflation," he said. "The power may be due to an oligopolistic market position or great products, but we believe you have to have it. Next, we want more U.S.-based companies, because we think the non-U.S. consumer is worse off (economically), at least over the next few quarters. Finally, we want less food service because consumers are moving out of eating away from home."

Mr. Katzman said each of the four companies he cited line up well with those themes.

Expanding on two of the companies, Mr. Katzman said General Mills is in the midst of a "very strong new product development period," tapping into the most germane consumer trends of today.

"They’ve successfully exploited growth in convenience, weight loss and organic," he said. "I don’t think those themes will change soon. Private label is a smaller threat in those categories."

In the case of The J.M. Smucker Co., Mr. Katzman said the consumers’ new tendency toward parsimony is an advantage for the company

"We believe they’re well positioned for a consumer move toward more eating in home, across a lot of their products," he said. "That ranges from a very inexpensive cup of coffee (Folgers) to a p.b. and j. sandwich (Uncrustables). The stock has a low valuation and the company’s performance has been good."

Mr. Katzman also is a fan of Flowers Foods, Inc., Thomasville, Ga., and the company’s prospects.

"Flowers arguably is one of the best managed companies in the food industry," he said. "The company is attractive measured against management’s experience or the strength of its balance sheet. The consolidating category in which they play positions them well for many years to come. I think fresh bread is fragmented in a way that there can be several winners. I don’t think there’s any doubt that Flowers will be one of the winners."

For several years Flowers Foods has been selected as a favorite among analysts following grain-based foods, and Mitch Pinheiro, an analyst with Janney, Montgomery, Scott, Philadelphia, said the blush is not off the rose for Flowers in 2009. Janney, Montgomery continues to rate the company a buy.

"We think 2009 is going to be a terrific year for Flowers," he said. "It has all the elements of Flowers core strategy in place. It has the recent Holsum acquisition, which gives them exciting top-line potential as the Nature’s Own brand expands to the West. Lakeland, an in-market acquisition, gives them the potential to improve supply chain and logistical costs, not to mention strengthen its relationship with Publix, a major customer.

"That’s the acquisition part of the story. Meanwhile, the company has pricing in place, which fully offsets their commodity cost increases. And, they’ve been growing organically in new markets. They have moved into Cincinnati and Wichita. They continue to do very well in the mid-Atlantic in the Baltimore-Washington market. The breakfast breads — English muffins and cinnamon raisin bread varieties — are doing well, adding another eating occasion into their arsenal. They continue to innovate with new products. While they do that, it pushes the threat of private label back. Private label doesn’t have the health and wellness credentials of Nature’s Own."

Against this backdrop, shares of Flowers are hovering toward the lower end of the 52-week range, Mr. Pinheiro said.

"Everything they strive for as a company is coming together this year, but meanwhile the stock is beat up," he said. "It’s our contention that the fears will be unfounded."

Mr. Pinheiro has been upbeat on Tasty Baking Co., Philadelphia, for several years. While a number of circumstances have made an investment in Tasty unsuccessful in recent years, he remains positive on the company and believes the long-term play will begin to yield fruit in 2009.

"This is the year they are moving to new corporate headquarters," he said. "More importantly, toward the end of the year they will open up and begin commissioning their new bakery. It’s a transformational event for Tasty, when they will leave their facility built in 1922 and move into a bakery being built in Philadelphia Navy Yard. When they begin operations in the new plant, we estimate that their EBITDA will double. It’s hard to find a food company whose EBTIDA will double in the next couple years. The new lines will be so efficient that they will need 40% fewer employees, which is the bulk of their employees."

J&J Snack Foods Corp., which has seen good growth in recent years, still has a positive profile but with certain risks looking ahead, Mr. Pinheiro said.

"It’s a lean company with a pretty diverse product line," he said. "The only negative I see, and the reason I’m neutral, is that 90% of their business comes through food service. In this environment, I think it’s prudent to remain cautious on those channels. They rely on movie theaters, stadiums, arenas and other venues that are susceptible."

For Lance Inc., 2009 is an "inflection point," Mr. Pinheiro said. While many grain-based foods companies were adversely affected by the surge in commodity prices, "Lance was rocked by them," he added.

On the plus side, 2009 should be a year of significant margin recovery, he said.

"They benefit from exposure to private label," he said. "They also are able to leverage Brent & Sam’s, a premium private label cookie business, and they may see benefit later in 2009 from the Archway acquisition (purchased from bankruptcy late in 2008).

