NEW YORK — The best stock market price performance in 13 years by grain-based foods companies should not obscure challenges facing the sector as 2014 begins, Wall Street analysts said recently in interviews by Milling & Baking News.
Weak volume trends and threats of price deflation are two factors making investment professionals wary of the stock market outlook for food companies going into the new year.
“We are neutral on the group relative to the market,” said Eric Katzman, an equity research analyst at Deutsche Bank, New York. “I think you will need to be very selective.”
Among causes for serious concern for packaged food companies has been the lack of a rebound in top-line growth.
“The biggest negative surprise for packaged food names last year was that sales growth was disappointingly weak,” said Robert Moskow, an analyst with Credit Suisse, New York. “U.S. consumers remained very cautious. They did not increase volume consumption even though pricing inflation dissipated. I think it’s just a function of everyone being on a tight budget. Lower income consumers are feeling more economic pressure, and that tends to be the primary target for many of the food companies.”
Compounding the situation for many food companies has been a slowing of sales growth in markets outside of the United States.
Quantifying this disappointment, Mr. Moskow said he entered 2013 anticipating 3% volume growth but 1.5% was all the sector could muster.
“Emerging markets are still stronger than developed countries, but China slowed,” he said. “Brazil slowed.”
To a significant degree, the broad share price strength in the food sector was attributable to a raging bull market rather than any specific strengths to food, Mr. Moskow said.
“The overall investor appetite for equities increased last year,” he said. “A lot of money was on sidelines or in bonds. In a rather sudden shift, many went to equities because the dividend yields were attractive. A second reason is that pretty prestigious private equity shops and Warren Buffet said there was real value out there in food — 3G Capital and Berkshire Hathaway bought H.J. Heinz. When smart investors see value, it’s a positive signal.
“Food companies were up 21% in the year meaning they underperformed the overall market. But they were still up.”
Delving deeper into the performance of the food sector in 2013 and the impact of the Heinz deal was Mr. Katzman. He suggested the manner in which the year unfolded offers a glimpse into how the industry may do in 2014.
“Last year was a tale of two different halves,” Mr. Katzman said. “The first half was largely a function around merger and acquisition speculation in connection with the Heinz purchase by 3G Capital. That wore itself out basically toward the spring and summer when companies’ fundamentals, particularly volume and expectations of deflation, became more noticeable. Overall, the food sector performed in line with the market. All of that was traced to the first four months of the year. After that, food really underperformed. Fundamentals in terms of volume were still quite weak.”
While commodity cost inflation had been characterized as a headwind for food companies in recent years, Mr. Katzman said pricing deflation is a concern in the new year.
“We did a fair amount of work that showed food stocks tend to underperform during periods of deflation and outperform during periods of inflation,” he said. “I think that reflects the fear that the slippery slope of promotion and companies’ willingness to use gross margin expansion to fund promotion tends to get out of hand. So we see it as an area of concern rather than as a positive. Many companies talk about price elasticity models that are broken. Recent history shows promotions don’t work as well as they used to. They lead companies into worrisome spending habits.”
Making promotions more tempting has been volume trends in center of store categories that have been very disappointing in the United States and Europe, Mr. Katzman said.
“I don’t think the industry has a great explanation yet as to why that is,” he said. “Most of these companies’ earnings models are predicated on some type of volume growth. Add a little mix, market share gains, efficiency improvements, new products and suddenly, mid-single digit EBIT growth, high single digit E.P.S. growth. All these are based on some volume growth. Food companies are battling for a consumer that is seemingly shopping less.”
To their credit, food company executives enter 2014 with more conservative forecasts for growth than was the case in 2013, Mr. Moskow said.
“The only real bull case for these companies is that commodity deflation should boost margins, which assumes that pricing will be sticky,” he said. “I think consensus estimates for E.P.S. growth are pretty high — 9% for food group is consensus, up from 7% in 2013. This sounds overly optimistic to me.”
Calling the overall food business “pretty stable,” Mr. Moskow said traditional makers of consumer packaged foods are facing serious challenges.
