KANSAS CITY — After years of restructuring, leadership changes, portfolio optimizations, acquisitions, cost slashing and other dramatic moves, few packaged foods companies are viewed as attractive investments on Wall Street going into 2019. Indeed, neither of two veteran securities analysts interviewed recently by Milling & Baking News had a single food company rated a “buy” for investors.
The absence of full-throated recommendations to invest in what historically has been viewed as a conservative but stable sector represents a humbling downgrade from recent years when analysts were more enthusiastic, at least on a highly selective basis.
“Big food companies remain heavily pressured on several fronts,” said Robert Moskow, senior equity analyst, Credit Suisse, New York. (Mr. Moskow and Amit Sharma of BMO Capital Markets spoke with Milling & Baking News before the overall stock market tumbled toward the worst December performance since the Great Depression.)
“I look at these companies as big glaciers that are subject to global warming trends,” Mr. Moskow said. “Every year they seem to get a little smaller. You can’t see it in a short time frame, but over longer you see them wearing down and becoming less relevant.”
Catalysts cited by Mr. Moskow for the steady decline of the businesses include market share losses to smaller competitors, private label growth at large retailers and consumer interest in healthier eating.
“All of these companies appear to have some exposure to these issues,” Mr. Moskow said. “What they’ve done this year is recognize they cut too far back on investment. They have used corporate savings to reinvest in marketing, innovation and give more money to retailers to merchandise and discount their products. These efforts have helped stabilize sales to some degree but have come at a huge cost. Profit margins have fallen over 100 basis points this year.”
The weaker margins reflect diminished pricing power among the largest food companies.
“If you look back 10 to 20 years ago, Walmart and Kroger let the big companies provide all the category management insights, direct-to-consumer marketing and innovation ideas,” Mr. Moskow said. “Over the past two years, retailers have made much bigger investments. They’ve become much better at data analytics, supply chain automation and e-commerce services.”
A product mix shift away from traditional branded packaged foods and toward convenient meal offerings has contributed to the balance of power shift away from large food companies.
“They (food retailers) don’t rely on national brands as much as they used to, which gives them more ammunition to push back on pricing than they used to,” Mr. Moskow said.
He said profit margins in 2019 are likely to remain under pressure, reflecting the need for further investment in marketing, innovation and acquisitions. This expectation is buttressed by indications companies have failed to achieve price increases projected earlier in 2018.
“Price realization from companies has gone down, not up, over the past six months despite claims they would take pricing to counter inflation,” he said. “That will be the biggest driver in 2019 causing margins to decline.”
The diminished pricing power of food companies has dimmed the luster of the businesses as attractive, conservative investments.
“Food companies are no longer a dependable safe haven for investors during stormy times,” Mr. Moskow said. “Over time, maybe all these investments will get them back on track. For now, that’s not the case.”
While the food and beverage sector underperformed the overall stock market through most of 2018, weakness stemmed far more from food than from beverage, said Mr. Sharma of BMO Capital Markets.
“It was not a good year, especially for the food companies,” Mr. Sharma said. “They lagged the overall market. It wasn’t just the market performance. It also was operating performance, earnings growth and margins expansion.
“Generally, the beverage companies outperformed food. If you look at the S.&P., which is flat for the year, most beverage companies are flat to down 1% to 2%. From an absolute basis, both segments underperformed.”
While numerous forces have combined to make the industry less attractive to investors, one particular problem has plagued the food business for the last seven or eight years, Mr. Sharma said.
“The top-line trends are simply not good enough for earnings to grow, and the valuations continue to shrink,” he said, “From an investor’s point of view, it is very difficult to get excited about a sector that doesn’t have growth to show. Investors have said. ‘If I have to own staples, I’d rather own the beverages than the food sector.’”
Behind the inability of food companies to generate top-line growth are numerous structural changes across the consumer packaged foods marketplace.
“There is a very, very big range of topics and reasons,” Mr. Sharma said. “Publicly-traded food companies are brand centric, built on brands. Our view is traditional reasons to have a portfolio of large brands, on the food side, those advantages are slowly withering away, whether it is because of innovation, economies of scale, distribution and food safety. All are being slowly taken away.”
