GLG News by Brian Stevenson

Implications: The basic Agricultural Commodity Markets will remain Volatile as long as the U.S. uses Corn for Fuel and the world continues to experience an emerging middle class in developing countries. Hedging can be a two edged Sword. Companies should manage to margins not markets. It is the Brands that Matter.

Analysis: As long as the U.S. continues to use Corn for Fuel and the middle class continues to emerge in developing countries the World Ag Commodities market prices will remain Volatile.  For us Ag Economists types we see this continuing for the next few years.  With that being the case, the world needs to find more acres to till and great pressure will be put on yields of familiar crops.  In the long term, the world will discover other ways to make motor fuel more efficiently and governments will allow the most efficient producers of motor fuel extenders to export their products.  In the meantime, users of Ag Commodities will continue to suffer from extreme price volatility.

General Mills, like other fine companies look at their firms and must protect themselves from going broke.  To do this they will buy protection in the form of Hedges to protect the company.  As the markets go up, the buy hedges look great.  As the volatility moves to the down side, the hedges get marked to market as a negative.  Therefore, as the markets go down, we see what can happen even to fine companies.  The news from VeraSun(VSE) in the last two weeks is an extreme example of what can happen when "hedging" turns into panic buying.

These reasons explain why it is important for Firms to manage their businesses to margins.  When they buy these commodities to hedge their products does it allow them to make a margin?   It is time for CEOs of great companies to get involved in margin management in these volatile price times.

Great brands allow companies to pass on price increases during the up commodity cycles and hold those price increases through the down commodity cycles.  The more the product sold is like a commodity, the more difficult it is to hold price increases.  Cheerios has much more pricing power than does Ethanol.

Conclusion--  In the past commodity price fluctuations were not great enough to put fine companies at risk.  That all changed in 2007 when Ag Commodity prices went to record high prices in just a few months.  All Hedges eventually run out.  Great brands will allow firms to give price increases and hold those prices for some time when markets turn down.  CEOs should now be involved in Hedge decisions during these trying times.  Those decisions should be margin driven.  The better the brands, the greater the chance to keep margins.

Implications: 1.  Prospective corn planted acres by USDA are at 86 million2.  If realized, expected harvested acres are 79 million3.  Usage of Corn continues to rise with Ethanol production plus emerging middle class diet improvement in South/East Asia4. In the end, Yields will be the most important factor for this year's crop5.  Expect extremely volatile commodity markets this year.6.  The markets may be forced to find a price at which corn usage is actually rationed.

Analysis: The "Prospective Planting" report from the USDA reported that corn acres are expected to be around 86 million acres.  That implies harvest acres of around 79 million acres (there is always a flood or drought somewhere coupled with silage off take).  Usage of Corn for the September 1, 2008 to August 31, 2009 period is around 13.1 billion bushels.

Implications: 1.  Corn is used in 97 pct of Ethanol Production in the U.S.2   Corn Prices are at record high levels at around $6.00 per bushel3.  Expected Planted acres are below what may be needed to provide corn for all uses during the next year.4.  Sugar Ethanol is much cheaper to produce than is Corn Ethanol5.  Brazil has surplus Sugar and surplus Ethanol capacity6.  Ethanol Import tariffs may be in question with a new administration7.  Imported Ethanol may help solve some of the Food verses Fuel debate.

Analysis: In a Dow Jones article titled "Brazilian Ethanol Makers Eye U.S. Market" the author points out that Brazil is on the cusp of a burdensome Sugar Production year.  They have excess capacity for Ethanol Production Capacity available.  

Implications: 1.  Consumer Product Goods companies are at risk for commodity price increases even if they are not directly involved in the basic commodity businesses. 2.  In this case, Milk is the Produced article which is "manufactured" by cows eating basic commodity ingredients. 3.  Companies like this need to devise hedging strategies to protect shareholders from the risk of basic commodity price increases 4.  Just as importantly, pricing at the retail level is hard to get.  The consolidation of food retailers will only continue.  These massive buying agencies are not going to allow pricing easily.

Analysis:  Shareholders buy fine companies because they love the brands they own and manage.  In the CPG space, nearly all of those brands have some element of risk associated with input costs of basic commodities.  The closer the brand is to the basic commodity, the more it is likely to be affected by commodity price risk.  Firms need to study their risk portfolios as it relates to basic commodity prices and develop strategies that will reduce that risk for their share holders.  My bet is that raw milk prices have a very good correlation to the price of Corn.  A solid hedge program in corn may be an answer for price risk control for raw milk.

