A wave of merger and acquisition activity the likes of which have not be seen in nearly a decade may be beginning to take shape in the food processing industry, said Eric Katzman, an analyst with Deutsche Bank, New York.

Mr. Katzman and Mitch Pinheiro, an analyst with Janney Montgomery Scott L.L.C., Philadelphia, offered their perspectives on the outlook for food processing companies in recent interviews with Milling & Baking News.

In addition to expanded merger and acquisition transactions, the analysts identified promotional activity and other deflationary pressure as creating a major question mark for the industry in the year ahead.

While buyers were the principal drivers of the last wave of takeover activity around the year 2000, sellers, jarred by severe market swings of the past two years, may be the principal movers during the next round, Mr. Katzman said.

“I think that a lot of the families and foundations and trusts that control public companies today are finally considering for the first time, ‘What do the next 5 to 10 years look like?’” he said. “They want to know what the impact will be in terms of stronger retailers and fewer of them. Inflation will be a long-term pressure point for the industry. To the extent that many companies have become highly efficient in taking out costs, and so have limited further costs to remove, pricing may become their only option. That option becomes a little more challenging as retailers gain power.”

Other drivers of such prospective activity include tax issues related to tax planning and questions of scale.

“I’m not talking about scale that was the catalyst of M.&A. 10 years ago, but scale in terms of having resources to grow in places like China and India,” he said. “PepsiCo is investing a billion dollars in China. Campbell Soup Co. is investing $50 million. That to me is a great example of the kinds of issues boards, managements and foundations need to consider long term. Who has the scale to tap into these emerging markets?

“There are a number of companies in the food industry that could fall into this category. Bill Wrigley was the last person many people thought would sell. Guess what? He was the first. I believe it’s a combination of all these things that are spurring the boards to think about the topic. Just because a board thinks about it doesn’t mean it automatically happens. But I certainly think there are many more discussions about merger and acquisition than a couple years ago when things were pretty quiet.”

Mr. Katzman said buyers will come at M.&A. activity from a different perspective than was the case beginning in the late 1990s.

“There was a belief at that time that just being large would get a food company to the promised land,” he said. “That clearly turned out not to be the case. This go around, it will need to make a lot of strategic sense. It will not be scale for scale’s sake. It will be about being strong in a particular category or an adjacency.”

Mr. Pinheiro took a fairly hopeful view of how deflation will play out for grain-based foods companies in the year ahead.

“When wheat prices were $8 or $10 a bu, food prices were up,” he said. “Now wheat is in the $5 range, and prices should come back down. Or at least that’s what investors think. It’s been more true for commodity-dense products like pasta, and a little less so for bread. Investors have been anticipating retail price declines and margin pressure. What’s happened over the last six months, though, is that commodity prices have stabilized and even inched back up. That gave food companies more ammunition to maintain current pricing, not give it back. We think what you will see in 2010 is stable pricing, maybe expanding margins.”

An example of a company Mr. Pinheiro expects to benefit from the evolving ingredient price market is Flowers Foods, Inc., Thomasville, Ga. He said Flowers struggled through much of 2009 with an unfavorable hedged position. He said at least one significant competitor benefited from “not being able to hedge last year.”

“That’s behind Flowers now,” Mr. Pinheiro said. “In the past four quarters, they became more aggressive on pricing while maintaining margins. In 2010, I expect Flowers to be more aggressive with promotions, maintain margins and toward mid-year there is a possibility of a price increase. I don’t think Hostess has the long-term wherewithal to fight someone as strong as Flowers. I think Flowers will grow earnings 10%, maybe better. Much of that will come from margin recovery. On the top line, what happens will depend on Hostess to an extent, but you also have the West coast entry, ongoing geographic expansion, breakfast bread gaining distribution and tortillas all as sources for growth. Flowers has multiple growth drivers. They are in an enviable position.”

Mr. Pinheiro hedged his remarks about Flowers by suggesting that earnings growth may fall shy of the heady gains of the past few years. Still, calling Flowers “quite a story,” he said the company’s current price/earnings valuation is “in line with the food group.”

The product promotion issue will loom large far beyond the prospects of Flowers or any other single food company, Mr. Katzman said.

“The single most important question investors have about the industry is, what will be the depth and frequency of promotion this year,” he said. “Every company talking about 2010 describes the need for volume growth since there is minimal pricing potential.

“Everyone assumes they have margin growth and they have profit firepower to promote those volumes.

“The good news is that the comparisons versus a year ago, at least for the first couple quarters, are pretty easy. Last year you had trade deloading, private label growth and consumer pantry deloading.”

From Mr. Katzman’s perspective, the near unanimous determination to increase volume in 2010 may create a very difficult situation.

“It is a mature industry,” he said. “Not everyone will win when it comes to volume growth.”

Raising the hurdle for several companies in terms of volume growth is ongoing stock-keeping unit rationalization urged by retailers and expected to continue in 2010 and several years further forward.

“Retailers have been promising shelf optimization to improve their profits,” Mr. Katzman said. “That’s a 20-year promise. It seems the recession is finally leading to the pressure on tertiary brands on the shelf.”

Among companies that have learned the lessons of the first years of the decade, General Mills, Inc., Minneapolis, has been a standout success, Mr. Katzman said.

“General Mills is about a respected company in the industry as you can find today,” he said. “It’s a tale of two halves in the decade. They struggled with Pillsbury in the first half of the decade, and in the second half they realized the power of that acquisition.

“Today it’s one of the better managed companies in terms of executing on the top line. Here I’m thinking about the many sub-categories in the industry in which there is a lot of growth — ethnic, health/wellness, weight management, convenience. When you combine with cost savings (what they call h.m.m. (holistic margin management)), the outlook is pretty strong.”