Elaborating, he noted that in the past only large companies were positioned to introduce innovation into the marketplace.
“Large companies could make everything cheaper,” Mr. Sharma said. “Today, co-packing is a great deal for a small brand.”
“Now, up and down the aisle,” shoppers will see an array of new products, he said.
The growth of new channels has helped smaller brands gain traction, Mr. Sharma said, adding that traditional retailers have been giving more space to smaller brands and online has been growing. With the expansion in social media, the need to purchase expensive television time has been diminished.
“We still eat the same amount of calories as in the past, maybe more,” Mr. Sharma said. “Those additional calories are not coming from traditional brands. Organic and natural are just one aspect. A lot of fresh foods are available. Snacking is another reason.”
With this view of the food business, it may not be a surprise that BMO Capital Markets does not have a single “buy” rating for any of the companies in the food sector.
“Our buy recommendations are largely on the beverage side,” he said. “These are the companies able to grow their top line more effectively. We don’t think that changes in 2019. Could we become more optimistic about their stock performance? It’s possible. We don’t see the underlying operating environment changing versus 2018. We think there is relative outperformance for beverage companies in 2019.”
Companies with buy recommendations from BMO Capital Markets include Constellation Brands, Inc.; Molson Coors Brewing Co.; Cott Corp.; Primo Water Corp.; and Monster Beverage Corp.
BMO currently has neutral ratings for Flowers Foods, Inc., Thomasville, Ga., and TreeHouse Foods, Inc., Oak Brook, Ill. Still, Mr. Sharma said both companies will be interesting to watch in the new year.
For Flowers, 2019 may be a telling year for the company’s Dave’s Killer Bread brand of organic bread.
“D.K.B. has been a very strong performer for them for the last two years,” Mr. Sharma said. “That brand has really carried the company from an operating perspective. There is not that much more incremental distribution opportunity for D.K.B., and they will need to maintain momentum without relying on new distribution. That will be a very interesting development in our opinion.”
About Flowers’ recent acquisition of Canyon Bakehouse L.L.C., Johnstown, Colo., Mr. Sharma said the business does not have the same upside potential as D.K.B. Still, the D.K.B. comparison may be apt.
“Canyon is another brand among the leaders in the gluten-free segment, and it is not well distributed,” he said. “Gluten-free is a much smaller market than organic, but there is still a large segment of the population that does ask for gluten-free. To the degree they can replicate what they did with D.K.B., that will be interesting.”
Also important to watch, another “wild card” in Mr. Sharma’s view, is the performance of key inputs during the year ahead. A plus for the company has been the decline in wheat prices in recent months. The setback is welcome news for Flowers and other bakers because higher costs prevailing earlier in the year would have prompted additional price increases in a market that isn’t growing.
A key going forward is how much Flowers is hedged and how many, if any, additional price increases are needed to help offset cost inflation.
Outside of organic and gluten-free, Flowers essentially is treading water with the Nature’s Own and Wonder brands “doing fine in the context of a flat to declining fresh bread category,” Mr. Sharma said.
“If the whole category is flat, you aren’t going to see tremendous outperformance from these brands,” he said. “They are as mainstream as anyone else. That’s why D.K.B. has been such a strong contributor.”
In snacking, Mr. Sharma said Flowers has the potential to become a larger player at some point, but the strong market share gains by Hostess over the last few years appear to have shut off that opportunity for the time being.
From a corporate perspective, Project Centennial is expected to make a greater bottom-line contribution in 2019 than 2018, Mr. Sharma said. He predicted the company also will benefit from lapping a year that featured escalating costs and operational difficulties that muffled the effects of Project Centennial.
“They have made a number of changes in the operating structure, not just at the c-suite level, but at the bakery level,” Mr. Sharma said. “The company now is less hierarchal. Flatter. The changes haven’t yet had a large impact on their EBITDA margins. Flowers has a long-tenured management team. It’s pretty difficult to see them change dramatically the way they operate.”
In contrast to the flat market for baked foods in which Flowers competes, the private label market that is the focus of the TreeHouse business is quite dynamic, Mr. Sharma said.
“TreeHouse is in a very interesting phase for the company,” he said. “We have written extensively about private label in the United States and have a very positive outlook on the ability of private label to take share from brands.