Corn is now the basic feed stock for the Alternative Fuel Program in the U.S. and other parts of the world.  That will likely continue for at least 5 to 10 more years.  The average analyst missed their guess for earnings at Dean Foods.  This may be because they are not asking the correct questions to company's management that have exposure to basic grains.  My suggestion is for interested persons to ask management how they are protecting the value of the company through Commodity Price Risk strategies.

Finally, in the "old days", fine brands had a lot more pricing power on the shelf.  Today with the consolidation of the retail sector (Wal-Mart, Albertsons, Others) that have centralized purchasing, pricing becomes very difficult.  This especially if a competitor supplier of the brand has covered the risk of price exposure and uses this as a strategy to get more shelf space.  In short, these big retailers will not give pricing easily.

Summary, CPG food companies must understand their brand's underlying basic commodity price risk profile and have strategies in place to cover those risks.  Otherwise, the brands will be put at risk or margins will get squeezed.  Either option is a problem for Shareholders.

Implications: 1.  The demand curve for Grains in the world is shifting to the right.  How much we do not know.  The market has not found a place where usage is rationed.

2.  Many CPG food companies will suffer in the short term while Big Box Retailers hold the line on price increases.

3.  We as consumers can count on food "inflation" in the next year and as long as the market has to search for a rationing price level.

Analysis: 1.  Even with the recent narrowing of margins in the Ethanol and BioDiesel industries, the best margin use for grains today still is in the BioFuel industry.

2.  Those firms feeding Grain Consuming Animal Units (Cattle, Pork, Poultry and to a lesser extent fish) are facing reduced margins as they continue to pay comparatively high prices for their largest input Carbohydrate feed (corn) compared to last year.

3.  The spill over effect from high corn prices will be/is high prices for other carbohydrate grain sources like Wheat.

4.  The world is relying on historical increases in planted acres on U.S. and world farms with well above average yields just to satisfy the current demand level at current prices.

5.  If pricing is hard to get on the retail shelf, even good brand names will see margin shrink which will lead to "disappointment" on quarterly earnings releases.  I would suggest that firms like Smithfield Foods, Tyson and the like will struggle as they sell a lot of product that is non branded and thus will find it difficult to get price increases to the consumer.  As well, those firms that concentrate or have a lot of exposure in the world of private label manufacturing will see margin erosion.  To make one pound of Beef takes about 8 pounds of feed.  Corn prices this year are up nearly 2X from last year.  Can private label Beef producers get enough price increase from the Big Box Retailer to cover the cost increases implied above?

6.  Very fine brands like Coke and Pepsi may even gain in this high commodity input cost environment.  The cost of the commodity input Fructose (corn syrup used to sweeten beverages) is small compared to the sales price of the product.  As the world realizes there will be food inflation, these fine brands will have more pricing power and perhaps even gain margins during this high input price challenge.  A significant corn price increase represents only a few cents per case increase in the cost of beverages.

7. In the end, the world will look to other sources of energy besides that coming from Corn/grain.  Millions of research dollars are moving to solve the Cellulosic ethanol riddle.  That will likely take another five years, but at current high Crude Oil prices which can be hedged many years in the future, that will likely happen.  We can also expect other new energy ideas as long as Crude remains at or above current levels.

8.  Mr Cromarty mentions the emerging nations and their increased needs for food.  The cheap dollar does allow those nations to buy inputs for their food/fuel industry relatively cheaper than the U.S. domestic industry.  The fact that China and India and other countries economies are sponsoring a huge emerging middle class that will increase meat and vegoil in their diets is not to be over looked.  As well, those emerging nations continue to increase their use of cars and industry which demands more fuel. 

9.  The job of the market is to find a price level that will ration demand.  That then will allow us Economists to get a better handle on the new Demand Curve.

10.  Other companies that will likely struggle during these near term high commodity prices will be IBC, Lance, Tasty Baking and other firms that have a large exposure to private label products sold in the Big Box Retailers.

Implications:  

• IBC asks the court to extend the DIP
• MOR for 4 weeks ending Dec 16 is reported
• Jung gets real incentives to turn the company around

Analysis:

• Yesterday, Craig D. Jung was named the new CEO of IBC pending the court approval of the Employment contract. Tony Alvarez II, resigned as Interim CEO along with one board member (Mr. Weinstein).
• Mr. Jung appears to have a great resume for the job with PepsiCo and Coke experience. However, other questions remain as IBC is an animal with many tentacles.
• IBC asked the court to accept the proposal put forward by IBC and its lenders to extend the Debtor In Possession Financing to February of 2008. In the documentation, the new DIP sets forward clear EBITDA hurdles. Can they make them?
• For the Four Weeks ending December 16, IBC reported a bottom line loss of $12.9 million and an EBITDA loss of $733,000. Cap Ex expenses still lag "normal".
• Sales were reported as $213.1 million down from the four weeks prior (implies a $2.8 billion pace of sales for the year at that rate).
• Christmas week is always a difficult time for Baking companies, so expect another weak performance for the 4 weeks ending mid January.
• Big question for Mr. Jung is can he turn it around to collect the big incentive bonuses as named in his employment contract? Help will not likely come on the cost of goods sold line (Commodities that is except for energy) compared to last year.
• Other questions loom as well where benchmarks can be discussed including operational efficiencies.

