New Rules Could Be Worse, but They Still Aren't Good

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Food is an essential aspect of life. No one can live without it. However, long gone are the days when a person would grow their own food. Now large companies do the work and send their products to processors and retailers.

While this is clearly more efficient, it has opened up the risk of mass illness, something that seems to have become all too common of late. The U.S. Food and Drug Administration (FDA) is trying to shift its stance from reacting to contamination outbreaks to preventing them in the first place. Regulatory changes, while possibly needed, can be a very expensive proposition for food related companies. The new rules should be relatively easy for big food processors to handle, but small food processors and farmers, like Dole (NYSE: DOLE) and Fresh Del Monte (NYSE: FDP), may have a bigger problem.

New rules can hurt
In early January, the FDA released its proposal for making the shift from defense to offense, giving the public a period of 120 days to comment on its plans. This is the second step toward making a new rule a reality (it happens after the agency has created the rule in the first place). FDA rule changes are a big issue for food companies, with virtually every publicly traded company putting this fact in the “risks” section of its annual filings with the Securities and Exchange Commission. The big problem is always the added cost of compliance.

Rule one
“Preventive Controls for Human Food: This rule sets safety requirements for facilities that process, package or store food for people." (There is a separate, upcoming rule for animal food.) The rule will require that food facilities implement “preventive controls,” a science-based set of measures intended to prevent foodborne illness.”

This rule's bark is probably bigger than its bite for large food processors. Essentially, all the FDA is asking is for food processors like Kraft to create a written plan that “evaluates hazards that are reasonably likely to occur in food,” spells out the steps the company will take to minimize those risks, creates a monitoring and recording system, and creates a road map for dealing with an outbreak if one should occur.

While the impact of the rule shouldn't be downplayed too much, it really requires a company like Kraft to sit down and think about and formalize its food safety plans. Such a large entity probably has similar documentation already, though maybe not in the manner the FDA would like to see. So, for many, tracing the process of making and delivering a hot dog or cheese to the store will be paperwork more than anything else.

The rule may require some changes to a processor's operations, but major changes will be unlikely at most large companies. Moreover, this process will probably be more of a one-time expense than an ongoing commitment. While smaller companies will struggle more than larger ones to deal with the rule, and there are plenty of small food processors, it shouldn't cause notable hardship for financially stable entities.

Rule two
“Produce Safety: The food-safety law requires that science-based standards be set for the production and harvesting of fruits and vegetables, and FDA is proposing such standards for growing, harvesting, packing, and holding produce on farms.”

The shift to a more offensive stance, attempting stop illness outbreaks before they hit the market, means pushing down the, pardon the pun, food chain. Although land, seeds, water, and fertilizer are the first steps to growing food, its the framers that are likely to feel the biggest pinch from the new regulations. This is a fairly competitive industry filled with many small players.

This is notable because companies like Calavo Growers (NASDAQ: CVGW), which sells avocados and tomatoes, among other things, doesn't actually grow all of what it sells. It has deals with multiple farms to collect and sell their produce. Thus, a rule that hits Calavo is really one that hits its produce providers, requiring the compliance of not one company, but many—some of which may be little more than a mom and pop operation. Calavo will likely be responsible to make sure its suppliers are in compliance.

Even more difficult to deal with is the fact that much of the produce consumed in the United States, including Calavo's avocados, come from farms in foreign countries. Many of the avocados enjoyed in U.S. homes are imported from Mexico, for example. So the rules not only have to reach down to small farms, but also to foreign countries at some point in time (this is one of the key rules with which the FDA is still grappling).

Rule two is a biggie!
This rule is likely to have a far greater financial impact than rule one. It will attempt to regulate almost every aspect of the growing process, including irrigation, worker hygiene, fertilizers, and general sanitation, among other things. Thus, large public produce companies like Chiquita (NYSE: CQB), which is best known for its bananas and other fresh produce, Dole, which sells fresh fruits and vegetables, Fresh Del Monte Produce, which sells fresh fruits and produce, and Calavo Growers could see a material increase in costs on an ongoing basis as they try to comply and ensure that any of their suppliers comply.

While most farms will already have “clean” operations, formalizing what is common sense is likely to require a lot of legwork and monitoring. It will also likely mean notable changes in some areas. Worse, ensuring compliance could be a nightmare, since the FDA has limited resources and thousands of farms to oversee. This suggests that big companies could be responsible for much of the monitoring. While the toll on individual farms is expected to be low on an absolute basis, the profit margins in the space can be thin. Thus, any added costs can quickly eat into the bottom line.

Softening the blow of this rule is the fact that it is specifically targeted at foods that are known problems, including foods eaten raw. Unfortunately for Chiquita, Dole, Fresh Del Monte, and Calavo, much of what they sell falls into the high risk category.

Nothing's changing overnight
While the FDA's rules aren't final just yet, investors should keep an eye on their progress. There's a reason why rule changes make it into the “risks” section of SEC documents. Rule two could hurt the profitability of many key players, with weaker and more leveraged companies feeling the biggest pinch. Smaller food processors, meanwhile, are likely to be stung hard by rule one.

ReubenGBrewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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