Analysis: Soaring wheat costs may turn grocery prices higher

NEW YORK Fri Aug 6, 2010 2:23pm EDT

Canadian wheat grows in a Manitoba field in a file photo. REUTERS/Shaun Best

Canadian wheat grows in a Manitoba field in a file photo.

Credit: Reuters/Shaun Best

NEW YORK (Reuters) - A severe drought in Russia could result in higher prices for bread in U.S. stores, as a spike in wheat costs may lead manufacturers to ease up on the discounts retailers pushed for during the recession.

But consumers and retailers may push back. Shoppers could opt for cheaper options as unemployment remains high, while retailers -- who try to drive traffic with discounts -- could point out that the spike in wheat is no where near the level of two years ago, when manufacturers raised prices on many goods.

Russia, one of the world's biggest exporters of wheat, is enduring its worst drought in 130 years, sparking a temporary ban on exports and sending U.S. wheat prices soaring.

If prices do not retreat, food makers such as General Mills Inc (GIS.N), Kellogg Co (K.N), Kraft Foods Inc KFT.N and Sara Lee Corp SLE.N may need to raise prices on bread, crackers and cookies to protect their profit margins.

"If this persists, you could see promotional spending get ratcheted back," said Morningstar analyst Erin Swanson, referring to the money manufacturers spend to fund temporary price cuts or deals when certain items are purchased together. An easing of promotions can amount to an increase in prices.

"Then the question is, what happens to volume," Swanson added. "Consumers have become more accustomed to buying on promotion and weaning them off of that might be difficult given the uncertain economic environment, especially domestically where unemployment levels remain elevated."

Earlier this week, Clorox Co (CLX.N) announced a 5 percent increase in the price of its Glad trash bags to make up for higher resin costs, while J.M. Smucker Co (SJM.N) raised prices on most of its Folgers and other coffees by 9 percent to make up for higher coffee prices. Kraft Foods Inc KFT.N also raised prices on select Maxwell House and Yuban coffees, a spokeswoman said on Friday.

Wheat is a relatively small cost for Kraft, compared to sugar or cocoa, but the company expects higher commodity costs overall may contribute to easing promotions.

"I think, particularly with rising input costs, that it is conceivable that the aggressive promotional activity that we might have seen in the first half of the year will moderate slightly," said Kraft Chief Executive Irene Rosenfeld in an interview late on Thursday.

For companies such as General Mills, maker of Cheerios and Pillsbury baked goods, and Kellogg, maker of Mini-Wheats and Pop-Tarts, wheat is only 3 percent to 5 percent of their total cost of goods, said Edward Jones analyst Jack Russo, with labor, packaging and freight making up the bulk.

Still, Russo thinks food makers and restaurants will raise prices, especially if wheat costs remain high and outlast the hedges companies put in place as a shield from market volatility.

He added that increased demand from emerging markets could also help sustain a rally in commodities and that it could ultimately affect deal-making in the food sector.

"If you're a buyer, you better be looking at things like that," Russo said, noting that a spike in wheat costs could complicate any potential sale of Sara Lee's bread business.

Sara Lee is quietly seeking buyers for its bread unit, but has not launched a formal auction, sources said last month. Sara Lee at the time declined to comment.

SUPPLY AND DEMAND

U.S. wheat futures on the Chicago Board of Trade fell 5 percent on Friday after surging more than 20 percent earlier this week and nearly doubling since early July to $8.41 a bushel.

Futures prices also remain well below the spike of 2008, when world and U.S. wheat stocks were much tighter and prices rose above $13 a bushel. In the 2007/08 marketing year, the U.S. wheat stockpile fell to its lowest since the 1940s, while world wheat stocks fell to a 26-year low following crop shortfalls in Europe, North America and Australia.

Demand for corn due to the expanding ethanol sector added to the spike in grain prices that year that led to inflation across a host of grocery store aisles.

Now, the spike has more to do with opportunistic trading than a wheat shortage, said the American Bakers Association.

"This price increase does not suggest that there is an issue of availability of U.S. wheat for U.S. bakers and consumers," the trade group said in a statement on Thursday.

"Due to the large U.S. wheat crop this year, supplies will be ample, however the price could remain high," it added, citing volatility from "the presence of index funds that treat wheat futures as an asset class rather than an exchange in which actual users and producers mitigate their price risk."

Tom Graves, a Standard & Poor's equity analyst covering packaged food makers, said existing wheat inventories will help buffer the food industry from any significant erosion in profit margins, along with ongoing cost-savings.

"While the recent spike in wheat costs can certainly be viewed as unfavorable for food manufacturers, it's not sufficient, in the greater scheme of things, for me to feel like the overall investment outlook ... in this area has changed," Graves said.

He affirmed his "strong buy" opinion on General Mills shares on Thursday.

General Mills shares have fallen 5.8 percent since the end of June, while bakery company Flowers Foods Inc (FLO.N) is down 4.4 percent. But shares of Post cereals maker Ralcorp Holdings Inc RAH.N and Sara Lee are up over the same period.

HEDGING THEIR BETS

General Mills and Kellogg both expect commodity and input costs to rise 4 percent to 5 percent this year. Kellogg, which reported quarterly results on July 29, had earlier forecast a rise of only 3 percent to 4 percent. It cited higher prices for sugar and packaging and said it was about 90 percent hedged on commodities for the rest of the year.

A Kellogg spokeswoman declined to comment on wheat.

General Mills gave its forecast on June 29, before the steep spike. Since then it has not issued any new forecast and a company spokeswoman declined to comment.

Campbell Soup Co (CPB.N), maker of Pepperidge Farm bread and Goldfish crackers, said it sees the wheat spike as a short-term event that will not impact its promotion plans.

"Because of our hedging strategy, the impact of spot wheat prices has little impact versus our plan. There is plenty of actual supply in the market, so no shortage is forecast that would create potential long term issues," said Campbell spokesman John Faulkner.

(Reporting by Martinne Geller; additional reporting by Julie Ingwersen in Chicago; editing by Andre Grenon)

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