Implications:  

• Corn Prices now top $4.00 per bushel, Ten year average is $2.10 to $2.30.
• Year ago prices were $2.25 to $2.50 per bushel.
• Pricing at the Big Box Retailers is hard for CPG companies to get.
• The best margins in the Ag Industry are still in Ethanol however even some of those companies will begin to feel the pinch.
• Firms that feed corn to animals will likely be most threatened.
• Corn prices affect other commodity prices like wheat and soybeans.

Analysis:

U.S. Grain Animal Consuming Units (Cattle, Pork and Poultry) are up slightly from last year. The Animal Feed industry is now in the throws of consolidation (Smithfield Foods and Pilgrim’s Pride among others). For one pound of beef it takes about 8 pounds of feed, 4 pounds for pork, and about 2 pounds for poultry. Large feeders of these animals will see their input costs soar during this next year. Can these firms get pricing at the Big Box Retailers as their hedges expire and input costs go up dramatically? Hedge opportunities have been few in this bull commodities market. (Tyson, Pilgrim’s Pride, Smithfield Foods)

Ethanol margins that seemed bullet proof just six months ago now are at risk with their feed stock up nearly 2X from that time. Gas and other energy prices are now at two year lows and small inefficient Ethanol plants may have negative margins. (Pacific Energy, Other Ethanol manufacturers)

The job of the market is to encourage farmers to plant more corn acres at the expense of soybean acres. That sets the stage for a change in the soy complex (Veg oil users) pricing structure one to two years out.

Wheat and wheat flour users will also feel the pinch as wheat futures hold at prices over $5.00 per bushel. These firms that produce some “commodity” types of products will again have the challenge of pricing at the retail level. (Flowers, Sara Lee, IBC) The risk to flour users is the probability that wheat moves into the cattle/poultry feed rations during the summer account for the high price of corn. If this occurs, wheat will be in a difficult position in the third and fourth quarters of 2007 when it is needed to make bread, cakes and crackers.

Expect continued volatile commodity pricing as the world has turned to carbohydrates as a fuel source. Excellent yields for corn and wheat are required just to meet current carbohydrate demand in the U.S.  Analyst and investors will likely see earnings misses by good CPG companies on account of the imbalance between increased input cost verses lack of pricing power at the retail level.

Implications:

• High Fructose Corn Syrup Prices go higher as its input Corn competes with Ethanol Production
• The demand for Corn by Ethanol producers has shifted the Demand Curve out for Carbohydrate commodities like Corn
• Corn planted Acres are at risk for next year as Wheat prices encourage farmers to plant wheat in fringe areas of Corn country.
• Price volatility is expected to continue and perhaps increase into next year as yields get pressure to supply enough corn for all uses next year.
• Margins for HFCS production will remain firm as those streams continue to compete with corn streams going into ethanol.

Analysis:

Comments- This may seem like the same song written for other Branded Food Companies: it is. Pricing is difficult to get at the retail level especially now that large chunks of that business go to the Big Box Retailers who are very price conscience to the consumer. The Coke CFO mentions in the article that Aluminum cost are partly to blame for the increase in costs. The article mentions Pepsi Bottling as well.

This goes to prove that even fine Branded Food Companies are not immune to the margin squeeze caused by Ag Commodities. They also mention that this is an unusual time. The author believes that these types of Price Volatility will be with the Ag Commodity markets until another source is found for making Ethanol. Until that time, Margins in the Ethanol industry encourage more Corn into Ethanol Production and other uses must buy the right to use Corn based products. Other sources for Ethanol Production (Cellulose) are probably over five years away. The telling tale will be if companies find ways to solve this price risk problem. It will not be easy.

Other names that will likely have problems are Sara Lee, Pepsi, Flowers, all of the Meat Companies, Lance and Tasty Baking.

