Higher Food Prices Mean Slimmer Retail Margins

Higher food prices are being felt in many places. In Chesapeake, Va., school board officials are thinking about raising the price of school lunches — already the highest in the region — for the second time in two years. Mexico’s iconic corn tortillas are getting too expensive for some people in the country to afford. Near Wall Street, signs in pizzerias have popped up explaining the need to pass along soaring costs for cheese and dough, while Vietnam has banned the export of rice, to keep domestic prices down.

Brought on by drought in food-exporting countries, rising demand, sky-high energy costs, and the growing use of food crops such as corn and sugarcane for biofuels, food prices are soaring at a rate not seen in decades. The World Bank estimates food costs have risen 83% in the past three years, led by a 181% gain in wheat prices, and will probably stay high long into the future. In the first three months of 2008, food prices for U.S. consumers rose by a seasonally adjusted compound annual rate of 5.3% according to Commerce Dept. data, more than any other category except energy.

Around the world, food-price inflation is becoming a major issue for consumers, businesses, and government officials. Protests have erupted in a dozen countries where rising prices could lead to starvation for hundreds of thousands, according to the International Monetary Fund. In April the U.S. said it would release $200 million in food aid for developing nations.

For investors, rising prices can have a strong effect on the profitability of many food-related industries, although they tend to affect individual companies differently. Also, the price of packaged foods sold at retail is influenced by a wide variety of factors beyond the price of basic foodstuffs such as corn, wheat, soybeans, and rice. Standard & Poor’s equity analysts are upbeat on the outlook for food retailers, hypermarkets, and agricultural product companies, and neutral on packaged food companies.

Fetching a Prettier Penny

Retailers should generally be able to pass along the rise in food prices to customers, and some may even be able to widen their profit margins in the process, says S&P equity analyst Joseph Agnese. He notes that many have restructured their operations and acquired competitors, though they would probably have to absorb some of the costs if the current rate of food-price inflation quickens.

"The largest U.S. food retailers should have little problem passing along food cost inflation," Agnese says, in part because they "have developed strategies focusing on differentiating stores through product and service offerings rather than low prices." In fact, he believes, major food-retail chains may be able to pick up some business from their low-price competitors as inflation makes it more difficult to shop on price.

Makers of less expensive private-label products are also facing cost pressure in this environment, and they, too, are likely to need price increases to help protect profit margins. Thus, even if consumers look to trade down to private label, the private-label prices are likely to be more than what they were previously. Also, S&P equity analysts see some indication of a softer economy causing consumers to spend more of their food dollars on eating at home [vs. eating at restaurants].

If prices start to rise faster, however, food retailers’ ability to pass along the increases may diminish. S&P Equity Research has 4-STARS [buy] recommendations on six food retailers: Safeway (SWY), Whole Foods Market (WFMI), Kroger (KR), Ruddick (RDK), Great Atlantic & Pacific Tea (GAP), and Casey’s General Stores (CASY). Hypermarkets, like Costco Wholesale (COST) and BJ’s Wholesale Club (BJ), should also do well in an environment of rising prices, since they "generally appeal to price-sensitive consumers," Agnese says.

Reaping the Harvest

Agricultural product companies will probably fare well in the coming year because "strong end-product demand should help offset higher raw material prices in 2008," Agnese says. S&P equity analysts see price increases being partly due to the diverting of corn crops to ethanol production and relatively strong overseas demand for some products. With fast-growing economies, rising income, and changing lifestyles in such places as China and India, we expect increasing demand for proteins and packaged foods, including portable convenient foods. One company Agnese recommends is 4-STARS-ranked Corn Products International (CPI), a Chicago company that processes corn into starches, sweeteners, and other ingredients. While higher corn costs caused operating expenses to jump 23% in 2007, the company’s profit margins widened as prices rose even faster for dextrose and its other products. For 2008, the company says it expects to receive "low-double-digit" price increases for its products from customers in the U.S. and Canada, as well as higher sales and earnings per share.

The picture appears more mixed for the packaged food and meats industry. "We expect various food manufacturers or producers to face at least near-term pressure from relatively high agricultural commodity prices," says S&P equity analyst Tom Graves. "This includes the cost of grain fed to animals by meat producers, as well as ingredients used to manufacture packaged goods."

Major meatpacking companies have been particularly hard hit by the rise in grain prices, which raises their feed costs. Speaking to analysts earlier this year, Richard Bond, the CEO of Tyson (TSN), said grain costs rose by $300 million in 2007 and are set to climb an additional $800 million in 2008. Grain accounts for half the cost of raising a live chicken, Bond said, adding that Tyson would raise prices to help offset the additional expense. Smithfield Foods (SFD) is feeling the pinch of higher grain prices, too. In February the company said it would cut its herd of sows by 4% to 5% because of higher grain costs. The move would reduce the company’s 18 million annual hog output by as much as 1 million animals a year.

Rising grain prices should put profit margins for the two largest makers of breakfast cereal — Kellogg (K) and General Mills (GIS) — under pressure in the months ahead, Graves says. Both companies are looking at how to cut costs. Kellogg expects upfront costs of 14% per share during 2008 for some of its cost-reduction projects, while General Mills recorded a small charge to pay for restructuring activities in its fiscal third quarter ended Feb. 24, 2008.