Grain prices are set to drop after historically high yields, giving big food producers a chance to expand their margins and bolster their brand. But since those same companies are currently facing low volumes from the 2012 drought, and most analysts haven’t priced in the effects of food deflation, now is a good time to buy, explains Citi analyst David Driscoll.
“The U.S. harvest will produce a record for field crop production, which has resulted in grain inventory replenishment and declining future agricultural prices,” Driscoll writes. “We expect grain and oilseed deflation of 20 percent in 2014, which is expected to drive higher margins and volumes for food manufacturers.”
Deflating food prices can increase profits
The idea that deflating food prices can increase profits seems counterintuitive, but for companies like Hershey Co (NYSE:HSY)’s and Kellogg Company (NYSE:K) food, deflation lowers their costs without seriously affecting the price of their own goods. In general, the more heavily branded a product category is, the more prices will remain steady despite food deflation, leading to higher margins. Understanding this dynamic, large food companies will even overestimate inflation in their forward guidance as a way of keeping prices high.
“It is not unusual for food manufacturers to forecast inflation during years when input costs are down, as they are trying to hold onto as much pricing as they can,” says Driscoll.
Additionally, because large brands are able to maintain their prices during periods of deflation, they tend to divert some of the money saved to their advertising budgets, strengthening their brand and increasing long-term value.
EPS are positively correlated with deflation’s effects
Citi’s valuation of labeled food producers is currently above consensus across the board, partially because other analysts expect that “deflation will serve as a driver of irrational pricing behavior and weak earnings amongst the food manufacturers.” But Driscoll rejects that notion entirely. “Historical analysis on deflation is conclusive and shows that manufacturers’ margins, volumes, and EPS are positively correlated with deflation’s effects – ie, lower costs, drive higher margins and better volumes,” he writes.
With a share price that has recently dropped 8 percent due to falling volume and heavily branded product lines, The J.M. Smucker Company (NYSE:SJM)’s is a good option to take advantage of the deflation that Driscoll expects to start January 2014.