Return of food inflation to aid grocers, suppliers

By Mark Potter and David Jones – Analysis

LONDON (BestGrowthStock) – Signs that food prices are starting to rise again could help Europe’s traditionally defensive grocery and food manufacturing stocks to retain premium ratings even as the economic recovery gains hold.

Food price inflation — in moderation — is good news for food retailers, because it boosts sales and profit margins.

Beneficiaries could include major grocers like Carrefour (CARR.PA: ) and Tesco (TSCO.L: ), whose sheer scale gives them considerable negotiating power with their suppliers.

And food manufacturers, like Nestle (NESN.VX: ) and Unilever (ULVR.L: ) (UNc.AS: ), typically fare better with slight inflation than they do with either deflation, when they are under pressure to cut prices sharply, or high inflation, when they face difficulty raising prices.

“We expect modest food price inflation, somewhere between nought and 3 percent, picking up through the year. That’s a decent scenario,” said Shore Capital analyst Clive Black.

Food retail and manufacturing stocks traditionally trade at a premium to the wider market, thanks to their focus on essential goods and reliable earnings growth.

That premium has been rattled at times over the past few years, as volatile commodity markets have propelled the industry through extremes of inflation and, most recently, deflation.

Bernstein analyst Chris Hogbin believes a more settled outlook could boost shares of food retailers in particular. The shares trade about 6 percent above the broader MSCI Europe index compared with a 10-year average premium of 16 percent.

There are dangers: broader inflation measures are still running ahead of food price rises, largely because of surging fuel prices, creating a challenge for firms to manage costs and keep a lid on wages.

And consumer spending is fragile, raising the risk that if food price inflation picks up too strongly, shoppers might trade down to cheaper, less profitable goods.

So far, rising unemployment has helped to keep wages in check, but that could change if the recovery gains pace.

“Continued upside surprises in the general inflation rate might be a problem for 2011, we think, if it begins to exert a bit of pressure on wages,” Citi analysts said.

But the immediate outlook is positive.

Goldman Sachs raised its recommendation on European food retail shares to “neutral” from “cautious” last week, forecasting higher food price inflation would drive returns.

Its analysts suggest focusing on companies with a strong presence in emerging markets, like retailers Tesco and Jeronimo Martins (JMT.LS: ).

Applying the same logic to manufacturers would favor Unilever, which has a larger exposure to developing countries than rivals Nestle and Danone (DANO.PA: ).

CALMER WATERS

After a surge in inflation over the previous few years, much of Europe saw falling food prices in 2009.

That hammered sales growth at grocers and in some markets, like France and Germany, sparked a price war which contributed to big profit falls at firms like Carrefour and Metro (MEOG.DE: ).

Britain was spared deflation, thanks to a sharp fall in the pound, but still saw a rapid slowdown in food price rises.

The IMF Commodity Food Index showed a return to inflation in November and, with a typical six-month lag between changes in food commodity costs and changes in food prices, that is starting to filter through into official data.

Euro zone food price inflation rose 0.3 percent in March from February and was down 0.6 percent on March 2009, the smallest annual decline for nine months. Food prices in Britain also picked up in March.

With so many variables — like the outcome of harvests and movements in currencies and oil prices — it is difficult to predict with any certainty the future path of food prices.

But the consensus among companies and analysts appears to be for a modest increase over the months ahead.

Carrefour finance chief Pierre Bouchut said earlier this month it was “probably true that deflation pressures were over,” while Tesco Chief Executive Terry Leahy predicted a gentle rise in inflation.

Among manufacturers, Unilever sees commodity costs rising 2-3 percent this year, while Nestle said this month input costs were “within manageable ranges.

Such a benign outlook should benefit everyone, according to Investec Securities analyst Martin Deboo.

“Gentle inflation is generally good for the industry and retailers as it helps highly leveraged groups inflate away debt and helps like-for-like sales numbers which the market focuses upon,” he said.

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(Editing by Sitaraman Shankar)

Return of food inflation to aid grocers, suppliers