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Thursday, October 29, 1998

An Investment Opinion
by Alex Schay

Food for Thought

Hershey Foods Corp. (NYSE: HSY), maker of popular Halloween "treats" like Mr. Goodbar, Jolly Ranchers, Twizzlers, Hershey's Kisses, and Reese's Peanut Butter Cups, was left in investors' back pockets today, melting $13/16 to $66 5/16. Today's move came on the heels of a Merrill Lynch downgrade to "near-term neutral" from "accumulate," while Warburg Dillon Read reiterated its "sell" rating. Hershey's shares dropped 6% yesterday on a warning that increased milk prices and other costs may hurt the firm's Christmas season and Q4 results.

Earnings concerns have plagued both Kellogg (NYSE: K) and Nabisco (NYSE: NA) over the last couple months, while Bestfoods (NYSE: BOF), Ralston-Purina (NYSE: RAL), and Wrigley (NYSE: WWY) are all beset with questions surrounding their international exposure. These and other "scientifically formulated" bits of evidence about languishing food stocks have this columnist wondering whether or not things are getting stale in the packaged foods business (always keeping an eye out for good businesses available at cheap prices)? I know, I know, it's not a very profound question, and generalizations about the brand name packaged food companies are dangerous -- but here's what I dug up today. (It's more interesting than you might think.)

Taking a look at the popular S&P Foods Index this year, it's clear that investors are facing something new in the segment:

S&P Foods      Return
(year to date)
'97-'98 11.42%
'96-'97 31.91%
'95-'96 21.20%
'94-'95 20.61%

The capitalization-weighted index is composed of the following companies -- displayed along with their relative weightings:

Bestfoods   6.993%    Campbell Soup  11.066%
Conagra 6.693% General Mills 5.057%
Heinz 9.447% Hershey Foods 4.280%
Kellogg 6.047% Quaker Oats 3.724%
Sara Lee 12.587% Ralston-Purina 4.424%
Unilever 21.496% RJR Nabisco 4.122%
Wrigley 4.279%

For those who might be dubious of what seems like a Unilever Index, the company has indeed accounted for a sizable chunk of the overall gain for the index, which has appreciated almost 40% over the last year. Hence, the results for the index over the last year minus the returns from Unilever are more on the order of a 7% gain. An expanded group of 28 companies -- including all of the above with the exception of Unilever and RJR -- tracked by Merrill Lynch (research now available) actually declined 8.9% from the beginning of the year until the end of September. For Merrill analysts the segment looks cheap at 20.6 times their cumulative 1999 estimates, which is a 14% discount to their lowered S&P 500 multiple to earnings of 23.9 times.

Similarly, Lehman Brothers stated in the most recent issue of The Wall Street Transcript that its universe of packaged food stocks was trading at about 23 times 1999 numbers and 12 times enterprise value to EBITDA. Furthermore, the index traded (at the time of publication) at a 9% premium to Lehman's S&P estimates, which Lehman noted is toward the low end of its historic range (which stretches from parity to a 35% premium). So, all this -- albeit not very timely evidence -- seems to point to some unusually negative investor sentiment toward the segment, at least in terms of recent history. (Let's not go back to early in the decade.)

So what's going on? Here are some of the contributing factors to the current outlook: (1) the unprecendented amount of consolidation going on in the retail portion of the segment, which somewhat clouds near-term earnings visbility as synergies are worked out; (2) the lack of volume growth; (3) the lack of pricing power; and finally, (4) the fact that cost savings have been driving bottom lines (roughly 60% of the earnings for the ten largest) and that savings generated from restructurings might be drying up. Without being too flippant here, it can be safely said that the large capitalization packaged food companies have seen declining volume growth and a lack of pricing power for most of the decade. Fast growing, "price making" earnings are not what investors have been buying into, but rather, steady free cash flow and predictable earnings (even when based on cost cutting).

Consider the following data from Standard & Poor's. In years where S&P earnings decline, food company earnings hold steady. In 1981 and 1991, GDP growth was crummy and the S&P 500 came in with negative results for the year. Despite these factors, the well-worn cliche about people having to eat bears out in the relative stock outperformance numbers.

     Growth In  Growth In  Real    Stock Price Performance
S&P 500 S&P Food GDP S&P S&P Relative Stock
Year Earnings Earnings Growth 500 Food Outperformance
1975 (10.5%) 15.4% (0.8%) 31.6% 48.3% 16.7%

1981 3.6% 8.8% 1.8% (9.7%) 20.9% 30.6%
1982 (17.7%) (3.1%) (2.2%) 14.8% 32.9% 18.1%

1985 (1.7%) 4.1% 3.2% 26.3% 59.8% 33.5%
1986 0.9% 26.4% 2.9% 14.6% 4.9% 20.3%

1990 (4.3%) 19.1% 1.0% (6.6%) 8.6% 15.2%
1991 (10.3%) 19.7% (1.2%) 26.3% 32.6% 6.3%

None of this answers the question of whether or not some good businesses can be had for cheap prices, but it's definitely food for thought. Investors can begin by taking a look at the companies in the S&P 500 Food Index -- which all have been looked at in some way, shape or form on the Motley Fool site (especially the Drip Port). Considering that the majority (80%) of the fluctuations in the market's valuation of these companies can be explained by the cash returns that they earn over their cost of capital (according to CS First Boston Data tracking enterprise value/invested capital multiples as a function of ROIC/WACC spreads), it would be interesting to take a look at what's baked into some of these low-teen ROIC companies.