“Consumers are shifting on the high end to homespun organic or other niche products,” he said. “On the low end, they are going to private label. From a branded perspective, there are just as many headwinds as there are tailwinds, if not more.”
Any number of attributes elevate the outlook for individual food companies, Mr. Katzman said. These may include significant steps toward restructuring adopted by management or the positioning of companies in favored categories such as organic, snacks or confectionery as well as companies with exposure to emerging markets.
“Those companies are doing well,” he said. “Valuation fundamentals reflect good underlying growth in the categories. For those companies, 2014 looks promising.”
Among the grain-based foods companies favored by Mr. Katzman, Flowers Foods, Inc. stood out as a “unique situation,” he said.
“It is the second-largest bread company in the United States with an opportunity to gain significant market share in the next couple of years as they leverage liquidated Hostess assets,” he said.
In July, Flowers Foods completed the acquisition of most of the assets of Hostess Brands, Inc., including 20 baking plants sprinkled across large swaths of the United States.
“I would say that strategically, they managed the Hostess bankruptcy perfectly,” Mr. Katzman said. “Think about it. They had the opportunity to buy Hostess during many, many years. They waited until liquidation to pick off assets at the prices they wanted without pension liability or union challenges. That led their fundamentals to be extraordinary in 2013. They gained significant market share as Hostess ceased to be on the shelf. They have picked up the assets in a position where they can almost guarantee growth in the future.”
While earnings estimates for 2013 were lowered late in the year, Mr. Katzman said he isn’t concerned about Flowers’ ability to execute. He noted Flowers had been hesitant to issue earnings guidance much of the year because of uncertainty in the face of all the changes going on in baking.
“I think they have proven their ability in fresh bread and rolls to be one of the best managed businesses, and their integration of these assets I believe will go very smoothly,” he said. “They basically have bought assets and will reopen assets when they want. It’s all under their control. Retailers want them to be a competitor to Bimbo Bakeries USA.
“Our take is that the category’s consolidation will lead to more rational behavior, less promotion and more new products. The three leading players — Flowers, Bimbo and Pepperidge — will gain share. That’s what had been happening over any number of years. I don’t see why that will change.”
The Grupo Bimbo S.A.B. de C.V. strategy of expanding in the U.S. baking market is “clearly working for investors,” said Alan Alanis, executive director and Latam food and beverage analyst for J.P. Morgan & Co., N.Y.
“Bimbo was one of the better companies in terms of performance on the Mexican exchange in 2013,” he said. “Investors are happy. It is one of very few companies that has outperformed the Mexican Bolsa in each of the past four years.”
Compared with the performance of grain-based foods shares in 2013, the 20% gain in Bimbo shares was about average. But while U.S. food company share prices surged together with sharp gains in the overall market (the S.&P.500 was up 32%), Bimbo’s strong performance occurred against a backdrop of weakness for the Mexican stock market, which declined 2.2% in 2013.
Overall, Mr. Alanis said Bimbo has been “performing pretty well” in terms of financial results, though earnings trends were not especially promising over the four year period of share price strength. He noted earnings per share fell 9% in 2010, 6% in 2011 and 60% in 2012.
“Suddenly, 2013 was the year everything was working,” he said. “I’m expecting growth by more than 100%. After more than three years of investing and struggle, the company is developing more traction. My estimate is that they should grow earnings by 62% in 2014.”
Part of the improved results reflects the decline in commodity prices, Mr. Alanis said, noting corn is down more than 40%, wheat down 11% and sugar off 17%.
“They have beautiful tailwinds in terms of commodities,” he said. “There has been a good amount of pricing rationality in the U.S. And they maintained leadership and dominance in the Mexican market.”
While the two countries are equivalent in terms of sales for Bimbo, each accounting for 40% of the company total, Mr. Alanis noted Mexico still accounts for 60% of Bimbo profits.
“Mexico remains critical, but the amazing thing for Bimbo is that they tripled margins of the acquired U.S. assets in a short period of time,” he said.
Going forward, Mr. Alanis remains upbeat about Bimbo.
“They have been buying assets at a very reasonable price, and I think they emerged stronger,” he said. “They have done their homework in terms of making sure they have the right management leadership in place.”
