GLG News by Rick Shea

Implications: Increasing commodity costs are having a negative impact to the growth of organic and natural foods.As commodities increase consumers are being more selective and price sensitive in their grocery shopping.This trend does not bode well for retailers like Whole Foods (WFMI) and the manufacturers that supply items to the leader in the organic and natural foods segment.

Analysis:  Organic and Natural food items already command a hefty price premium vs. their regular food counterparts.As all items increase by 10-20%, consumers are beginning to trade down to lower cost branded and private label items. They are also reducing the number of grocery trips to the high end retailers like Whole Foods.  

For manufacturers like Hain (Hain) and United Natural Foods (UNFI) that get a large percentage of their sales from Whole Foods, this spells trouble for their sales growth.In addition, key retailers like Super Valu (SVU) have just announced the introduction of their own Wild Harvest line of Organic and Natural foods.While the timing may not be optimal for Super Valu, they nevertheless will siphon off some sales from Whole Foods by offering items that are 10-15% less in price and more readily available using the more plentiful locations of their stores.For Hain and United Natural Foods the key to offsetting the lower growth in Whole Foods is through gaining sales at traditional grocers like Super Valu and Kroger. 

  Longer term the positive trend for growth in the Organic and Natural foods will continue.However, for 2008 I would expect tough sales comparisons for Natural Food manufacturers as consumers watch their wallet when shopping for food.    

Implications: Apple once again delivered very strong results in the face of hesitant consumers under recessionary pressures.Total revenue growth for the latest quarter was +36% led by the Mac brand in personal computers at +51%.The MP3 segment led by the I Pod brand delivered growth of +1% while the I-Phone sold 1.7 mm units.   So how is Apple able to deliver consistent sales and profit growth in tough recessionary times with premium pricing while many of its competitors deliver poor results.In a phrase --it's their superior branding strategy.  

Analysis:   A company's brand name is often its most valuable asset.Simply put a "Brand" is a name that consumers associate positive or negative benefits or attributes about a particular product,service or company.Many people think of brands as it relates to the supermarket industry.However, a brand can be more than just a product name.Strong brands can evoke images of dependability " Maytag", safety "Subaru", luxury " Tiffany" or in Apple's case  "cool or hip and technologically superior".  

There are many types of Brand names.You can have a corporate brand name "General Mills" for example (GIS).Most General Mills products have their own individual product brands "Cheerios".The Big G logo is put on most General Mills products to signify trust and consumer confidence.The individual brand "Cheerio's is what most consumers remember.In Apple's case, Apple is the corporate brand with I-Pod being the individual brand.Some companies brand a service or a component of a product "Intel inside".Other companies use an "Umbrella" brand Pepperidge Farm (owned by Campbell Soup-CPB) This where they use the same brand for multiple products(cookies,bread,crackers etc).Umbrella brands are used when marketing funds are tight and the umbrella brand provides instant name recognition to the consumer.However, companies must be careful not to use the umbrella brand for all products.Kraft (KFT) means "cheese" to consumers.Cheese based products under the Kraft brand have done very well.However, when Kraft Foods has used the Kraft brand on other categories (salad dressings,barbecue sauce etc) their results have not been as strong and effective.

Apple's success in the last year is based on two strong strategic moves they have made over the last several years.The first was branding and marketing support behind the launch of the I-Pod.They created a segment (MP3 players) using a very cool, image based television campaign featuring big name music stars to appeal to the image crazed teenager crowd.They provided a good product (not superior in my mind) but correctly branded it and provided a high level of marketing support to cement their image as the only cool MP3 player.I have 3 teenagers and consistently tried to get them to settle for the less expensive Sansa brand (Sndk) but was told it was an I-Pod or nothing.Apple created a value added difference vs. their competition (image) based primarily on advertising and "Branding". 

