Most food companies, like Kraft Heinz (KHC -0.55%) and J.M. Smucker (SJM -1.37%), have been struggling with higher costs. Some of these rising costs are passed along to consumers in the form of higher retail prices; others aren't. It's a fine line to walk.
There's an important shift underway, though. Food commodity costs are coming down, while retail food prices are holding relatively steady. That means precisely what you think it means: The industry's profit margins are on the verge of improving more than they have already.
Subtle signs that cost pressure is abating
We caught a brief glimpse of this dynamic in Kraft Heinz's first-quarter report posted in May. Organic net sales were up 9.4% year over year, driven by a 14.7% increase in prices. Gross profit margin correspondingly improved 62 basis points to 32.8%.
Were it just Kraft Heinz, it might be dismissible. It's not just Kraft, though. Campbell Soup (CPB -1.15%) is telling the same basic story. Its fiscal third-quarter sales improved 5%, led by what it called "favorable net price realization."
J.M. Smucker said the same about its recently ended fiscal fourth quarter, citing price increases for the bulk of its 11% sales growth. Gross profits are starting to bounce back from their steep contraction suffered throughout the pandemic.
KHC gross profit margin (quarterly); data by YCharts.
The gathering tailwind is more than just a couple of quarters of declining costs and persistent pricing power, however. The beneficial cost trend is much bigger than that.
Less-subtle signs that food companies' costs are coming down
For perspective, there's the Bureau of Labor Statistics' producer price data. Unlike the consumer inflation rate, which measures retail prices you pay at a store, producer price inflation measures input costs for a variety of industries. The interest here are food companies' costs.
With that as the backdrop, a look at the producer price indexes for several of the food industry's most important commodities shows that they've been falling since the middle of last year -- in many cases reaching multi-month lows just last month.
Data source: Bureau of Labor Statistics. Chart by author.
Believe it or not, you're seeing some of these savings passed along. While most grocery prices remain shockingly high and others are still drifting higher, a handful of goods cost less now than they did a year ago. Eggs, for example, are much cheaper than they were as of the end of last year.
By and large, though, the prices consumers are paying for food are higher than they've ever been. It's just the pace of the price growth that has slowed.
Data source: Bureau of Labor Statistics. Chart by author.
Surprised? Maybe even a little irked? That's understandable.
Before becoming too frustrated as a consumer, though, think like an investor as well. This tale of two different trends ultimately translates into wider profit margins, something we've already seen glimpses of in quarterly reports. Here we're seeing even clearer evidence that the industry is enjoying lower costs but not being forced to give up pricing power.
And commodity prices are expected to continue falling, leading to even stronger profitability ahead. As another example, the U.S. Department of Agriculture expects strong crop yields to drive corn prices back to just above levels seen between 2015 and 2019, where they should stay for at least a few years. Hog prices are projected to continue falling as well, and remain flat all the way through 2032 on improved supply.
A multiyear dynamic worth tapping into
This dynamic won't be permanent. There will come a time when food commodity prices are fighting their way higher again. There will also come a time when food companies like Campbell and Kraft Heinz choose to wage a price war. Both are cyclical forces, coming and going in perpetuity.
These cycles are measured in years, however, suggesting shareholders can expect these companies to maintain above-average profit margins for long enough to matter.
And we have seen the packaged food industry capitalize on the very same circumstances in the past. When food price wars were finally coming to a head in 2016 following a streak of price increases going all the way back to 2012, rather than lowering its historically high prices, J.M. Smucker went in the other direction. In an effort to maintain its newly widened margins, it opted to lay off employees and cull other costs.
Smucker was hardly alone, though. Kraft Heinz was already doing the same as part of a major restructuring that was ultimately meant to preserve and even widen profit margins.
As tough this might have been to do, it was arguably the best possible long-term option for investors. It's difficult enough for food companies to raise retail prices once. To lower them only to re-raise them later runs the risk of alienating a wide swath of their customer base.
You can plug into this bullish dynamic with any of the three aforementioned stocks. In this particular instance, there's a case to be made for owning a smaller piece of all three.