In terms of reasons for caution, Mr. Alanis cited a new excise tax in Mexico on foods with elevated caloric content. He expressed concern both because of rumblings calling for similar action in the United States in order to contain obesity and because a large proportion of Bimbo’s portfolio in Mexico will be affected by the new tax.
“There is a trend toward taxing calories that goes around the world,” Mr. Alanis said. “We don’t know the impact, but we expect a volume decline.”
Mr. Alanis said Bimbo worked successfully to ensure sliced bread would not fall into the definition for products subject to the excise tax.
“I have had them as a neutral because of valuation,” he said. “I’ve been kicking myself. I should have had them as a buy.”
Mr. Moskow’s top choice on the food industry is a company largely beyond the grain-based foods orbit — The Hershey Co., Hershey, Pa.
“I have been recommending this stock for three years, and it has outperformed every year,” he said. “I think 2014 will be another year in the same pattern. Hershey is investing in advertising accelerating at 15% to 20% a year while every other company is cutting advertising. It’s a testament to the power of its brand and degree to which consumers love the chocolate category.”
While Hershey is skilled at advertising execution, Mr. Moskow said the company’s success extends to the intrinsic strengths of its products.
“It’s because they are selling an affordable luxury that consumers can’t live without,” he said. “There is no substitute for a Hershey. Hershey is the U.S. market leader in chocolate, with 45% market share.”
Directionally, Mr. Moskow remains a fan of the approach taken by management at Archer Daniels Midland Co., Decatur, Ill., and he believes others in the sector will take a similarly shareholder-friendly tack.
“What I really like about ADM is the management team has become disciplined in terms of capital spending and much more shareholder friendly,” he said. “They have implemented a major share repurchase program. They have organized their business based on generating cash flow. They have had a big dividend boost.
“Bunge is trying to adopt the same kind of philosophy. There has been a transition at the c.e.o., and they now recognize they need to go in this direction. Cargill too is doing more cost cutting.
“At Bunge it’s more talk at this point than action, but it’s early. The next most important step would be to sell the Brazilian sugar business, which they’ve indicated is on the table as an option.”
The analysts expressed similar views of the leading players in ready-to-eat cereal with continuing concerns about Kellogg Co., Battle Creek, Mich., and cautious optimism about General Mills, Inc., Minneapolis.
Mr. Katzman said General Mills and Kellogg have more challenges in common than exposure to a flat ready-to-eat cereal market.
“Both have high exposures to the U.S. and Europe, and both markets are challenges,” Mr. Katzman said. “Kellogg has not met its targets. Thank goodness for Pringles, which has been a very good acquisition. It has helped offset challenges in other business. They are otherwise not performing as well as they should in snacks, and cereal is struggling. They are continuing with a major restructuring to try to correct supply chain problems that have left them in difficult straits for number of years. And it looks like that will continue.
“General Mills is having a little more success despite its weak categories. It is growing in snacks and has found more growth in areas like gluten-free and health oriented messaging. They have done quite well with that and have had very good growth in international markets. The U.S. oriented food business has its challenges. We like them more than Kellogg, but the reality is the developed market industry is pretty challenging.”
Kellogg is digging out from a deep hole, Mr. Moskow said.
“I really struggle with Kellogg,” he said. “The last four years they underperformed the group and their own expectations for growth. I think it’s a combination of still recovering from years of denuding their supply chain — a productivity program that did more harm than good. They are now spending an incremental $100 million a year on training and staff to correct the problems they created. I think they might be getting to the ninth inning on that.”
Mr. Moskow said a takeaway lesson from the Kellogg problems relates to the importance of a thoughtful approach to executive compensation.
“When you incentivize your management team on one single metric, in this case cost savings, be careful what you wish for,” he said. “They had a three-year executive incentive plan entirely based on cost savings. “
Among reasons Mr. Moskow is more upbeat about General Mills than Kellogg is the smaller proportion of R.-T.-E. cereal revenues at the former company.
“And they’re in faster growing categories like yogurt and snack bars,” he said. “Breakfast cereal has slowed dramatically, but it’s only 25% of General Mills sales versus 45% at Kellogg. The categories are better at General Mills.”