Credit from Mr. Katzman goes to Kendall Powell, the company’s current chief executive officer.

“He has a very broad-base of experience,” he said. “He’s probably the first General Mills executive to have extensive international experience. Combined with operations expertise, he has served the company very well.”

Mr. Katzman said the ready-to-eat cereal (R.-T.-E.) category is benefiting from higher unemployment and the “cyclical needs of consumers who are choosing to eat at home.” The aging population and health and wellness credentials of the category also are pluses, he added.

Mr. Katzman also described as very well respected General Mills’ principal competitor in the R.-T.-E. breakfast cereal category — Kellogg Co., Battle Creek, Mich.

“They’ve been executing well for an extended period of time,” he said.

Attractive at Kellogg is the balance of the portfolio between cereal and snack, Mr. Katzman said.

“Most people don’t think of Kellogg as a snack company,” he said. “It won’t be too long before they are equal in size.

“In snack, it’s well known that this is a category that has been growing rapidly from the convenience angle, nutrition angle and has minimal private label competition.”

Smaller companies watched by Mr. Pinheiro include American Italian Pasta Co., Kansas City, and J&J Snack Foods Corp., Pennsauken, N.J.

AIPC has seen its stock falter because of deflationary fears in recent months and may be poised for a rally, he said.

“The reality is that pricing is holding,” Mr. Pinheiro said. “Promotions are a little heavier, more frequent, not deeper. We don’t really see a retailer wanting to deflate a category that is still up 4%, 5% on volume. Meanwhile, the category is in the perfect spot. There is a recession, and AIPC has the double whammy of leading in private label.

“Management is very bullish about 2010 with top-line growth and margins that could continue to expand.”

Mr. Pinheiro was more guarded in his forecast for J&J, which has been hurt by its heavy food service exposure amid the economic downturn. Stadium traffic and mall traffic are down.

“We’re looking for modest growth, driven in the near term by more favorable commodity costs,” he said. “It will be very challenging, maybe 3% to 4% top line and 7% to 8% bottom line. An acquisition is likely before too long.”

Much in the way J&J has been hurt by tough food service trends, The J.M. Smucker Co., Orrville, Ohio, has benefited, Mr. Pinheiro said.

“Certainly, the whole eating-at-home trend has helped Smucker in a big way,” he said. “The mix category with Hungry Jack, Pillsbury, etcetera has been in a sweet spot of consumer trends. They have maintained profitability and their trends with Folgers have been good. The stock has had a great run, and we see additional upside with their core jams, mixes and condensed milk throughout this calendar year. Folgers continues to outperform its competitors.

“In the back half of 2010, it will begin to slow. They will begin to buy back stock and dividend increases are possible, returning cash to shareholders. An acquisition is possible, too.”

Like Mr. Pinheiro, Mr. Katzman has a favorable view of Flowers, despite the company’s challenges in 2009.

“It’s a category in fresh bread and rolls that was very rational, that had been moving the consumer up in terms of product mix and price points,” he said. “That kind of rational category approach came to a quick end as Hostess, with that company seemingly focused on market share and volume gains. That disrupted what had been a solid status quo for much of the past four or five years. It took Flowers a little while to recognize the changing dynamics of the category. While profit growth was strong, their top-line performance was weaker than they or investors expected.”

He called 2010 “a bit of a question mark,” but said if wheat prices regain strength, bakers will be forced to be more rational.

“I think Flowers management has recognized the change and is much more aggressively pursuing share; they have tail winds from lower input costs,” he said. “I see 2010 as a pretty good year for Flowers. They use the cost tail winds to drive their share.”

Among companies poised to make significant acquisitions is Sara Lee Corp., Downers Grove, Ill., Mr. Katzman said.

“It’s an interesting time for Sara Lee,” he said. “The last four or five years have been a period of asset selling as they got rid of the conglomerate structure and have become a more focused food and beverage business. It’s come at a cost and hasn’t been easy from an external or internal standpoint. Assuming their current deals go through, if you combine the cash the company will get with cash generated by their remaining business, Sara Lee will have several billion dollars to use. The management has been vocal that they are no longer in asset disposition but in acquisition mode. It will be interesting to see what they buy, how they integrate, whether it will be positive for shareholders.

“Do they add to coffee, their largest business? Do they double down in fresh bread and rolls, where it has been a struggle? Do they add to meat? All three?”

Mr. Pinheiro has been following Tasty Baking Co., Philadelphia, for several years, and he described 2010 as being “all about the new bakery.”

Tasty has been in the midst of a major shifting transition into new corporate headquarters and a new baking plant to replace the company’s flagship facility in 1922 in Philadelphia.

“The company is transitioning, and the good news is that they are meaningfully ahead of schedule on the transition,” Mr. Pinheiro said. “We thought they’d have one line up running by January, and they have three, nearly four. There will be a total of seven, which is good for profitability because they had 15 at the old plant. They are a quarter ahead of schedule. Cost savings will be meaningful because they will reduce workforce by 200 employees, with more efficient equipment and the same capacity. Tasty will be in a totally different cost position in June 2010. That’s the whole story.”

Building sales going forward will “remain a struggle” at Tasty, Mr. Pinheiro said. Going forward, the company will be better positioned to invest in marketing.

“There will be some bumps in the road, but they have passed the major hurdles,” he said. “I’m very encouraged by their execution. It speaks well of management. By the end of this year, you may see a dollar per share earnings run rate for Tasty.

“This is the inflection point for them. This is it. There isn’t much more they can do. If they can’t move the needle now, it’s a problem.”