Analysis: As costs bite, food makers' margins may drag

NEW YORK Wed Jun 30, 2010 7:14pm EDT

NEW YORK (Reuters) - Rising commodity costs and promotional discounts are pressuring the profit margins of U.S. food companies and more of the same may be on the horizon, analysts said.

General Mills Inc (GIS.N), maker of cereals such as Cheerios, Wheaties and Chex, said on Tuesday the gross margin in its most recent quarter was flat, excluding higher advertising costs and accounting adjustments. Reporting weeks before competitors, it said its margin for fiscal 2011, which began on May 31, would be flat.

Its comments were seen as a harbinger of things to come, especially since its fiscal 2011 earnings forecast missed Wall Street estimates.

"I think 'canary in the coal mine' is a good way to think about it," Janney Capital Markets analyst Jonathan Feeney said. "This is the first company to talk since Wal-Mart's rollbacks."

Earlier this year, Wal-Mart Stores Inc (WMT.N) introduced discounts, which it calls rollbacks, on thousands of items, leading other stores and brands to cut prices.

Discounting is adding to margin pressure for food makers because they are sometimes asked to make up the difference for retailers between a sale price and regular price through "promotional spending."

Judging by the market's reaction, Feeney said, "Many, many people ... were expecting a lot more than this."

General Mills shares fell 3.7 percent on Wednesday on the New York Stock Exchange, while the S&P 500 .SPX lost 1 percent. Kellogg Co (K.N) shares lost 2.8 percent and Kraft Foods Inc KFT.N lost 1.6 percent.

When discussing its margins, General Mills said it had sold a larger proportion of lower-priced goods and cited higher promotional activity. It also forecast higher commodity costs.

"We're projecting an increase of 4 to 5 percent in our commodity and fuel costs next year, after a 3 percent decline in 2010," said General Mills' Chief Financial Officer Don Mulligan. "Key drivers of our 2011 increases are energy, resin-based packaging and dairy."

Edward Jones analyst Jack Russo said he did not think all food companies would see the kind of cost increases predicted by General Mills, though he said price competition was present in many grocery aisles.

"It's happening in soup, in cereal, in dairy. It's happening in a lot of categories, even beyond food," Russo said.

Last week, ConAgra Foods (CAG.N) also reported a flat gross margin.

Barclays Capital analyst Andrew Lazar pointed out in a note to investors that General Mills' margins had improved in recent quarters before turning flat. And, he wrote, manufacturers may be skittish about reducing their promotions, even if other costs continue to rise.

"With a strapped consumer likely to be around for some time, it's unclear to us whether manufacturers will fully relent ... even with some reinflation in the picture," Lazar said in the note.

With consumers combing grocery aisles for bargains and two of the country's biggest food companies reporting flat margins, Credit Suisse analyst Robert Moskow said it was getting more difficult to justify premium stock valuations for the food sector.

"We think investors who seek a relative safe haven should invest in names with better exposure to growth in emerging markets like Kraft, Pepsi (PEP.N) and P&G (PG.N)," Moskow wrote in a research note.

General Mills' flat margin was surprising, Feeney said, because the company has a track record of cutting costs and driving sales with innovation. In addition, he said, the cereal category has seen less discounting than others.

"For this to be the arena for price competition right now speaks to me volumes about ... the kinds of struggles they (other categories) might see in the next year," Feeney said.

"People need to be realistic about food companies' ability to grow their U.S. businesses over the next year and what margins will be associated with that."

But flat or tighter margins for all food companies are not a forgone conclusion, Morningstar analyst Erin Swanson said.

"It depends on the degree to which commodity costs could go up and also the length of time over which promotional spending continues at the same rate," she said. "Both of those will determine what impact you have."

(Reporting by Martinne Geller)

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