  Secondly, they followed up that success by supporting their Macintosh line of personal computers and highlighted the ease of use vs. the Vista operating system and other computer manufacturers.Their recent quarterly results for Mac's +51% shows this effort has also delivered.Consumers have bought into their branding efforts for Mac's -- they are easier and simpler to use and also more cool than traditional personal computers from Hewlett Packard and others.In this situation Apple,also benefitted from what's known as the "Halo" effect.In advertising terms this is when when one product or brand from a company benefits in sales from a 2nd product or ad campaign from the same company.The I-Pod has had a halo effect on the Macintosh brand by bringing in younger,more image conscious consumers.The I-Pod brand has also provided some of this same "halo effect" to the I-Phone. Consumers clearly know that all 3 products are made by Apple (the corporate brand) and this translates to consumers believing Apple's products are more hip and technologically superior than competitive products.  

The benefits to Apple as company for this superior branding strategy are immense.It provides a fantastic platform for future new products.Consumers will constantly seek out their new products and view them as the next generation with a cool image and technological superiority,It will also provide them with superior pricing power over the long term.This means that Apple will continue to lead and deliver above average sales and profit growth.As in consumer food products a superior brand name is worth its wait in gold.   

Implications: With ever rising commodity costs food companies that have hedged their key commodity purchases with forward buying have done quite well over the last year.Several key manufacturers have announced that they have hedged their raw materials by forward buying 60-70% of their 2008 needs.Lost in the discussion has been the potential for commodity prices to go down in the latter half of 2008.

Analysis: As with any commodity like oil and precious minerals,speculators have the ability to drive up prices in the short term.General Mills reported a strong quarter recently with a substantial gain being delivered because they hedged their commodity purchases at favorable prices.

However, investors and companies need to realize that hedging can be a double edged sword if commodity prices drop.In the oil market experts estimate that around $20 per barrel of the price is due to speculators.That same phenomenon may be occurring in the grain and other food commodity markets.

For food companies its important that they lock in the raw materials so they have ample supply of the commodities they need to produce their products.However, they should not be in the business of trying to book additional gains based on commodity speculation.It will be interesting to see in the 2nd half of 2008 if commodity hedging is still a hot topic. It may be, but it could have the potential to be a drag on food companies earnings not a benefit.Commodities are very volatile lately and have as much potential to go down as their potential to go up.

Implications: Kraft and Sara Lee executives recently spoke at analyst conference concerning their recent improvements to drive sales growth and improve operating margins.Both suggested the progress is real and sustainable.   Kraft highlighted new products and headcount reduction as keys to their progress.New products are clearly needed and our key to drive future sales growth.The job cuts they mentioned are real and should help them provide a lower cost basis to expand marketing and potentially improve margins at the same time.  Sara Lee also touted new product innovation and organizational restructuring as means to improve their growth and enhance profitability.Pricing is also key at both companies as they face strong headwinds in the face of commodity inflation.  Do we believe both CEO's assertions and are better days ahead for both companies ?

Analysis: As a former Director of Marketing at Kraft and VP of Marketing for one of Sara Lee's main rivals in the bakery industry I have mixed thoughts on their CEO's proclamations of better days in the future.
 I believe Kraft is making progress to achieving increased sales growth through new products and reinvesting in their brands.Their sales growth is up but operating margins have yet to improve.The headcount reduction will take time to flow through the P&L yet they are investing in their brands to grow now.This is the right strategy and will pay off over time.The key question is still can they fix the cheese division and keep it from pulling down overall profits and sales.
 I am a bit more skeptical about Sara Lee's assertion that a turnaround is imminent.Grain prices are still killing baking margins and no end appears in site.Sara Lee has a much leaner operating staff so headcount reduction and regorganizations will only go so far.They also have much stronger competition in baking and their other segments and their brands do not command premium pricing.
 I believe Kraft will improve over time and their strategic decisions are correct.I do not think the same will occur for Sara Lee and their profits and sales growth will continue to suffer.