Implications:

• Ag Commodity Prices are volatile to the up side
• The Demand curve for Ag Commodities is shifting on account of the production of Biofuels
• Pricing at the retail level is difficult to get
• Pricing many times comes with lower unit volume
• Margins get squeezed at the Manufacturing Level
• Even fine Brand Name stocks get hurt

Analysis:

In the article, Lance management mentions that earnings will disappoint for at least the next two quarters. The reason given is the “Lack of Promotion” for Private Label retail sellers (read inability to get pricing) and the higher cost of Flour (read higher commodity prices).

Lance has a very strong brand in their area of sales. Wheat Prices and therefore Flour prices are up significantly compared to last year and even compared to historical values. That in the author’s opinion is likely to continue as wheat continues to fight for planted acres verses Corn and Soybeans.

When will this Bull market in Ag Commodities be finished? It is difficult to tell but wheat, since we will know acreage planted in the early spring, will be the leader to show if high prices do in fact cure high prices. At current prices, Wheat should attract more acres in the world. Statistically speaking, the weather in the Northern Hemisphere during the months of February, March and April are the greatest determinant for Yields. Therefore, stay tuned.

The dilemma for U.S. Ag Commodities is that if acres move from Feedgrains or Soybeans to Wheat, Corn and Wheat will be at greater risk next year. The pressure on yields to provide the quantity demanded next year will keep the Ag Markets very volatile. The author’s expectation is that many more fine branded food companies will suffer the same fate of reduced margins or reduced units as those branded companies struggle to get pricing at the Big Box Retailers to cover higher Cost of Goods Sold.

Companies that will likely see pressure are the Likes of Tyson, Pilgrims Pride, Smithfield, Sara Lee, Flowers, Tasty Baking and the above mentioned Lance among others.

Implications: Corn is a major input for making Meat.

Corn Prices last year at this time were between $2.10 and $2.25 per bushel.

Current prices are well over $3.00 per bushel.

Folks in the U.S. Domestic Grain Business estimate that Tyson Uses about 250 million bushels of Corn per year.

Analysis: Comments--  Pricing at Big Box Retailers is not easy to get.  One has to wonder if Tyson can get up to $200 million in pricing for its products??  Perhaps Tyson has a great Price Risk Management position on the books and that means they are ok.  To really value these companies one has to know or have an opinion on the value of the Risk Management team at these great companies.

Other companies that use basic Ag Commodities will have the same exposure.  My advice for investors is to be aware of the commodity risks of even fine branded companies.  The likes of Pepisco, Coke, Flowers, General Mills, Kelloggs and other fine brands will not be immune to these strong commodity prices.   If they can not get pricing, margins will suffer.

Implications:

• Commodity price increases increase Cost of Goods Sold
• Even good brand names find it difficult to get pricing at Big Box Retailers
• These two facts will lead to Margin Squeeze for Producing firms
• Animals are very inefficient converters of Grain Carbohydrates into Protein
• Carbohydrate use (corn) for Ethanol has shifted the demand curve for Carbohydrate usage. This will keep prices firm

Analysis:

Comments: My opinion is that Deuche Bank is right on target with this one. Cattle take 8 pounds of feed to make one pound of beef, Pork 4 pound and Chickens 2 pounds. Tyson is in this business and will see input cost increases.

Price increases at Big Box Retailers are difficult to get and take time. Volatile input prices occur quickly. Other firms that will face this same exposure are those like Smithfield Foods, Pilgrim’s Pride, and many other fine brand name firms.

Only time will tell if the world can produce enough carbohydrate commodities to satisfy both feeders and Ethanol producers. Price Volatility will be the norm not the exception.

Implications:

• Australian wheat crop devastated by drought
• U.S. Bread wheat Crop also hurt by drought
• The world will use more wheat than it grows this year reducing stocks
• Prices made 10 year highs and are expected to remain volatile
• This will likely have a strong affect on earnings of companies that use wheat

Analysis:

Comments: The wheat crop in Australia was devastated this year by drought. The crop this year may be below 10 million metric tons verses last year’s crop size of 25 million tons. That means a reduction in available Wheat for export to the world.

The U.S. Hard Wheat Crop was also hit hard by drought and now is at price levels not seen since 10 years. Volatility in trade is at a level not seen, perhaps ever.

This means that companies that use Wheat Products as the primary inputs for the products they make and sell will be in a difficult position. True, they may all be in the same boat on the cost side; however pricing has never been more difficult with the growth with Big Box Retailers. For those firms that have not hedged their risk, this will hurt their bottom lines quickly.