“Unfortunately, TreeHouse has not really benefited from that opportunity. We feel as though one of the largest reasons is that they don’t have pricing power in most of the categories in which they operate. In some categories, that offsets the good work they’re doing in other segments.”
Looking forward, much will rest on the shoulders of the company’s new president and chief executive officer Steven T. Oakland, Mr. Sharma said. Specifically, he said management will need to describe a path forward under which TreeHouse is able to restructure its portfolio in a way to exit categories in which it is unable to generate reasonable profit margins.
“If he articulates a good vision for the company, I think the stock will do well in 2019,” he said.
“In snack nuts, TreeHouse is doing business with 2% operating margins,” he said. “This is a packaged foods company. How do you do that? It isn’t just snack nuts — others as well.”
Subsequent to the interview with Mr. Sharma, TreeHouse acknowledged the difficulties faced by the nut business and said a sale would be considered.
“Is this a company best run inside of TreeHouse?” Mr. Oakland said Dec. 11, during the company’s annual investor day. “We think this is a wonderful business. We think it has underachieved under our ownership. Is it better suited to leave us today or better suited to be run at TreeHouse? I would say we’ll have a good understanding of that in the next quarter or so.”
Mr. Oakland said the company has hired an investment bank to help determine next steps.
From a fundamentals perspective, Mr. Sharma said most food companies are finishing the year no better than they started it, weakened in part by heightened freight inflation.
“Still, food companies did a little better during the sell-off,” he said. “Some may be seen as attractive, especially possible merger and acquisition targets.”
For several years Mr. Moskow has made the case that consumers are looking to elevate their intake of protein, and that companies well positioned to satisfy this demand will be better positioned for success. He said his belief in this trend has not diminished.
“There is a lingering perception in consumers’ minds they should be trying to add more protein and reduce carbs from their diet,” he said. “Recently, seven of the eight best-selling diet books recommended cutting carbs and sugar. Only one advocated whole grain. Rather than a fad, that kind of mindset has had staying power.”
He identified Hormel Foods Corp., Austin, Minn., and Tyson Foods, Inc., Springdale, Ark., as two companies positioned to benefit from this shift. By contrast he said breakfast cereal companies such as Kellogg Co., Battle Creek, Mich., and General Mills, Inc., Minneapolis, may face challenges.
Among companies identified as overdue to invest in their underlying business after an extended period of cost cutting was The Kraft Heinz Co., Pittsburgh.
“They clearly cut too far and underestimated the dynamic consumer and retail environment,” Mr. Moskow said. “There has been a lot of technological advancement and an influx of entrepreneurs offering all kinds of unique, niche-y offerings. Health and wellness solutions. What they’ve done is created an incubator platform to invest in these types of start-ups.”
He noted the company has not been able to execute a large, transformational transaction. A run by Kraft Heinz at Unilever about a year ago fell short.
While encouraged by certain steps Kellogg has taken in recent years, Mr. Moskow said he is skeptical about its outlook.
“My issue here is that despite all the acquisitions they’ve made, they are still heavily exposed to the breakfast cereal category — 40% of sales,” he said. “It is a troubled category with consumers shifting to more protein-centric breakfast.”
He said recent new products aimed at asserting the company’s health and wellness credentials “don’t seem to resonant enough to me to move the needle.” In November, Kellogg launched Hi! Happy Inside, a wellness brand targeting consumers seeking digestive health.
Positives in Mr. Moskow’s assessment include the early performance of RXBAR, acquired in late 2017 for $600 million. Since the acquisition, the brand has generated considerable sales growth for Kellogg, and the company is poised to launch numerous product platforms under the brand, he said, reflecting over whether the rapid growth would be sustainable.
“RXBAR is receiving lots of resources from Kellogg to execute their growth plans,” he said. “That’s an example so far of an integration that has respected the entrepreneurialism of the target while still giving them the resources to grow.”
Mr. Moskow also credited Kellogg with successfully executing its transition to warehouse delivery from direct-store delivery, with minimal disruption.
Calling the shift “the right strategic move for Kellogg,” Mr. Moskow said he was confused by the company’s decision to seek a buyer for its cookie and fruit snacks businesses.
