By Matt Andrejczak
At what point will grocery shoppers gag on higher prices?
The answer to that question will go a long way toward determining food companies' share prices this year. So far, investors are taking a wait-and-see approach to the sector, but there's a sense a showdown is coming soon.
Agricultural commodity costs continue to surge and brand-name food makers still must vie with cheaper store brands that gained popularity during the recession.
During this four-month rally for the U.S. stock market, Kraft Foods Inc. (KFT), Campbell Soup Co. (CPB), General Mills Inc. (GIS) and other packaged food makers have not kept pace.
Compared with the 20% gain for the S&P 500 since Sept. 1, the S&P Food Products Index is up 3%. Campbell shares are down 6%, General Mills is off 2% and Kraft is flat.
Food companies became less appetizing as 2010 wore on. Ineffective price wars and sluggish volume growth disappointed investors as did less sanguine outlooks from food makers. Analysts responded by reining in their profit projections, moves that constrained share prices.
Now, surging prices for corn, wheat, coffee and dairy products are of concern. Brand-name food companies are implementing modest price increases to protect their margins. But the move might keep a lid on the amount of food sold if shoppers opt for cheaper store brands.
Unless food companies successfully pass along price increases and volumes improve, "I believe the pressures could worsen," said Rob Dickerson, analyst at Consumer Edge Research, who last year made timely stock calls on Kellogg (K) and Sara Lee (SLE).
Looking ahead, can Kraft make the Cadbury deal pay off for investors? Will new items help Kellogg jump start cereal sales after twice cutting its forecast in 2010? Can Campbell convince consumers to buy more soup?
The wave of food company earnings starts Feb. 2 with Hershey, followed by Kellogg on Feb. 3. Sara Lee reports Feb. 8 and Kraft issues earnings Feb. 10. Analysts at Janney Capital and Wells Fargo Securities recently upgraded Hershey (HSY) to a buy, predicting its growth will outpace others in the food sector.
Matt Kaufler, portfolio manager for the Federated Clover Value Fund (VFCIX) , is one investor who isn't counting on the food group to outperform the broader stock market this year.
If the economy and consumer confidence continues to improve, he thinks investors will put money into faster-growing sectors. "Share prices will be somewhat stagnant," said Kaufler, whose fund owns Kraft and H.J. Heinz (HNZ).
Barclays Capital analyst Andrew Lazar believes fundamentals at food companies will recover with companies cutting back on heavy promotions.
Still, "it will be a slow grind at best," said Lazar, who estimates Wall Street's earnings expectations for the major food companies are too high for 2010's fourth quarter and the first quarter of 2011.
Large food makers are planning to unleash new products, which often carry higher price tags and can help improve volumes as shoppers are lured to try something new. Most food companies backed off innovation during the economic downturn, instead focusing on ditching marginal products, closing manufacturing plants and slashing supply-chain costs.
If new products fall flat and consumers shun higher prices, profit estimates for food companies will be scrutinized come this summer, said Deutsche Bank analyst Eric Katzman.
"Should the consumer stay in hibernation, this will present meaningful challenges to growth and meeting stated financial targets," Katzman said in his Jan. 5 outlook report.
Supermarket chains, whose margins suffered last year when food prices dropped in value and consumers stocked up less, are passing along price increases from food companies.
Supervalu Chief Executive Craig Herkert forecast Jan. 11 prices for items sold in center-aisles of grocery stores would go up between 3% and 14%, based on dealings with vendors. He said Supervalu (SVU) would try to keep prices down.
While investors wait to see how the scenario of price increases and higher commodity bills plays out, there should be some support for shares of food companies in the form of healthy dividends and potential industry consolidation.
Food makers generate steady cash flows and have long grown their dividends, making them a relatively safe place for more conservative investors seeking steady income even if share prices stay subdued.
Acquisitions remain a wild card. Low interest rates will keep this a possibility as private equity buyers like to use debt to finance deals.
Del Monte Foods (DLM) is being acquired for $4 billion by a consortium of private equity shops, while suitors have been circling Sara Lee, whose shares have spiked the last few months. Sara Lee said Friday it plans to split its company into two publicly traded companies.
-By Matt Andrejczak, 415-439-6400; AskNewswires@dowjones.com