Premier Foods is set to feel the squeeze

The Bisto gravy, Homepride sauces and Ambrosia custard maker said last month that trading profits for the year would be 10 per cent below expectations. The shares dropped as much as 15 per cent on the day, but we feel there could be further to go given the confluence of factors working against it.

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Like many consumer-facing businesses, costs are rising for the company. It has been hit by short and sharp rises in soft commodity prices, including sugar, chocolate, milk, wheat and palm oil. Broker Davy points to sugar prices rising over the past 12 months by 28 per cent in euros and 45 per cent in sterling, with the post-Brexit drop in the pound exacerbating the pain.

There are two main ways businesses can deal with this: cut costs or raise prices. Premier Foods is going to give it both barrels. The group announced a £10m cost-saving programme for its financial year ending in 2018 and expects equivalent further savings the following year.

That's fine, but pushing through price rises without sacrificing volumes and higher-margin branded sales might be an issue. The group has been widely reported as saying prices might have to increase at a mid-single-digit percentage rate and a trend in its third-quarter update potentially highlights the pain this could cause. At group level, for the nine months to 31 December, branded sales, which make up four-fifths of the total, dropped 3.7 per cent, while non-branded sales rose 10.7 per cent.

To further illustrate this point, the group sold more than 216m mince pies in 2016, which was a 17 per cent rise on the prior year. But, some of the volume manufactured switched from Mr Kipling (branded) to non-branded versions it makes for customers, including supermarkets. If some customers are trading down to own-brand versions already, price rises have the potential to make them do so more.

Another issue for the company is a change in the way supermarkets are approaching promotions. A reduction in multi-buy promotions, such as buy one get one free, is expected to weigh on volumes through to the summer, although the group is developing multipack ranges to try to mitigate this.

Pressure on trading could also squeeze the amount of cash the company generates. Davy already expects free cash flow to drop from £65.5m to £22.7m this year. The situation has not been helped by a jump in payments to plug a whole in the pension between now and 2020. First-half deficit contributions rose £26.1m to £32.1m and total cash outflows for the year are expected to be between £54m and £56m. This is a particular concern given net debt stands at 3.6 times cash profits, although Premier managed to satisfy covenant tests in April and October last year.

Premier's tie-up with Japanese company and 20 per cent shareholder Nissin Foods could provide some cause for optimism. A Soba noodle product should be hitting shelves this month. There's also the prospect that management has been conservative on its potential cost cuts and finds further fat to trim. But there's still a lot going against the business and its worth noting that Paulson & Co, run by famed hedge fund manager John Paulson, dropped his holding in Premier from 63m shares to 16.5m in one trade in November. Meanwhile, BlackRock initiated a small short position on the stock on 31 January, highlighting that pessimism persists even after the bad news of a profit warning out there.