Gorging in America: Packaged Food Stocks Start to Look Expensive

Kraft, Hormel and others have held up through the downturn, but their lofty valuations may not last.
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One of the unforeseen consequences of the economy's deterioration hasn't been widespread starvation among Americans -- a visit to your local food court will confirm that.

That's the philosophy of Kari Bayer, a quantitative strategist at Merrill Lynch. Her firm has been overweight consumer staple stocks, which include food, beer and tobacco, for about a year now -- and it's paid off. In the second quarter, for example, the S&P Packaged Food Index showed earnings growth of 9%, while

S&P 500

earnings dropped 20%.

"Food stocks have outperformed the S&P 500 during four out of the last five profit cycle decelerations," said Bayer. "In those times, you want stable earnings growth sectors." Chew on this: Since the beginning of August, the food group is up 6.4%, while the S&P 500 is down 6.6%.

For the past 18 months, it's been good to be a food investor, as takeovers have put premiums on several stocks, such as Keebler (bought by

Kellogg

(K) - Get Report

), Quaker Oats (bought by

Pepsi

(PEP) - Get Report

), Bestfoods (bought by

Unilever

(UN) - Get Report

) and Earthgrains (accepted bid by

Sara Lee

(SLE)

.) But industry experts don't expect much more consolidation.

In addition, there is a growing belief that packaged food stocks are getting pricey. "A weak economy and consolidation in the industry havedriven the stocks up lately," said John McMillan, a research analyst at Prudential Securities. "But valuations are high, and there aren't many bargains left."

On Aug. 16, McMillan downgraded shares of

Hormel Foods

(HRL) - Get Report

, for example, noting that the company has had a big price move over the past few weeks and was beginning to look expensive. The stock is up 39% so far in 2001, and 36% higher since the beginning of April. Hormel reported fiscal third-quarter earnings of 24 cents a share, 2 cents lower than McMillan's forecast.

At Prudential's investor conference yesterday in Boston,

Kraft

(KFT)

said it is on track to meet earnings forecasts for the year. The foodmaker, which went public in mid-June, expects earnings of $1.18 to $1.21 a share for 2001. And the company also sees strong results through 2003.

Shares of Kraft jumped 65 cents, or 2%, to $34 Thursday, hitting a new all-time high at one point in the day. But the stock is trading at a price-to-earnings multiple of 24.20, about three points above the average P/E for the packaged food index. McMillan recently agreed that the macaroni and cheese producer isn't cheap, but he said it is attractive enough for Prudential to recommend.

Separately, cerealmaker Kellogg said at the conference that it remains comfortable with its guidance for 2001 earnings of $1.30 a share before costs related to the recent acquisition of Keebler. The company also expects double-digit earnings growth in 2002. Kellogg rose 2 cents to $32.22 on Thursday, and the stock is trading just below its52-week high of $34.

Campbell Soup

(CPB) - Get Report

reported a 12% drop in fourth-quarter earnings Thursday. The company posted earnings of 15 cents a share, before a charge. Analysts expected the soupmaker, which is in the midst of restructuring, to earn 17 cents a share. Shares of Campbell, also the producer of Godiva chocolate, lost 22 cents, or 0.8%, to $28.40 on Thursday.

"Economic uncertainty has taken some food stock prices beyond where they should be," said Christopher Growe, a research analyst at A.G. Edwards. "The large-cap food stocks I cover have a price-to-earnings multiple of 20, two points above the five-year average PE of 18." Growe mentioned

Heinz

(HNZ)

as an overpriced stock, but he said Kraft, Sara Lee and

Suiza Foods

(SZA)

still have room to move higher.

"Our studies show that investors are paying a premium for cyclicality, or lower-quality stocks," said Bayer. "In the current environment, they should be willing to pay a premium for safety."

But if the stock prices keep fattening, investors might lose their appetites for packaged food.