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Food Stocks That Will Weather the Drought

BOSTON ( TheStreet) -- With the U.S. farm belt suffering its worst drought in 60 years, it's inevitable that food companies that rely on corn and grain are going to be hurt, resulting in slimmer profits and higher prices for meats, milk, bread and cereals for consumers.

But that shouldn't scare off investors as buying opportunities will crop up on dips in stocks of some food processers with the fiscal strength and management skills to ride out the drought.

Due to the drought, the yield per acre of corn may hit its lowest level since 1995, the U.S. Department of Agriculture projected last week.

And that projected low supply of corn, which is used in livestock and poultry feed, human food and drink, and processed for use in the gasoline additive ethanol, is moving up futures prices and the prices of end products.

For example, the Bureau of Labor Statistics said Wednesday that the average price of 100% ground beef hit a record high in July, at $3.085 per pound, while prior to June, the average cost had never topped $3.

Sharply higher prices in all grades of beef along with pork and chicken are also on the way, as livestock farmers are sending their animals to slaughter much earlier in the year than usual, because they know that feedstock later this year will be scarce and so pricey that it will be hard for them to turn a profit.

Some food-processing companies will be able to manage through this challenge by using hedges on raw materials prices to maintain profit margins, and also by passing on costs to customers. But smaller firms are likely to have a tougher time implementing those strategies and will likely suffer.

Their prospects for industry players will also change based on other intangibles, such as the length of the drought and the chances that droughts will become a long-term trend brought on by climate change.

But opportunistic investors with good timing have the chance to profit. "This sometimes-boring, sometimes-high-risk industry can sometimes be very rewarding," writes Thomson Reuters' Alpha Now analyst John Kozey, in an Aug. 14 research note. "When the drought finally breaks, that's the moment that investors will want to begin viewing food-processing companies as potential investments -- although their timing will be crucial.

"If you think this drought has staying power, companies that have signs of compressed margins and other hallmarks of a weak balance sheet or other credit issues should be avoided," he said.

Smaller food processors and those most exposed to raw-materials prices are dealing with that prospect now and it is showing up in their share prices. Poultry processor Sanderson Farms's (SAFM) shares are down 23% over the past three months, while Smithfield Foods (SFD), the world's largest pork processor, has seen its shares lose 20% of their value this year.

Even some of the larger firms have been hurt by the anticipation of higher raw-materials prices. One of the largest agricultural-commodity companies, Archer Daniels Midland (ADM) has seen its shares slump 19% over the past three months.

Beef and chicken giant Tyson Foods' (TSN - Get Report) stock has tumbled 23% this year. It reported fiscal third-quarter earnings this month that were off 61% versus last year, and the company lowered its revenue estimate for this year by $1 billion to $33 billion, citing weakening demand for some more expensive products as consumers have become price sensitive.

But Kozey notes that in the past, slumps in Tyson's stock have represented buying opportunities. "Except during the 2008 financial crisis, every spike upward in the price of corn in the last five years gave investors the opportunity to jump into Tyson's common stock a few months later, and to pay lower prices each time -- and generating healthy gains each time. In each instance, a key ingredient was a recovery in the grain markets."

There have also been some worthwhile long-term plays in the packaged-foods industry among its stalwarts, so a dip on price may represent a good buy. Over the past five years, packaged-foods maker Kraft Foods (KFT) has a total return of 44% and cereal industry leader General Mills (GIS - Get Report) has a 58% return.

"The largest food-processing companies, such as Kraft and General Mills, boast the industry's highest operating margins and balance sheets that are (mostly) stronger than those of their peers, (and so) seem to be better positioned to cope with the soaring cost of corn," as their scale and skill in hedging helps smooth out the price bumps and preserve margins, Kozey's report said.

Mid-sized firms such as packaged-foods and meats maker Hormel (HRL) and synthesized corn-products maker Ingredion (INGR), both with operating margins a bit lower than their larger peers, have offered competitive returns to the market and the biggest companies, and may be appropriate for active investors willing to take on risk, he said.

Hormel's and Ingredion's stocks "have trounced the S&P 500 over the past five years, while Hormel's total return topped even that of industry heavyweight Kraft," Kozey said. Hormel's shares have an average annual return of 13% over five years, versus the S&P 500's 2.2%, while Ingredion's shares have returned 5.7% annually in the period.

The reason may be that "both firms have operating margins that are in the high single digits or low double digits, within shouting distance of those boasted by their largest peers," Kozey said. "A little extra margin, it seems, can go a long way in helping to generate returns."

A relative stand-alone in its niche in the food processing industry is the nation's biggest dairy products producer Dean Foods (DF - Get Report). It has so far been little impacted by the prospect of higher feed prices for cows, as second-quarter earnings were strong because its scale has given it the power to pass on higher costs to consumers. Its shares are up 47% this year.

Standard & Poor's offers a mixed view of the food-processing industry's prospects. It says that rising food prices will prompt consumers to buy less expensive products including store brand items, but some manufacturers of higher-priced branded products should be able to maintain market share due to consumer brand loyalty and marketing support from manufacturers.

Longer term, the industry S&P says the industry should benefit from rising standards of living in developing countries, and a shifting product mix to healthier products, which will provide new avenues for growth.

Here are the varied prospects for seven food-processing industry stocks likely to be hurt by the drought, arranged in inverse order of the number of analysts' "buy" ratings:
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