A Sour Aftertaste in Packaged Foods? We ask our industry specialist if food firms are still great investments. by Josh Peters, CFA | 03-03-06 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints Analyst Gregg Warren is a stock analyst covering packaged food companies, food distributors, commodity processors, and tobacco firms. Before joining Morningstar, he worked as an equity analyst for a buy-side firm, covering consumer staples and consumer cyclicals. He holds a bachelor's degree in accounting and English from Augustana College and holds the chartered financial analyst designation. Morningstar DividendInvestor: These companies have solid long-term records, but are lagging of late. What's changed? Gregg Warren: In the 1980s and most of the 1990s, these companies were able to flex their strong brands and dominant market positions by passing annual price increases along to retailers and consumers. Volume growth wasn't a huge concern, because price increases could always be used to offset any volume declines for product lines. Profit margins were stable, if not expanding, and most firms were flush with cash. When disinflation became prevalent in the late 1990s and early 2000s, raising prices became much more difficult. If that weren't enough, the companies saw their ability to raise prices limited by the consolidation of the U.S. grocery retailers. Meanwhile, Wal-Mart's WMT rapidly growing grocery efforts were focused on stocking the number-one and -two products in any given category, as well as a private-label offering. With cash flows under pressure, many companies started to take shortcuts, like lowering marketing spending or pulling back on research and development, to make earnings and cash flow projections. But this did little to stop the sea change occurring in the industry, and the lack of product innovation and marketing support only added fuel to the fire. Many top brands were steadily losing share to other branded products and private-label offerings. Others bought competitors that had top-rated brands, believing that economies of scale and a wide breadth of product offerings would be able to restore the balance of power in their favor. So far, that hasn't proved to be the case. We see 2006 as a pivotal year, with many companies desperate to offset rising raw-material and energy costs with higher prices in the grocery channel. In 2005, many firms did initiate price increases, but saw their market share deteriorate as other branded and private-label manufacturers chose not to follow their lead. This year may be different, though, as everyone is dealing with higher energy prices. MDI: Is it fair to say their moats are narrowing? Warren: That certainly looks to be the case. From 2000 to 2005, the average operating margin for the 12 companies I cover (which doesn't include the well-positioned Wrigley WWY and Hershey HSY) fell from 13.4% to 12.4%. Returns on invested capital dropped from 13.7% to 11.2%. Without price increases, we think it will be difficult for these companies to regain the profitability that they enjoyed even just a few years ago. It's easy to see why the stocks have gone nowhere during most of the past few years. MDI: With these headwinds, what kind of long-term growth can food companies achieve? Warren: Top-line growth will be difficult without price increases. Volume growth tends to follow population growth, so we expect only low-single-digit sales growth. Companies with better branded product portfolios and a commitment to new product launches and promotional spending should do better than average—but still no more than midsingle-digit growth. With cost savings and operational efficiencies, operating profit growth could average 4%-6%. Share repurchases and falling interest expense could boost earnings per share growth to 8%-10%. Every company in the group is projecting sales and earnings growth in this range, with McCormick MKC being the last to succumb to the gradual decline of expectations. Dividend growth is ultimately driven by earnings growth, but if a company is generating healthy cash flows, it should be able to deliver a slightly higher rate of growth in the dividend. MDI: Are any dividends at risk? Warren: Once a yield pushes past 4%, I begin to worry about sustainability. In the 1990s, Heinz HNZ and Campbell Soup CPB reduced their fat payouts to fund product innovation and marketing. Heinz went even further than Campbell, eliminating more than 40% of its sales base in the past five years. Much like the “bigger is better” mantra, the “less is more” concept has had only limited success. I'd be especially wary of companies that have to sell assets to cover their annual dividend payout, which has become a concern for some whose cash flows have deteriorated significantly. ConAgra CAG (which yields 5.3%) and Sara Lee SLE (yielding 4.5%) are two examples. Both companies are eliminating close to 40% of their sales base (through asset sales and other divestitures), and each is clinging to a dividend predicated on having a much higher level of sales and profitability. Two small-cap stocks covered by my colleagues, Lance LNCE and Tasty Baking TSTY, also have dividends that could be cut. MDI: Let's get down to your favorites. Are there any stocks we should buy? Warren: Other than 5-star rated Wrigley, covered by analyst Mitch Corwin, most of the companies are trading at prices that are close to our fair value estimates. That makes it difficult to single out a buy right now. From a business perspective, McCormick and Kellogg K are probably the two names that really stand out from the rest of the group. McCormick controls the retail market for spices and seasonings in North America and Western Europe, giving it a wide economic moat. It has 50% share of the branded spice category, with the only significant competition coming from private label (where McCormick maintains 50% market share as well). Kellogg boasts one of the industry's lowest-cost structures. It's benefiting from a commitment to reinvest profits in productivity enhancements, new product development, and marketing support for its brands. I'm also impressed by the direct store delivery system that Kellogg acquired when it picked up Keebler in 2000. This type of distribution vehicle, which allows manufacturers to control the delivery, display, and inventory levels of key products at retail, would have been extremely expensive for the company to develop in-house. Kellogg has used the system to drive new products through the grocery channel and regain market share leadership in the ready-to-eat cereal category, which has added to sales and earnings growth over the past five years. MDI: Thanks, Gregg.
