Sunday, September 23, 2012

Which Stocks are Hot in the Food Sector?

Theoretically the private label food manufacturers should be one of the great winners out of the new retail reality. However both the main listed plays Treehouse Foods THS and Ralcorp Holdings $RAH are down substantially this year. Go figure! Unfortunately, there are many moving parts to their business and the food retail industry is in a genuine state of flux right now. So what is going on and what are their prospects going forward?

The New Retail Reality

The US seems to have fallen in love with frugality and deleveraging. Over consumption is definitely off the table. Customers are not only trading down; they are buying food in smaller packages and changing where they shop by moving away from the traditional supermarkets and grocers towards alternative channels, such as the dollar stores, discount stores and, interestingly, specialist shops like Whole Foods.

I make the last point to highlight that this isn’t just about trading down. There is a curious kind of bifurcation going on here. The brands that are doing well are those at the premium end and those offering unrelenting value, particularly those sold through anything containing the word ‘dollar:’ Dollar Tree, Dollar General $DG or Family Dollar $FDO.

As such, private label is also doing well. Not only do they tend to be cheaper, but retailers are increasingly differentiating their product offerings within private label, in order to capture different segments of the marketplace. Again, the premium brands and category leaders are doing fine but it is the second to fourth line brands within a category that are suffering the onslaught of the growth of private label.

In addition, food costs have been rising in recent years and the consumer has been demonstrating that food is, after all, not a price inelastic good. Prices go up, consumers consume less and woe betides the company that tries to hike prices in front of its competition. The golden equation of the new retail reality is prices up=volumes down, and then let’s hope you get lucky on margins.

It’s time to confess. I lied. It's actually not new. We have seen this before: After the reunification of Germany, the economy fell into a period of slower growth as the West accommodated the East. One of the consequences of this was that the German consumer hankered down and started shifting to discount stores and it is no surprise to see that Europe’s leading discount stores emanate from Germany, namely Aldi and Lidl. Before you ask, both are private companies.

Turning back to the US, here is how Treehouse demonstrates industry forecasts for the potential growth in private label food and beverage.

So why aren’t the private label companies doing better?

Changes Turn and Face the Strain

Treehouse recently lowered its full year adjusted EPS guidance to $2.75-2.90 from a previous forecast of $3-3.15 amid plans to shut down a soup plant early in 2013 and then a salad dressing plant later in the year, while Ralcorp recently said it would be consolidating its business. Both stocks are down sharply this year.

The explanation comes if we understand that these businesses are also subject to change and as consumers shift to alternate channels they will need to adjust who they sell to. This is somewhat of a challenge for private label manufacturers because they suddenly realize that the contract they signed with a previous store is not going to be as profitable as they might have hoped.

In a way this highlights one of the difficulties with these companies. They are subject to the strategic and operational considerations of their clients, and if they don’t want to sell or promote a certain food product anymore than Treehouse et al will just have to eat it while they start anticipating taking a hit on the inevitable restructuring that will follow.

Soup Wars

Moreover, as times and prices change so do consumer tastes. One area that is proving particularly tough is soup, and investors in Heinz $HNZ and Campbell Soup Co $CPB need to pay attention to what Treehouse is saying here. The category seems to be in decline, and the closing of its soup plant portends further problems for the product. As ever with tough end markets, the protagonists start fighting ever harder for a larger piece of a smaller pie. As such, price competition is heavy and Treehouse has lost a lot of work with a key private label customer in recent times.

To their credit, Heinz and Campbell are innovating with new flavors and recipes, but it just looks like a difficult category to be in and I note that Heinz has previously remarked over the issue of smaller packaging and the growth of discount retailers taking away traditional traffic for their products.

Where Next for the Industry?

The soup plant restructuring has hit Treehouse’s forecasts for this year and remains a salutary reminder that the industry remains in flux. Last year it was pickles and this year it's soup. As for Ralcorp, investors in ConAgra can thank their lucky stars that the previous bid failed. Conditions look challenging at Heinz and Campbell but they both remain dividend darlings and the market has had time to digest their own going trends.

As for the dollar stores, I wrote about them at more length three months ago in an article linked here arguing that while prospects looked good, the evaluations were a bit rich. Since then, only Dollar General has outperformed the S&P 500 and the other two dollar stores are flat to negative.  I like these stocks, but isn’t the new retail reality about not overpaying for something even if you like it?

The challenge for Treehouse and Ralcorp is get their relative restructurings done in line with the way retail traffic is trending. If they can demonstrate this then I think end markets are favorable although cautious investors will want to see demonstration of this first. The food industry remains in flux as it adjusts to the changes.

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