The Winter Drought: Wheat Prices and Your Portfolio

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

This past summer was a dry one.  Not dry in the boring sense of the word.  Dry as in the no water normal sense of the word.  Farmers, meteorologists, scientists, and investors alike all sat and watched what happened as the worst US drought in 50 years grabbed a hold of the country.  This caused food prices to rise, especially corn and soybean.  Companies like Buffalo Wild Wings and Tyson struggled in the inflationary environment.

But then things seemed to be getting better.  Some rain started falling.  Some temperatures started dropping.  We seemed to be out of the woods and into the tulips.  But hold your horses.  It appears that the drought relief was short-lived.  The drought is still here and worsening.  This couldn't be happening at a worse time.  After farmers saw the corn wither and the soybean fade, now they can only hope and pray that the winter wheat crop remains unaffected.

It might be too late.  The wheat has already started coming up, and it doesn't look good.  About a quarter of the wheat is in sad shape according to the USDA.  If this drought takes a firm hold of our beloved midwest and ruins the wheat crop, what dreadful things to we have to look forward to as investors?

Rising Costs

When one commodity rises, it rarely leaves the rest of the economy unscathed.  Everything is interconnected, so there is a ripple effect.  But for the purpose of this article, let's keep things simple.  If the drought puts a damper on the winter wheat crop, then wheat prices would necessarily rise.

Who are the players that would be most effected by a rise in wheat prices?  Logically it seems that makers of baked goods would be the first to feel the pressure.  I've picked out five companies that have wheat make up a significant portion of their costs.

  1. Kellogg (NYSE: K)
  2. General Mills (NYSE: GIS)
  3. J & J Snack Foods (NASDAQ: JJSF)
  4. Flower Foods (NYSE: FLO)
  5. Mondelez International (NASDAQ: MDLZ) 

As wheat prices potentially rise, then the cost of goods sold will also rise for these companies.  This will chip away at their profit margins.

K Profit Margin Quarterly data by YCharts

When you look at this chart, General Mills seems to be the best positioned company for rising wheat prices based solely on their profit margin.  Flower Foods seems to have the most to lose with a very low profit margin.  Mondelez International doesn't have a profit margin much higher than Flower Foods, but they also have a larger number of non-wheat products that will help dampen the effect rising wheat prices might have.

Food Contracts

When food prices rise, manufacturers quite often pass the expense on to the consumer by means of price increases.  But that is when food prices rise slowly.  When food prices spike, the manufacturer can't raise the price fast enough and subsequently take the fall.  To counteract this, several companies try to get food contracts in place to shield them from sudden spikes in food prices.

Kelloggs expects there to be significant inflation across the board in 2013, not just wheat, and has accordingly hedged 40%-50% of their costs.  Mondelez International has also hedged a significant portion of their food costs for all of next year.  The bigger the company, the more likely they are to be able to do this and to do it profitably.

J & J Snack Foods is significantly impacted with food cost inflation.  From their earnings release "...however, there has been a very significant increase in the market cost of flour...which we anticipate will result in higher costs over some portions of our fiscal year 2013."  That's management talk for communicating that when flour costs rise, J & J gets hurt.  The over some portions part means as long as flour costs are high.

Winners and Losers

When I say winner, I mean which companies will be better off.  It's not really a win when commodities rise.  But I think that Kelloggs and Mondelez will be relatively unaffected because of the hedges they have in place to protect them.  I also think General Mills will be just fine through this potentially difficult time, if for nothing else than for their higher profit margin.

The losers are both Flower Foods and J & J Snack Foods.  Flower Foods doesn't have much of a margin to give up.  J & J has already admitted the difficulty of higher costs.  I think both of these companies are pretty vulnerable to a difficult commodities market.

Conclusion

I hope the drought doesn't continue to get worse.  2013 is looking difficult enough without the extra baggage of a worsening drought.  While I don't believe it's economipocolypse, it is something we investors need to keep an eye on.


thequast has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Flowers Foods. 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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