Are food producers feeling pinched?

Unlike food retail, food production is an innovative sector which has enjoyed a huge amount of investment, diversification and change over the past few years. True, share prices for some of these companies have been hit since the start of the year by a combination of the supermarket slump, lower consumer spending, currency headwinds and raw material costs. But overall, the sector is in rude health. So, this week we're delving into the industry to examine the various trends and find out where, if at all, the best value and long-term growth potential lies.

It's accepted that global demand for food is set to rise for at least another 20 years on the back of population growth and rising incomes in developing economies. Of course, that doesn't necessary entail smooth sailing for those in the food business. Global food prices fluctuate and are highly volatile as consumer demand ebbs and flows and economies go through their usual cycles of boom and bust. Already this year, we've seen the price of staple commodities such as milk, sugar, wheat and meat fall significantly - good news for some food producers; but bad news for others. Sion Roberts, of the European Farming and Food Partnerships, explains that while emerging market growth was essential in driving up food prices between 2000 and 2008, a subsequent economic slowdown in these markets has caused prices to move in the opposite direction. However, he believes agricultural commodity price volatility will be a dominant theme for many years to come.

There are several other factors that can affect global food prices, including weather patterns and politics. EU reform of the Common Agricultural Policy and forthcoming abolition of sugar and milk quotas is already having an impact, while Russian import bans on certain foods from the EU and US are also affecting the market. On the UK retail front, food prices are in deflationary mode for the first time in years as the supermarkets go head to head in a bloody price war. All the while, household budgets remain squeezed. Wages might be looking as if they're finally growing ahead of inflation, but it will take a while before consumers actually feel richer. Even when they do, shoppers won't necessarily abandon their frugal spending habits straight away.

So, with lower volumes and prices, it's perhaps no wonder that many food producers have felt the squeeze and that the sector has seen a general de-rating since the start of 2014. Nevertheless, Mr Roberts reckons there are exciting prospects in the industry - helped in part by a 27 per cent fall in the price of Brent crude, which will slash the cost of transport and manufacturing for many food producers. We agree. Although short-term challenges do persist, the sector is stronger, and better positioned than one might think.

Why? Over the past few years, food producers have spent hundreds of millions of pounds upgrading their infrastructure and this has brought down the cost of production drastically. They've also worked hard to diversify their businesses, both in terms of products, customers and geographies, which has helped to ride out volatility. Meanwhile, many producers have rationalised their business models, focusing on core areas of high-growth or value-added, higher-margin products.

The most recent example is Dairy Crest (DCG). Having cut costs, sold a number of freehold properties and offloaded its dairies business, the group is now focusing on its core branded products and the production of highly specialised whey for the fast-growing infant formula market, in conjunction with New Zealand's Fonterra. Hilton Food Group (HFG) continues to invest in its manufacturing, which is now state-of-the-art. Last year it entered Asia for the first time through a joint venture with Australia's Woolworths, perhaps a springboard to the rest of the region. Tate & Lyle (TATE) has had a pretty terrible year, largely due to a slump in the price of sucralose sweetener. But, that aside, the group's speciality food ingredients division is growing strongly, particularly in emerging markets. This high-margin division has been a huge focus for Tate & Lyle and benefited from a great deal of investment, which has helped the group to diversify away from bulk ingredients. Similarly, Associated British Foods (ABF) has admitted that while sugar profits will continue to slump this year, its fast-growing value-added divisions are outperforming, while its retail arm Primark is booming.

Over at pork producer Cranswick (CWK) there's also reason to be cheery. Cranswick's exports have grown 10 per cent year-on-year. Half of these exports wing their way to China, where consumers are prepared to eat cuts Britons aren't too fond off: ears, trotters etc. Chief executive Adam Couch knows that price volatility is a big theme, so expanding geographically is a good way to smooth out the ride, ditto Cranswick's wide-ranging products: from fresh pork and gourmet sausages to handcrafted pastries and charcuterie. The customer base is also diverse. The supermarkets are big clients, but Cranswick has expanded into the fast-growing convenience sector, forecourts and food service providers - from Starbucks and KFC to easyJet and East Coast rail. Most recently, it acquired cooked poultry producer Benson Park, marking a first step away from pigs.

