Tackling high food prices

GRAIN prices are near their lowest in a year and global stockpiles are on the rise - so meat, dairy and pasta prices are poised for a fall, right?

Not so fast. Food companies from Coca-Cola to General Mills to Sara Lee, which fought hard to push through price increases earlier this year, are unlikely to give them all back right away.

Beyond the practicalities that typically delay the pass-through impact of commodity costs through food producers, the fact is that companies are still in the process of recovering the profit margins they lost when prices spiked to record highs earlier this year.

And even with US consumers fretting over recession, they tend to get used to higher prices over time, giving companies the confidence to maintain margin rather than grab for share.

PepsiCo said last week that consumers did not cut back on its Frito-Lay products as much the company expected when it raised prices on a host of items this summer, and that it planned more increases in coming weeks.

“The reality is if you’ve taken price and you’ve made it stick ... it’s not something you necessarily have to react to immediately,” Ken Harris of Kantar Retail Americas Consulting said about the easing of commodity prices.

That means it will likely take months of lower commodity prices before most companies cut retail prices, if they do at all, which could provide some padding for corporate earnings.

“Prices go up like a rocket and drop like a feather," said Sterling Smith, an analyst at Country Hedging in St Paul, Minnesota. “Hedges will have to roll off and prices will need to show some signs of stability before companies will start to lower prices on the shelves.”

A history lesson

Part of the reason it will take time for prices to come down is practical: makers of packaged food and drinks often use forward purchasing and hedging techniques to protect against volatility, meaning they won’t actually pay lower prices until those hedges expire.

Corn futures surged nearly 150% to a record of about $8 per bushel this summer from their lows the prior summer, as supplies dwindled amid growing global demand for meat and the use of corn in US ethanol production.

Yet in September, corn prices slid 22% their biggest monthly decline in 15 years, as US farmers began to harvest their crop while the debt crisis deepened in Europe.

As costs begin to subside, companies must consider whether lowering prices would help them win back customers, who might feel emboldened to spend more freely if they had money left over after buying their basics.

“The most interesting question for packaged food stocks is: 'Is there a wealth effect within food spending?',” said Janney Capital Markets analyst Jonathan Feeney.

Since the beginning of 2010, the food and drink component of the US Bureau of Labour Statistics’ Consumer Price Index is up about 4% while the Producer Price Index, which measures costs for manufacturers, has gained about 7%.

But that has not been as destructive to margins as it may seem. Feeney said that in general for food companies, a 1% rise in retail prices would offset a roughly 5% to 7% rise in commodity cost pressure.

When a company raises the price on a product, some consumers stop buying. Still, most brands are willing to forsake some sales to protect margins, but sometimes they will end up having to spend money to fund special promotions - such as buy one, get one free - that effectively relower the price.

For the four weeks ended October 1, US packaged food prices were 7.1% higher than a year ago, and sales volume was 4.1% lower, according to Bernstein Research analyst Alexia Howard, who cited data from Nielsen.

But Nielsen currently does not track Walmart, the biggest food retailer, whose approach could yet turn the trend on its head.

Walmart X-factor?

Unlike oil prices, which filter into the economy quickly via gasoline prices, crop-commodity prices have a delayed effect.

But one wild-card that could speed up any decline in retail prices is Walmart Stores. The retailer said last week that it planned to significantly reduce operating expenses over the next five years, and use the extra cash to invest in price decreases that can help it gain share on rivals.

Edward Jones analyst Jack Russo said that between the pressure from Walmart and consumers in general, “the days of raising prices are going to be over” next year.

Retail prices are unlikely to keep going up, but they are also unlikely to come down across the board, Russo and others said, except for categories that are very competitive or have a large private-label penetration, such as bread or milk.

Earnings could get a lift if commodity costs stay lowered, but given the strength of food stocks over the past few years, because of their relative stability, Russo doesn’t think the sector will rise much further.

The Standard & Poor’s packaged food index has gained 14% this year and 39% since August 2009, or the earlier days of the economic recovery. The wider S&P 500 is down 3.7% this year.

“Probably a lot of the easy money has perhaps been made, and now it’s just going to be what companies can put up the best numbers,” Russo said. He likes shares of General Mills for their good brands and dividend, and shares of Campbell Soup for the possibility of a turnaround under new management.