Food Price Inflation: Worst To Come In 2013

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Consumers are relatively pleased with the performance of food producers, according to a recent study. In the 3Q, the food manufacturing portion of the American Customer Satisfaction Index increased by 2.5% over the year ago period to an average rating of 83.  Food manufacturing was the single best performing index category and there were some familiar brands driving the performance.

Customer Satisfaction*

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Rating</strong></td> <td><strong>Change</strong></td> </tr> <tr> <td>Heinz</td> <td> 89</td> <td> unch.</td> </tr> <tr> <td>Mars</td> <td> 86</td> <td> -1%</td> </tr> <tr> <td>Quaker</td> <td> 86</td> <td> -2%</td> </tr> <tr> <td>Hershey</td> <td> 85</td> <td> +1%</td> </tr> <tr> <td>Nestle</td> <td> 85</td> <td> +1%</td> </tr> <tr> <td>Con Agra</td> <td> 84</td> <td> +1</td> </tr> </tbody> </table>

*Source:  American Customer Satisfaction Index

Although it is not listed above, Kellogg's (NYSE: K) was part of a four-way tie that extended to Dole, General Mills and Sara Lee. The maker of Frosted Flakes and Nutra Grain bars also showed the greatest jump among large food companies, increasing its rating by four to 83.

Ironically, customer satisfaction ratings were driven in large part by food prices. Unfortunately, consumers may soon be in for a rude awakening. That's because food inflation resulting from this year's U.S. drought didn't rear its ugly head entirely yet. The full impact to food price inflation is expected to be felt in 2013, when consumers are likely to pay more at the supermarket check-out line.  

Food price inflation did, however, manage to eat into profits at some of the largest food companies, including Kellogg's, which has a market cap of more than $20 billion. In a recent analyst day event, Kellogg executives noted how food inflation suppressed the company's margins in 2012. 

Indeed, the U.S. Department of Agriculture is predicting that it's not going to get any easier anytime soon. Food inflation is expected to grow at a rate of between 3% and 4% in 2013, according to a recent USDA study. Prices on cereal and bakery products alone are projected to increase in that same range, which is not good news for Kellogg's.

Food Price Changes*

<table> <tbody> <tr> <td><strong>Consumer Price Index</strong></td> <td><strong>2013 Forecast</strong></td> </tr> <tr> <td>All Food</td> <td>+3.0 to 4.0</td> </tr> <tr> <td>Food Away from Home</td> <td>+2.5 to 3.5</td> </tr> <tr> <td>Food at Home</td> <td>+3.0 to 4.0</td> </tr> <tr> <td>Dairy Products</td> <td>+3.5 to 4.5</td> </tr> <tr> <td>Cereal & Bakery</td> <td>+3.0 to 4.0</td> </tr> </tbody> </table>

*Source:  U.S. Department of Agriculture

As for Kellogg, the company isn't letting food price inflation interfere with ambitious growth plans. Over the long term, Kellogg has high-hopes for its sales and profit performance.

Long-Term Growth Targets*

<table> <tbody> <tr> <td><strong>Component</strong></td> <td> <strong>Growth Target Range</strong></td> </tr> <tr> <td> Internal Sales</td> <td> 3%-4%</td> </tr> <tr> <td> Internal Operating Profits</td> <td> 4%-6%</td> </tr> <tr> <td> EPS</td> <td> 7%-9%</td> </tr> </tbody> </table>

*Source:  Kellogg's 2012 Analyst Day

Kellogg's is an interesting story because just about a decade ago, and for much of its 100-plus year history, it was largely a cereal company. In the past decade, however, through the acquisition of Keebler, Kellogg's began taking share in the snack food segment. This year, following its $2.7 billion cash acquisition of Pringles in February, the cereal and snack food categories are generating similar sales.

Pringles was clearly a boon to Kellogg's snack food portfolio. Performance in that business helped to offset the cost of a Kellogg Mini-Wheats cereal recall in the 3Q. It's also hard to ignore any anecdotal evidence, and social media has proven to be a fair yardstick. With nearly 21 million fans on its homepage, Pringles is ranked ninth among major brands on Facebook, just below Angry Birds, as noted by Pringles-turned-Kellogg's executive Chris Hood at the 2012 Kellogg analyst day.

Food Inflation Targets

Kellogg's rival General Mills (NYSE: GIS) recently reaffirmed its fiscal 2013 earnings outlook for $2.65 per share. The company behind Cheerios doesn't report fiscal 2Q results until December 19th. It should be interesting to see if the company was able to capitalize at all on Kellogg's weakness in the most recent quarter. In addition to food inflation, which is not partial to any single cereal company, Kellogg's gross profits and margins were also hurt by some internal issues. The company was forced to reinvest in its supply chain last quarter  instead of focusing more on product innovation, which compromised brand-building efforts and could work to General Mill's advantage.

H.J. Heinz (NYSE: HNZ) which topped the customer satisfaction survey, started to feel the impact from agricultural commodity price increases. In fiscal 2012, Heinz grew its gross profits and profit margins but results would have been even better were it not for a "$22 million unfavorable impact from foreign exchange and higher commodity costs," according to a press release. Both the ketchup maker and Kellogg's have more than $1 billion in free cash flow, and have trailing 12-month PE ratios of 18 and 17, respectively.

Food inflation is not something these companies with decades of history between them haven't seen before. That doesn't make it any less likely that food costs are going to be passed along to the consumer in 2013 as commodity price inflation finally catches up with the mainstream. While this could hurt customer satisfaction, it doesn't have to compromise financial performance -- as General Mills proved by reaffirming its earnings guidance.


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