While the overall grocery market remains challenging for ready-meal maker Greencore (GNC), it reported 8 per cent like-for-like growth in the third quarter, thanks to its focus on the fast-growing food-to-go and convenience markets. Previous investment in manufacturing has also brought costs down. In fact, throughout 2013, the group changed its portfolio to build scale and a balanced customer mix. It transformed the US business with a clear focus on food-to-go where it is now benefiting from several recent acquisitions and winning Starbucks as a major new customer. A new sandwich-making plant will soon enable the closure of two existing leased sites in the UK. Major investment in a food-to-go facility in Northampton will facilitate a raft of new business wins. Greencore has achieved all of this despite a weak consumer environment, limited growth among its largest food retail customers and the 'horsegate' scandal. It should also be a beneficiary of lower food commodity prices.

Sausage casings expert Devro (DVO) is in the middle of a massive overhaul of its manufacturing operations. That's impacting profitability, but lower production costs at its plants in the US and China will lead to massive savings - £8m a year in the US alone. It's also decommissioning an inefficient plant in Scotland. Combined, these measures will transform profitability, while lower raw material prices are also good news. Baker Finsbury Food's investment in production lines and automation is also paying off big time, yielding lower unit costs and allowing it to invest in price promotions. And with the 'big four' supermarkets in turmoil, it's perhaps no surprise that chief executive John Duffy told us Finsbury was supplying the likes of Aldi and Lidl and has moved into the world of foodservice and wholesale for the first time through the recent acquisition of Fletchers. Finsbury sees itself as a consolidator in a fragmented market. And, with overheads slashed and a balance sheet in order, we've no doubt there will be more M&A on the cards. To top it all off, lower prices for butter, cocoa and wheat represents great news for Finsbury.

Investors should expect further M&A across the sector, too. On the palm oil side, we reckon MP Evans (MPE) might be snapped up, following New Britain and Asian Plantations earlier this year. Fyffes' (FFY) failed merger with Chiquita was disappointing, but there's reason to believe a similar opportunity might re-emerge and peer Total Produce (TOT) will continue its acquisition-led growth strategy. Dairy Crest is now a prime acquisition target, given its balance sheet, freehold property and renewed focus. Players like Cranswick, Finsbury and possibly Greencore will continue to eye targets, as will Swedish ingredients giant AAK.

IC VIEW:

Supermarket woes certainly should not detract from what remains a robust food producer sector. Many of these companies enjoy a diverse customer base, well-invested facilities, low operating costs and slim overheads. Tate, ABF, Dairy Crest and AAK are focused on high-margin, value-added and highly technical products where barriers to entry are high. Others, such as Greencore, Cranswick and Finsbury are focusing on faster-growing areas of the market. Not only do these characteristics make many food producers better able to weather any volatility of supply, demand and pricing, it means too when the good times come, they'll be highly profitable. The prospect of further consolidation in the sector is always welcome, while some decent yields and strong balance sheets are on offer from some of these stocks.

Favourites:

We like Dairy Crest for the yield, new direction and potential to be acquired. MP Evans is another favourite acquisition target. Devro appears to have bottomed out and profitability should improve following this round of investment. Greencore's exposure to the US and fast-growing convenience and food-to-go sectors is a bonus, while Hilton has the benefit of a new market through its JV brand in Australia, well-invested machinery and a very able management team. Cranswick's shares are rebounding on the back of good trading and its entry into the cooked chicken sector. Finsbury's rating is too low given the acquisition opens it up to a brand new market and makes it one of the biggest players in the sub-sector, not to mention the tasty yield and enviable balance sheet.

Outsiders:

Premier Foods (PFD) might be lowly rated, but its portfolio of branded foods leaves little room for manoeuvre. It also endures serious balance sheet issues. Tate is a great company, but the recent supply chain issues and lack of earnings clarity means we're sitting tight on this one, while enjoying the tasty yield. Total Produce (TOT) was a former successful buy tip, but Russian bans on produce imports from the EU threaten prices - and sentiment.

How the food producers compare