Implications: As commodity prices increase, food manufacturers will be required to pass on higher raw material costs to their consumers.Over time these higher prices will put pressure on premium priced branded products and shift share to private label and value brands.Will this same pressure apply to retailers and hurt overall category sales ? Which retailers will benefit the most? Which retailers will be hurt on sales volume ?

Analysis:   Food retailers will not be as impacted by rising food costs in the same way that food manufacturers will be hurt by rising commodity costs.In the short term it will actually benefit most retailers as the total basket ring on shopping trips will increase.Retailers make money based on margin so rising food costs are a good thing for them in the short term.
 However, there are still many challenges that retailers will face.Consumers will tend to trade down to private label products and more value priced items.They will also tend to buy less higher margin impulse items.Consumers will also plan their shopping trips more diligently cutting down on frequency of trips in favor of large stock up purchases.
 These behaviors to rationalize their food shopping will benefit key discount retailers like Walmart,Costco,Target and other large discount food centers.It will likely hurt the neighborhood grocers like Kroger,Safeway & Super Valu.High end organic/natural retailers like Whole Foods will also suffer as consumers pare back their purchase of premium organic and natural foods.
 While this behavior and shift is probably only temporary it will amount to some changes to sales targets for select food retailers in the first half of 2008.Longer term I expect commodity prices to stabilize at only slightly above average inflation levels and retailers results will revert back to how well they execute and provide consumers with a pleasant shopping experience with good value prices.

Implications: Commodity prices continue to rise driving prices higher in the grocery aisle.Wheat ,corn,dairy and oil prices continue to climb creating a very challenging environment for food manufacturers and retailers.The rising prices begs the question of who will this benefit and who will this hurt over 2008 ? There are several distinct categories of companies that rising food costs will impact: --Branded Food Manufacturers (Kraft,General Mills,Kellogg's etc) --Value Food Manufacturers (Private Label producers,value priced branded companies) --Restaurants and Foodservice manufacturers --Grocery Retailers

Analysis:

Lets start with the branded and value food manufacturers.Rising costs means price increases across the board for most manufacturers.As price increases are pasted on, consumers will begin to shift their purchase habits to buying lower priced alternatives (private label,value brands) and to buying more food on deal.This will put tremendous pressure on the premium branded products made by Kraft, General Mills etc. However will it truly benefit private label manufacturers and value brands ?

 Lets look at the cereal category as an example.Kelloggs raw material cost per box of cereal is roughly 24%,General Mills 22% and private label and value brands at over 30%.As commodities rise its actually the private label and value brands that get hurt the most in the short term.The key is the ability to pass through price increases quickly to offset the margin hit.Here the branded items have an advantage because private label pricing has to be approved by the retailer and most private label pricing has definitive price contracts for set time periods.
What this means is longer term the private label products will benefit with share growth but margins will be significantly pressured in the short term.

Stay tuned for more on its impact to food retailers.

Implications: Large consumer packaged goods companies are finally waking up and embracing the volume opportunity in Organic and Natural Foods.For years ,most of the top selling products at Whole Foods and other Natural stores were made by small manufacturers.Large CPG companies were not quick to offer products because the volume was still small and there are greater difficulties in the manufacturing process to produce Natural and especially Organic products. Times are changing with many key retailers now starting to embrace Organic and Natural Foods.If their retail customers want these products its important that the large CPG companies offer them as part of their product portfolio.

Analysis: Organic foods and Natural foods have now gone mainstream and as such we can find product offerings in almost every food category.Whole Foods sucess has caused many upscale chains to embrace Natural and Organic foods to their customers. Target, Super Valu , Kroger and many others all offer Natural and Organic alternatives. If its gone mainstream then how come Walmarts initiative in Natural & Organic was unsuccesful ? Simply put ,lower income shoppers have not embraced Organic & Natural foods because of their higher cost.However, more upscale retailers like Target, Byerly's/Lunds,Publix, Whole Foods and many others have all done well with these items and they will continue to grow.

