Pricing Power in the Grocery Aisle

The near doubling of prices for agricultural commodities like wheat, corn, oats and sugar since last summer has tripped up big American food makers, which rely on them for key ingredients. Heinz, Campbell Soup, Kraft and General Mills have all recently come up short on quarterly profits, and their stocks haven't participated in the latest rally. The cost spike has put them in a real bind since most have little fat to trim, making it tough to maintain margins. And in this miserable economy hurt by high jobless levels, it's hard to pass the price hike on to consumers.

So who's in the best position to cope?

General Mills (ticker: GIS) looks like the top candidate, a possibility that isn't reflected in its share price. The company's stock now trades at a discount to the food sector, which also includes companies like ConAgra (CAG), Kellogg (K) and Sara Lee (SLE). Bulls believe General Mills could rise from below 36 to between 42 and 44. Add in the rich $1.12 a share annual dividend, and investors could reap a potential 20%-plus return over the next 12 months.

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The packaged-food giant has a top position in many of its key markets. That's given it some flexibility to raise prices and offset soaring ingredient costs.

The main reason the maker of Cheerios can react more boldly is its exceptional market position. Second only to Kraft (KFT) in revenues ($15 billion expected for the fiscal year ending in May) and market value ($22.8 billion), the firm is a huge player in U.S. packaged foods. Each of its key brands—which also include Betty Crocker, Pillsbury, Green Giant, Muir Glen, Nature Valley, Yoplait and Haagen-Dazs—holds either the No. 1 or No. 2 U.S. share in its category.

"The brands are strong and for the most part in categories that are growing," notes Vincent Andrews with Morgan Stanley, who sees the stock rising to $40.

This strength is in part due to the fact that the Minneapolis-based company has continued to invest heavily in advertising while peers have pulled back. General Mills is one of two food makers—the other is Hershey (HSY)—that as a percent of sales spent more each year on advertising from 2007 to 2010—a span that included a debilitating recession. Although it just recently trimmed ad spending a bit, its rate of more than 6% of sales is above its peers' average.

This translates into terrific pricing power—the ability to pass on higher prices without jeopardizing unit sales. It's generally accepted that a better known brand and a top-selling product inspire more loyalty in food retailers and shoppers. A retailer is more likely to absorb some or all of a price hike, and the customer, if required, is more likely to pay up, rather than ditch a product for a cheaper alternative.

General Mills has others strings to its bow. Private-label brands have been hurting all the major food makers, forcing price discounts and promotions, both of which on occasion eat deeply into margins. General Mills is not immune, just less exposed than most of its peers. While private-label items have a near 20% share of the overall food industry at retail, they hold only a 15% share of the food categories where General Mills operates. That difference gives the company another edge in pricing.

Though it hasn't laid out all the specifics, the company has said it will increase prices this year. It has also declared that it still sees opportunities for cost-cutting. Speaking at the recent gathering of world business leaders in Davos, Switzerland, CEO Ken Powell said the company is on track to cut $1 billion in costs by the end of May 2012. Powell said the food maker has seen input inflation of about 30% over the last five to six years, but has managed to keep price increases at 10% to 12%, with hedging on commodities markets helping to manage cost.

EVEN MORE IMPORTANT could be General Mills' focus on what could be called R&D and innovation. This can be crucial in the food business because new products and new variations of old products not only sell better but can also be priced higher. Per year, General Mills spends about $200 million (roughly 1.5% of sales) on new-product innovation and, unlike rivals like Heinz (HNZ) and Campbell Soup (CPB), has consistently done so over the last five years.

It's paid off. The company has a track record of coming up with successful new products such as Banana Nut Cheerios, the best-selling new cereal in the U.S. for 2009. The company also stuck to its philosophy by expanding the Pillsbury brand after acquiring the company in 2001: Today, Pillsbury controls 70% of its market.

"The combination of a high branded market share, a low level of private-label competition and the company's long-standing and successful focus on new-product innovation puts it in a position to fare far better than its rivals in coming months," says Chris Growe, an analyst at Stifel Nicolaus. "The company has posted an industry-high level of earnings growth over the past three years and deserves to be more highly rated by investors."

The 82-year-old company also is pushing into growth areas, specifically foods for the steadily increasing number of Americans eating meals at home and those putting more emphasis on health and wellness, especially whole-grain cereals. New products include gluten-free Bisquick and cake mixes, Progresso soups with added fiber, and whole-grain Hamburger Helper, plus fiber cereals and "restaurant-quality" home-dinner kits.

General Mills has a strong relationship with Wal-Mart (WMT), an increasingly important player. Wal-Mart now represents about 20% of domestic packaged-food sales and accounts for roughly 23% of General Mills' sales. The retailing giant has acknowledged that General Mills is gaining market share on its shelves. And Wal-Mart is growing faster than other food sellers.

General Mills' traditional weak spot has been overseas growth, but it's rectifying that problem. Over the past five years, international has been its fastest-growing segment, now accounting for about $4 billion in sales, 26% of the total. Its largest emerging market is China, where the firm is expanding its Häagen-Dazs ice cream cafés and popular Wanchai Ferry frozen meals. It's also had increasing success with its longstanding international relationship with Nestlé (NSRGY). The two operate a joint venture that markets the Cheerios brand in 130 countries, among other products.

That affiliation has prompted rumors that a merger could be in the offing. Nestlé, seven times General Mills' size, could afford it, especially given its recent sale of eye-care unit Alcon for near $30 billion. The companies have a common portfolio of products that each could market in home territories, and from Nestlé's perspective, General Mills is cheap, trading at 8.4 times enterprise value to its last 12 months' Ebitda, well under Nestlé's 10.4.

Earnings at General Mills are also expected to grow faster, at an 8% annual rate over the next five years, say analysts, versus no more than 5.6% for Nestlé. In the year ending next May, even though top-line sales will likely rise only 1%, profits are expected to climb near 8%, to $2.48 a share from $2.30. A further 8% rise to $2.68 (or maybe as much as 10%, to $2.73) is anticipated for fiscal 2012.

It's unusual for the shares of a company whose earnings are growing faster than its peers', with more pricing power and $2.2 billion in annual cash flow–more than enough to fund capital projects, product enhancements, advertising, stock buybacks and a dividend–to sell at a discount to its rivals. It would seem the stock deserves a premium—which could make it a choice morsel for investors. 

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