Will Food Companies Get Milked Dry?

The Household Staple Now Costs Almost As Much Per Gallon As Gasoline. Here's How Elevated Prices Could Affect Key Industry Players

Chances are when you last picked up a gallon of milk you noticed that its price has spiked dramatically. According to U.S. Department of Agriculture data, retail prices for whole milk in April, 2007 were at $3.32 per gallon, more than gasoline in some locations. Industry watchers blame higher feed costs for dairy cows, notably because corn is now being redirected to ethanol production. But this also had the effect of driving up demand as well as prices of alternative feeds, not to mention the higher energy costs dairy farmers must pay.

In 2006, rising milk production had the effect of lowering prices paid to dairy farmers. With little incentive to raise output, dairy farmers did not increase the supply. But demand, both domestic and from abroad [for milk and milk products], is now on the upswing and tight markets mean rising prices. The Department of Agriculture's Economic Research Service said in its April, 2007, report, "Milk and dairy product prices are expected to increase through the balance of 2007. Small production increases in 2007 will constrain supply in light of continued growth in demand."

For milk processors that purchase raw milk and other dairy products, higher prices can mean lower profits. Milk and dairy products are an ingredient in many foods, including cheese, chocolate, yogurt, and ice cream, not to mention pizza, coffee drinks, and many other foods and beverages.

Going Organic

Earlier this month, Standard & Poor's equity analyst Tom Graves downgraded Dean Foods (DF), the leading U.S. dairy processor and distributor, to sell from hold. He expects a near-term supply glut for organic milk, rising costs for traditional milk, and higher debt after a recapitalization will lead to weaker earnings comparisons for the rest of 2007.

"I see organic milk as being a relatively small part of Dean's overall dairy business, but a part that has been growing quite fast," he says. Near-term, he expects "promotional spending and possible price reductions will lead to margin erosion in Dean's organic milk business, with the company seeking to protect market share."

Through its WhiteWave Foods subsidiary, Dean sells a variety of nationally branded soy, dairy, and dairy-related products, such as Silk soy milk and cultured soy products, Horizon Organic dairy products, and Rachel's Organic Dairy products. Graves expects a sharp increase in the industry supply of organic milk may lead to expanded retail distribution, helping to stimulate demand in what was already a fast-growing category. Also, a larger supply of organic milk may allow and encourage other dairy companies to introduce or expand other organic dairy products, such as yogurt.

Reduced Intermediate-Term Outlook

Kraft Foods (KFT) is the largest U.S. branded food and beverage company, and the second largest in the world. Kraft was recently spun off from its parent company, Altria Group (MO). Graves has concerns about how the company will offset ingredient cost pressures in 2007. However, he notes Kraft stock trades at a discount price-to-earnings ratio to its peers, and he upgraded the stock to hold from sell in April. "I expect Kraft's results to increasingly benefit from product innovation and more marketing support."

Hershey (HSY) is the leading U.S. producer of chocolate and confectionery products. On May 10, Graves downgraded Hershey to sell from hold. Noting expected near-term profit pressure from dairy costs, Graves reduced his profit estimates. "I still think Hershey's plan for an improved supply chain bolsters longer-term profit growth prospects." But, with what he sees as a reduced intermediate-term outlook, Graves lowered S&P's $54 target price to $50.

Standard & Poor's equity analyst Mark Basham believes Domino's Pizza (DPZ) will be negatively affected by rising cheese costs. "We do not think Domino's and its franchisees have the ability to raise prices unilaterally to offset cost increases, so margins will likely suffer if chief rivals Pizza Hut [owned by Yum Brands, YUM) and Papa John's International (PZZA) do not also raise prices."

Having Your Cheesecake

Yum Brands owns both Pizza Hut and Taco Bell. "Yum has contracted for more of its cheese requirement than Domino's in the short term, so we expect somewhat less effect from rising dairy prices on Yum's margins than for Domino's," says Basham. He notes Yum has good insight into its food costs for 2007, for which it is expecting a 2% to 3% blended increase across all its food commodity purchases for 2007. Basham also notes that Starbucks (SBUX) has contracted for much of its milk requirements, and has budgeted milk cost increases into its guidance. S&P ranks both Domino's and Yum hold, while Starbucks is ranked buy.

Basham also notes Cheesecake Factory (CAKE) has contracts for most of its cream cheese requirements for all of 2007 at prices that are slightly less than it paid in 2006. Graves believes that in the longer term, packaged food industry profit margins are likely to be helped by cost savings accruing from aggressive restructuring actions undertaken by most major companies in recent years.

Growth of Packaged Foods

A number of companies should also see some benefit from higher product prices. "I expect that selective price increases and operating efficiencies will at least help to offset cost pressures in the year ahead." Cheesecake Factory carries a strong buy ranking from S&P.

Longer term, Basham sees the packaged food industry's ability to meet evolving consumer lifestyles and tastes enabling these companies to record higher sales and profits. In addition, "We believe that rising standards of living and increasing world trade liberalization will provide U.S. packaged food companies with more opportunities for longer-term growth."