"They’ve always been low-end tray pack sandwich cookies and sandwich bakers," he said. "Now they’re in table top box offerings. They will introduce more mass market cookies that will compete against Chips Ahoy! or Oreo. They have the whole gamut from low to high.

"Meanwhile Cape Cod has been growing at double digits through organic growth and distribution. The Lance brand is growing mid- to high-single digits."

In his analysis of Lance, Mr. Pinheiro looks at PepsiCo’s snack foods division as a measure of the ultimate potential.

"They have the same salty snack products as Frito-Lay, and Frito has a 25% EBIT margin," he said. "They have different brands and different scale, but can Lance reach 10%? If so, how fast can they get there?

"If they have a normalized margin in this business, you will get nearly a doubling in earnings from its current sales base and a stock in the mid-30s. I think management has been working hard on the cost side and it has all been obscured by the commodity cost increases."

In view of the brighter outlook for private label, it may not be surprising that several analysts take an upbeat view of prospects for Ralcorp Holdings, Inc., St. Louis.

"I’m very positive on Ralcorp," said Robert Moskow, a food analyst with Credit Suisse, New York. "Private label food has outperformed the overall market, taking market share. A lot of grocers are increasing their merchandising devoted to private label. Traditionally, they are not good at that and they tend to lose focus over time, but given the economic climate, I think they will maintain a greater degree of emphasis this time around."

If food processing companies are to have a good year in 2009, it may not be evident for several months, Mr. Moskow said.

"Fundamentally, I think that it will be a back-half loaded year," he said. "You may have a bigger benefit in the second half because commodity costs are starting to roll over. In the first half of the year, it will be tough. People are contracted at higher levels, and there has been much more pushback from retailers on pricing. They see commodity costs coming down. They are less amenable to vendors coming to them for another round of pricing.

"I think you have an opportunity in the back half, but again it will be the good brands, good companies with some degree of pricing power, that can negotiate with retailers to cover their costs. I put General Mills and Kellogg in that category."

While health and wellness will remain a viable food industry trend in 2009, Mr. Moskow said that certain companies focused on better-for-you foods are better positioned than others.

"Part of the reason General Mills will do well is because they are in many categories that satisfy the consumer desire for health and wellness, such as snack bars, yogurt and breakfast cereal," he said. "I think that the high end of health and wellness will have trouble. That means organic products, like Horizon milk, I believe will have trouble maintaining a price premium."

Despite that challenge, Mr. Moskow believes Dean Foods Co., whose White Wave Foods includes Horizon, could have a good year from an investment perspective.

"I think Dean is a special story — it is a deleveraging play," he said. "They have a lot of debt. Milk costs have been falling enough to improve their cash flow. That stock probably works its way back into the lower 20s again. But I think the sizzle of the story, which was growth in organic milk, soy milk and their non-dairy creamer, I think is hitting the peak."

By contrast, Mr. Moskow said his positive view of General Mills reflects the company’s strengths beyond the categories in which it participates.

"They are executing extraordinarily well," he said. "I think the capabilities were always there. Ken Powell as c.e.o. and Don Mulligan as chief financial officer deserve a lot of credit for taking on a much more hands-on approach. They began focusing on cost savings and cross functional teams. This follows the first several years of the General Mills/Pillsbury merger in which there were a lot of growing pains."

On the other hand, Mr. Moskow is more skeptical of prospects for Sara Lee Corp., largely because of concerns about the baking business.

"I’m neutral about Sara Lee with a negative bias," he said. "I believe Sara Lee continues to have a disadvantaged cost structure in the U.S bread business. I think a lot has to do with the sales force since its D.S.D. (direct-store-delivery) routes are company owned."

A pleasant surprise in a number of ways has been the performance of Kraft Foods Inc., Northfield, Ill. Specifically, Mr. Moskow has been impressed by management efforts to build the business through innovation and marketing.

"From a corporate structure standpoint, I believe they did the right things to increase accountability and move toward a more action-oriented company rather than an analysis paralysis company," Mr. Moskow said. "There are new products that have come out that are more resonant. Cakesters has been a big success. Bagel-fuls turned out to be more successful than we thought."

Still, Mr. Moskow said the company faces serious challenges because its principal categories such as cheese, coffee and sliced meat are "highly commoditized."

"There is not a lot of growth there, and it’s difficult for them to get pricing to stick when the underlying commodity is falling," he said. "Private label is taking market share in several of their categories."

This article can also be found in the digital edition of Milling and Baking News, January 27, 2008, starting on Page 1. Click here to search that archive.

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