Implications: The recent article on Interstate Bakeries bankruptcy hearings now officially puts the company in play.IBC struggling from high plant and route costs and the unprecedented rise in flour costs has been attempting to emerge from bankruptcy.IBC Management has stated that their proposal values the company at  a value of at least $580mm.Yucaipa and Bimbo (Mexican bread retailer and owner of the Oroweat brand) have formed a group to propose an alternative deal.The result has been to effectively put IBC up for sale to all competing companies.

Analysis:

 The baking industry has been due for consolidation for several years.Too many manufacturers and rising commodity costs have hurt all companies profit margins.So is this latest news the start of a bidding war for Wonder bread and IBC ?
 There are several companies that would be logical candidates to acquire IBC. First, Yucaipa and the Bimbo consortium has already expressed a strong interest and have the inside track due to their discussions with the powerful Teamster union.However several other players should also be considered.George Weston Foods( owner of Loblaws the largest Canadian retailer) also owns the Entenmanns, Thomas,Arnold/Brownberry,Freihofer & Stroehmans brands of bread cakes & bagels.Sara Lee is also a top bread maker and would be a good fit.Lastly, don't forget Flower's the owner of the Nature's Own breads in the Southeast.

All four companies have the size and resources to make a bid for IBC and have the ability to successfully integrate IBC's brands and products into their organizations.I also believe that all four companies will provide a better alternative than IBC staying independent.

Rick Shea is a former Vice-President of Marketing for George Weston Foods

Implications: Ralcorp's potential pucrhase of Post cereals for $2.8 billion dollars will shake up the cereal category and provide another stronger competitor to General Mills and Kellogg's.The winner will be Ralcorp if they can successfully integrate Post and leverage their brands to strengthen their private label sales.The losers will be Malt-O-Meal and Quaker as both brands will be under further pressure in a consoildated category.  For Kraft Foods it means their divestiture strategy will speed up and provide them additional dollars to pursue acquisitions.Kraft's growth startegy is predicated on shifting their portfolio to focus on more international growth and focusing on the key snacks,beverages and possibly confections in markets outside the US.

Analysis:  As a former VP of Marketing for Malt-O-Meal cereals and former Director of Marketing for Kraft its interesting to see these widely different companies potentially come together.Kraft Foods is the classic marketer with heavy focus on brands and advertising.Ralcorp has a wide variety of private label offerings in many categories.They do very little classic brand building or marketing and rely on relationships with key retailers to drive volume and profit.
At first it would seem an odd fit but clearly Ralcorp has a strategy that brings the two companies together.Time will tell if the marriage can produce strong results.

Implications: Wheat prices are up 100% in 12 month's. Dairy prices continue to climb, increasing the costs of most food manufacturers.Is this a temporary phenomenon or is food inflation here to stay ?  Both Kellogg's and Kraft have provided disappointing guidance in the last few weeks blaming wheat and dairy along with other commodity prices as the chief culprits.Does this mean all food companies will underperform for the next year or two ? What companies are best positioned to withstand the increasing cost pressures ?

Analysis:   I firmly believe that not all food companies will be affected the same by rising commodity costs.Increases in raw materials have occurred forever in the food industry and there are many ways to offset rising producer costs.Some companies like Unilever,Nestle & Campbell Soup are less impacted by wheat & dairy price increases.Others have more room to take pricing and to improve productivity in their operations and sales systems to offset rising prices.Lastly, commodity increases impact all food companies so raising prices has never been more easy because all food companies have to raise prices.Ever try to take a price increase into the Walmart buyer ? I have and its never been pretty.This time around the Walmart buyer will shrug and ask when will it go into effect.
 The fact is commodity prices hurt private label manufacturers and price competitors with less known brands more than they do the major brands.The major food companies have the ability to grow share or maintain profits within this environment.The tough part is deciding which one profit or share is more important !