The future is cloudy for Wheat production and therefore Wheat prices at this time. The U.S. Winter Wheat plantings are going well. Conditions at planting time are very good. However, statistically speaking, the most important weather will be in the spring. Therefore, expect Wheat markets to remain very volatile until at least into mid spring when winter wheat comes out of dormancy and the spring wheat is planted.

Companies at risk for this price volatility are firms like: Sara Lee, Flowers Bakery, General Mills, IBC, Lance, Tasty Baking and other fine CPG companies. To properly analyze these companies, people should understand as much as they can about the Price Risk Management of these types of Firms. Watch the Cost of Goods Sold lines in the next few quarters.  As well, watch the sales line as firms struggle to get price increases and those with good Price Risk Management in place, price their products to maintain or grow unit sales.

Implications:

• Beef takes about 8 pounds of feed to make one pound of beef
• Corn is the largest component of Cattle feed
• Ethanol is the best economic use of Corn today
• Packing Company margins have been squeezed to the point of shutting down capacity
• Can McDonald’s and the like keep their cheap pricing in face of likely increases in beef and other meat products?

Analysis:

Comments- Beef cattle are very inefficient converters of carbohydrates to protein. Chickens are better, but still require about 2 pounds of feed to make one pound of meat.

The best margins for Corn Producers today are through Ethanol plants. That will likely be the case for some time (unless one is $15 bearish on Crude Oil) and therefore, as Hedge positions (forward purchase contracts) run out for the McDonald’s of the world; new pricing for meat will likely be the case.

Corn and wheat prices are at ten year high prices. The demand curve for Ag Commodities have shifted and in some cases are being measured with value basis their BTU content. Wheat for flour to make buns is also part of this mix as the world production and expected carryout of wheat (as measured in Stocks to Use Ratio) is at 10 years lows as well.

Margins at the packing houses have been squeezed to the point of capacity closures.

One must wonder if the likes of McDonald’s and other users of commodity based inputs will be able to pass along these increased costs in the way of increased consumer pricing. If not, one can expect to see margin erosion in the next few quarters in my opinion.

McDonald’s will not be the only cowperson at this rodeo.

Implications:

1. World Carbohydrate (Ag Commodities) prices will likely remain firm in the next few years as the demand curve for carbohydrates shifts account of Ethanol production.

2. Rice acres in East Asia are at risk to urban and transportation growth

3. Companies that use basic Ag Commodities are at risk of making their numbers in the next few years as their input costs increase and stay high compared to the last few years.

Analysis:

Corn is the world’s most plentiful Ag Commodity Carbohydrate. The best economic use for corn today is to make Ethanol. That market will continue to attract corn and other carbohydrate sources which has forced a shift in the demand curve for these Ag Commodities. Rice must protect itself from becoming a fuel carbohydrate and thus, the price should remain firm for the foreseeable future.

Companies that use Ag Commodity Carbohydrates are at risk for making their numbers in the next few years as production finds it difficult to keep pace with this new demand paradigm.

Big Box Retailers will keep margins under pressure as even the fine-branded food companies find it difficult to get pricing at the consumer level. That will cause problems for these companies to make their numbers in the next few years unless they have strong Price Risk Management procedures in place.

Implications:

• Some Ag Commodities are now part of the Energy Complex shifting the Demand Curve for Ag Commodities.
• Volatility has dramatically increased for Ag Commodities
• Can CPG companies compete against Energy users for Commodity Inputs?
• Limited pricing flexibility makes CPG companies vulnerable

Analysis:

Comments- Ag Commodities especially corn, now attract new buyers as it becomes an input for the Energy sector as well as an input for consumer products. Soybean Oil will likely join corn with energy ties in the near future.

What this means to CPG companies that use these items is that the cost of the inputs they use will likely be historically higher than in past years. The expectation is that nearly 30 percent of the corn grown in the U.S. will be used to make Ethanol. If that is the case and corn yields can not keep pace, a shortage of corn (a carbohydrate) will force the world to ration the carbohydrates they now take for granted as inputs for their products. Today, there is no better economical use for corn than Ethanol.

The most vulnerable companies are those companies that use Corn as their major input. Companies that have the greatest exposure are those that feed animals. Relatively speaking, Animals (especially beef) are very inefficient converters of carbohydrates into meat.

Wheat will also be involved in this paradigm shift as it must protect itself from a price standpoint from being fed as cattle feed. Therefore, those firms that use Wheat products, especially flour are vulnerable to commodity price hikes.

Finally, very fine CPG Companies that have great brand names have less pricing power than they once did. Big Box Retailers have and will continue to squeeze margins for these high fixed cost companies. In the end the bottom line of companies will suffer as they continually fight for price increases in the face of strong pushback from retail buyers.