Still, Mr. Moskow expressed certain reservations about General Mills as well.
“My problem with Mills is yogurt is so important to them, and they were very late to the game in developing a Greek yogurt that was authentic for the American consumer,” he said. “This might be the third year in a row U.S. yogurt has failed to execute against its operating plan. Yogurt used to be the growth driver of the U.S. business. It has become a drag on growth even though the category is still growing. They haven’t made any management changes, and this is a surprise to me.”
Mixed feelings also were evident in Mr. Moskow’s view of The J.M. Smucker Co., Orrville, Ohio.
Longer term, he described his opinion as “very positive,” boosted by the strength of the company’s brands and supply chain he called “best in class.”
“From a corporate culture perspective, they do the best job at creating value for employees, shareholders, customers and consumers,” he added.
The other side of the equation for Smucker in Mr. Moskow’s view is intensifying competition in the company’s largest category — coffee. Specifically, Kraft Foods Group, Inc., Northfield, Ill., has begun devoting increasing attention to its Maxwell House brand.
“Kraft up until recently had been a pretty easy target,” Mr. Moskow said. “In addition, I think they’re disadvantaged in the single-serve coffee segment, which has seen an influx of new entrants.”
The competitive threat to Smucker was emphasized ever more strongly by Mr. Katzman.
“We had recommended the stock for many years, and we just downgraded them,” he said. “They are having on the margin more challenges in coffee, which is half the business. Other categories are becoming more promotional and competitive, including nut butter and jam/jellies. The oils business always has been competitive. Those key businesses seem more competitive, and they are losing market share. That’s why we went from a hold to a buy.”
Kraft Foods also is a company with encouraging long-term prospects in the view of Mr. Moskow. The manner in which Kraft is marshalling its resources, marketing its brands and managing executive talent accounts for why he has a positive outlook for the company.
“If you want to go back into history, Kraft Foods before the spin-off was guilty of underinvesting in the brands, underinvesting in the supply chain and boosting margins in an irresponsible way,” Mr. Moskow said. “They allowed private label to gain market share and brand competitors to regain market share.
“Now at Kraft Foods Group, they are reinstituting all the training they used to have in the 1980s. They called it Kraft University to create better general managers without just cost cutting in mind.
“This is going to be a different company now that it is no longer part of Mondel?z. We are seeing early signs of success in cheese, which has grown sales, margins and profits every year for three years. They have a lot brands that are ‘in the hospital’ so to speak: Jell-O, Capri Sun, salad dressing and mayonnaise. This is a multi-year turnaround.”
A different aspect of Mr. Vernon’s approach was highlighted positively by Mr. Katzman.
“Our view of the United States and Europe is you have to require relative top-line targets with restructuring and cost reductions,” he said. “Kraft came out a year ago with a relative performance objective, and I think that’s a reasonable approach. All other companies promote absolute targets, but as long as volumes are weak, they will have a tremendously difficult time. Kraft is bringing in executives from companies like Procter & Gamble. I think Tony Vernon is changing the culture and is focused on reducing costs and maximizing free cash flow. I think all that will reward shareholders. I think total return will be healthy.”
Looking at Mondelez International, Inc., Deerfield, Ill., Mr. Moskow sees positives there too, but not especially when it comes to how the business is being managed.
“I try to keep my estimates cautious for Mondelez, but I also think the stock deserves a valuation premium given the emerging market platform and the fast-growing snack categories they are in. I think it is being undermanaged, and I think there is a lot of room for management improvement and sales improvement.”
More specifically, Mr. Moskow said Mondelez has experienced execution problems from the time of the spin-off of the Foods Group, exacerbated by what he said was an overpromise on growth rates that would be achieved.
“They stubbornly stuck to the goals and devoted resources to targets that weren’t achievable,” he said. “I think what she (Irene Rosenfeld, chairman and chief executive officer of Mondelez) has created has a ton of potential. It is a combination of three very strong brands with a lot of runway in Oreo, Cadbury and Trident. I give her all the credit for having the vision. I think she also underestimated the challenge of integrating them and maintaining assets during the integration.”