Implications: Commodity cost increases (wheat,corn,oil,sugar) are causing havoc with food and CPG companies bottom lines.The significant upward pressures of wheat (+100% latest 12 months) specifically impact all cereal,baking, pasta and many other food companies profits. The key questions surrounding these increases include: 1) Are companies able to take pricing to offset this increase in costs? 2) What companies will benefit the most and be hurt the most by rising commodities ? 3) What impact will it have on consumer sales if companies pass through the cost increases? 4) What % of their total P & L is tied to commodities and can they offset the increases with savings and productivity in other places ?

Analysis:

CPG Food compnaies are facing the most difficult commodity inflation in the last 20+ years.Wheat,corn,oil and other basic ingredients are at multi-year highs.The two most likely culprits are ethanol and International demand.The key questions are will it continue and how will companies offset the rising costs without destroying their bottom line or destroying sales of their products.
 As an industry veteran in the baking and cereal segments pricing pressures is not new.However,the scope and size of the commodity increase particuliarly wheat is unprecedented.Companies have used hedging and price increases to try and minimize the impact to their P & L but these solutions can only go so far to cover some of the commodity inflation.

 To understand the impact to the companies earnings you need to understand the cost structure and other variables that make up a CPG companies P & L.Obviously,sales volume and the impact pricing increases have on volume is the largest and most relevant variable.But their are many other line items such as trade spending,fixed manufacturing costs,sales and distribution and consumer spending that also can influence both top line and bottom line.

 Companies in the cereal and baking segment are being hit the hardest.How they respond and utilize all components of their P & L will determine if this is a temporary hit to their bottom line or whether it will impact their profits for years to come.

Implications: Interstate Bakeries and its unions are locked in a negotiating stalemate  over employee jobs and compensation.Specifically, IBC's management is looking for job cuts and lower costs from the unions to make the company more cost competitive.The unions obviously are seeking to minimize impact on its members and disagree with IBC's strategic plan to reorganize the company.The results will likely determine if IBC can survive and exit bankruptcy.

Analysis:

Interstate Bakeries reorganization plan is in severe jeopardy based on their inability to gain concessions from its key unions.A significant cost saving program is required to save Wonder bread & Hostess cupcakes from being sold at thrift sale prices.Competitors Sara Lee,George Weston,Flowers and Bimbo Bakeries (Oroweat) have been stealing share from Wonder bread the last few years and this will likely continue.

Many things have gone wrong for IBC the last few years and there's plenty of blame to go around for all parties.Management was too slow to innovate and provide volume building new products.IBC' cost structure both in manufacturing and route systems is the high cost supplier within the industry.The bakery business has too many suppliers and is in serious need of consolidation.Raw material costs continue to increase hurting already thin (or in IBC's case) or non existing margins.

The next 60 days are crucial for IBC's long term survival.No agreement with the union will likely mean possible sell off its brands and assets. A weak agreement that drives some cost savings will likely mean a continued slow death.Only with radical changes and large cost cuts will they be able to save IBC's brands from being sold at thrift outlet pricing. 

Implications: Kraft Foods has reported some progress in their recent quarterly earnings but the jury is still out on whether they can show sustainable sales and growth.Kraft has underperformed its food company peers over the last few years primarily because they have gotten away from what made them successful: new products and innovation and world class marketing.  If you look at what's been successful in the last few years in CPG food its been competitors & retailers embracing the natural & organic food trend and stronger focus on catering to the alternate channels (Walmart,Target,Warehouse clubs and even drug & convenience stores). Kraft has yet to devise a strategy that taps into these growing segments and growing customers.Until they do any volume growth will only be temporary and will be unsustainable. 

Analysis: Alot of attention has been focused on Kraft divesting some of its non strategic businesses.The real issue is how are they going to generate sales growth in their mature and large divisions like the Cheese & Dairy Group,Beverages and Convenient Meals.The Cheese division has sorely lack new product innovation and impactful marketing.The Beverages group continues to be hurt by the sheer size of the coffee segment and its commodity type category.Convenient meals has struggled primarily because of Oscar Mayer.
New Products and better marketing are required to move sales growth in these large underperforming divisions.