“This part is a bit of a headscratcher for me,” he said. “They want to make snacks a bigger part of their portfolio. Announcing a significant divestiture like this strikes me as a bit of step a backward. Bigger picture, it fits the theme of all these companies trying to reshape their portfolios with acquisitions and divestitures to reduce their exposure to declining categories.”
While General Mills is not as dependent on its breakfast cereal business as Kellogg, growth has been elusive.
“The last four years have been disappointing in U.S. retail,” he said. “Sales have declined every single year. They’re trying to get more innovation into the yogurt business with new sub-brands for Yoplait, and leveraging Cheerios with new product launches. However, they’ve struggled to execute price increases just as much if not more than their peers. I think they are going to have to discount more aggressively over the next six months to regain some of the market share they lost, especially in breakfast cereal and snack bars.”
General Mills’ most recent large acquisition, Blue Buffalo Products, Inc., acquired in 2018 for about $8 billion, appears to be generating sales slightly below expectations, Mr. Moskow said. He said specialty retailers, the core of Blue Buffalo’s distribution, have reduced merchandising support in response to General Mills’ plans to expand into the food-drug-mass merchandising markets.
“The company says the expansion will offset what they lose in specialty retail,” he said. “It remains to be seen whether that will work.”
Subsequent to the interview with Mr. Moskow, General Mills issued earnings and said the Blue Buffalo business had stabilized.
Even as General Mills gains distribution from Walmart, Mr. Moskow said Blue Buffalo’s traditional business was still in peril.
“We fear that Blue’s sales in the specialty channel (about 50% of total) will continue to decline at a double-digit rate due to backlash from retail operators in the channel and cannibalization of consumer demand,” he said after the General Mills earnings announcement. “Management insists that the growth in F.D.M. (food-drug-mass market) will far outweigh the sales it loses in specialty, but this will become very hard to do once the company laps the initial Walmart distribution gains.”
Among grain-based foods companies, Mondelez International, Inc., Deerfield, Ill., has the most promising outlook, Mr. Moskow said. The company is rated “outperform” by Credit Suisse.
“Mostly because I like the company’s international footprint,” he said. “It looks like the investments they made there are generating good top-line growth. In the United States, supply chain problems have held it back. The new c.e.o. has brought in a very sensible plan for the next three to five years, but I think he needs to provide greater clarity as to how long it will take the U.S. to recover. They say they have manufacturing facilities that are 40 years old in the United States. They haven’t invested sufficiently to bring in state-of-the-art production lines. It’s unclear to me why they held back on those investments given that they talked about this five years ago as a big priority — North American supply chain revitalization after the spinoff (from Kraft Foods). That’s why I don’t quite get why antiquated plants is still the holdup. Nabisco is the issue.”
The consumer shift away from carbohydrates is not a tailwind for Mondelez, Mr. Moskow said.
“Their health challenge is that there is a lot of sugar in all those products,” he said. “Consumers still want good tasting snacks. But there is more self-regulation on how much sugar they are willing to consume in a given day. Even though the snacking occasion is very high for consumers, there is also a desire to keep total sugar under control.”
A slightly more upbeat view of the food sector was offered by Moody’s Investor Services, New York, which characterized the U.S. packaged foods outlook as “stable.” Acknowledging slow growth in operating profits, Moody’s said “cash flows remain strong.”
Moody’s said global packaged foods companies should experience 4.5% to 5.5% EBIT growth in the new year, lifted by cost cutting and demand from emerging markets. In the United States, slower growth is anticipated — 2% to 3%. Sales should edge higher, but margins will be under pressure, the company said.
The benefits of cost cutting overall are expected to diminish in 2019 with the exception of recent acquirers, Moody’s said.
While the credit ratings service said escalating trade tensions will be harmful for consumer durables companies and could lead to shifts in global supply chains, trade tensions are likely to have “limited, if any, impact on global packaged goods, global beverage and U.S. packaged goods companies.”
Among companies highlighted by Moody’s in its outlook was Campbell Soup Co., Camden, N.J. Campbell Soup, Moody’s said, faces “multiple challenges ahead as the company simultaneously works on a complex acquisition integration, major divestitures, a turnaround in soups, a c.e.o. transition and deleveraging its capital structure.”