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Packaged Foods (Food / Agribusiness (US)) / MARKET WEIGHT 09 January 2014 Americas/United States Equity Research Packaged Foods (Food / Agribusiness (US)) / MARKET WEIGHT 2014 Packaged Food Preview Research Analysts SECTOR REVIEW Robert Moskow 212 538 3095 [email protected] Valuation Multiples Are Higher And Growth Is Rachel Nabatian 212-325-2131 Slower? Doesn't Sound Promising [email protected] Clay Crumbliss, CFA Our outlook for packaged food stocks in 2014 is more bearish than usual. 212 538 1076 Sales growth is decelerating, consensus expectations for EPS growth are [email protected] overly-exuberant, and valuation multiples are two turns higher than they were a year ago. This does not sound like a good formula for stock price appreciation. We forecast stock price appreciation of only 0-5% on average in 2014 with EPS growth decelerating to 5% (compared to consensus of 9%) and a modest contraction in valuation multiples. Gross margin benefit from ingredient deflation will prove disappointing. The bull case on packaged food stocks is that the depressed operating margins of companies like Kellogg, General Mills, ConAgra, and Campbell can return to their historical averages now that the prices of major ingredients like corn, sugar, and cocoa have fallen. The problem with this theory is that these companies have a lot of exposure to big categories with declining volume and huge fixed costs. As a result, we expect gross margin expansion to be held back by price discounts and supply chain inefficiencies as companies adjust to the "new normal" of weaker volume. Food companies have been shifting their marketing away from advertising and into trade merchandising, which reduces gross profit dollars and puts the long-term health of their brands at risk. Our EPS estimates for Campbell, General Mills, Kellogg, and ConAgra are modestly below consensus. We forecast mid-single digit EPS growth instead of the high single-digit pace factored into consensus. We are lowering our 12- month target price on Smucker to $108/share to reflect a P/E multiple of 16x, which is in-line with U.S. food peers. Hershey and Mead Johnson are our top large cap picks. Outstanding top- line growth, competitive advantages, and a high probability of positive earnings revisions differentiate Hershey and Mead from the rest of the pack and justify their valuation premiums. We are raising our 12-month target price on MJN to $92 to reflect a higher P/E multiple of 22.5x. We lowered our rating on Mondelez to Neutral earlier today. Mondelez has the best self-help potential in our coverage, but is trading at a hefty valuation premium to U.S. food peers. It is also trading at a premium to global peers like Nestle and Unilever, which arguably have stronger emerging market platforms. All material changes are summarized on page 3 of this report. DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION® Client-Driven Solutions, Insights, and Access 09 January 2014 Table of contents Our Favorite Stocks For 2014 3 Quick 2013 Review 4 P/E multiples returned to peak levels in 2013 4 Sales growth decelerated more than expected 6 More earnings misses than beats in 2013 6 Consensus for 2014 is Overly Optimistic 7 Themes for 2014 10 Persistently weak top-line sales 10 Benefits from ingredient deflation will prove disappointing. 11 The definition of a "lean" cost structure will take on a new dimension. 15 Large caps will continue to make tack-on acquisitions 16 Private label market share will continue to stagnate 17 Performance in Emerging Markets will diverge 18 More innovation at the low end 18 Campbell Soup 20 ConAgra 24 General Mills 27 Hershey 33 Hormel 38 Kellogg 42 Kraft Foods 44 Mondelez 46 McCormick 50 Mead Johnson 52 Smucker 55 Our Thesis: More Headwinds Than Tailwinds 61 Lack of emerging markets exposure 61 Weak economy = weak volume, despite trading down 62 Emerging market opportunities are limited 65 Marketing effectiveness is declining 65 Most processed food companies are poorly positioned on health and wellness 67 Private label is still expanding 67 The result of all these headwinds is market share erosion 67 Commodity volatility continues to reduce visibility 68 The Bull Case 71 2014 Packaged Food Preview 2 09 January 2014 Our Favorite Stocks For 2014 ■ We expect Hershey to grow sales 7% and EPS 12%. In an environment where just about every food company is cutting advertising, Hershey keeps accelerating its investment and keeps driving volume higher. We forecast another 100 bps of gross margin expansion for Hershey from operating leverage even though cocoa prices are ticking higher. ■ We expect Mead Johnson to grow sales 7.5% (ex FX) and EPS 10%. We expect Mead's market share gains in China at Danone's expense to be a significant driver of top-line growth. In addition, we expect Mead to benefit from gradual improvements in the U.S. birth rate and continued strength in Latin American and non-Chinese markets. ■ We expect Hormel to grow EPS 16% in FY 14. Hormel is a high-quality company that is poised to benefit from two big factors: 1) We expect a significant rebound in the commodity elements of the portfolio to boost margins to the high end of the company’s normalized range, especially in turkey; 2) We believe the Skippy peanut butter acquisition is likely to exceed its accretion targets. Here we provide a summary of the earnings and target price changes were are making in conjunction with this report. Price Price Rating* Target Price Year EPS EPS FY1E EPS FY2E EPS FY3E Company ccy 08 Jan 14 Prev. Cur. Prev. Cur. End Ccy Prev. Cur. Prev. Cur. Prev. Cur. Campbell Soup Company US$ 42.59 — N — 41.00 Jul 13 US$ 2.48 2.47 2.61 2.60 — (CPB) ConAgra Foods (CAG) US$ 33.62 — N — 35.00 May 13 US$ — 2.36 2.55 2.54 2.79 2.77 General Mills (GIS) US$ 48.57 — N — 51.00 May 13 US$ — 2.87 3.07 3.06 — 3.28 J.M. Smucker Co. (SJM) US$ 98.17 — N 115.00 108.00 Apr 13 US$ — 5.80 — 6.30 — 6.85 Mead Johnson Nutrition Co. US$ 84.26 — O 90.00 92.00 Dec 12 US$ — 3.37 — 3.71 — 4.07 (MJN) *O – Outperform, N – Neutral, U – Underperform, R – Restricted [V] = Stock considered volatile (see Disclosure Appendix). Source: Company data, Credit Suisse estimates. 2014 Packaged Food Preview 3 09 January 2014 Quick 2013 Review P/E multiples returned to peak levels in 2013 As was the case across the consumer staples sector, the market shrugged off bad fundamental news and bid up P/E multiples by more than two turns on average. This was a result of increased flow of funds into equities and increased interest from private equity bidders in the space. The low interest rate environment and the willingness of experienced and highly respected acquirers like Berkshire and 3G to pay a big premium for Heinz was a positive signal for the market. Barring a radical change in expectations for interest rates, we think valuation multiples will contract only modestly over the next 12 months. Exhibit 1: Forward P/E Multiples Now Average 18x, Up From 16x Last Year 2008 2009 2010 2011 2012 2013 2014 CAG 14.9 11.2 12.9 11.9 14.0 13.6 13.6 CPB 16.5 13.7 13.3 13.5 13.7 13.4 16.4 GIS 15.7 14.8 14.9 13.7 14.8 14.4 16.7 HSY 18.3 18.8 15.4 17.0 19.8 20.1 23.6 K 1 17.7 13.9 15.0 14.8 14.3 15.0 15.2 KRFT NA NA NA NA NA 15.1 17.1 MDLZ 16.8 13.6 12.5 13.6 14.8 16.1 20.2 MKC 17.9 14.5 14.4 16.6 16.3 18.8 20.0 SJM 16.0 13.2 13.9 13.5 14.5 15.6 16.5 MJN NA NA 18.4 23.4 22.0 19.9 23.0 Average ex MDLZ, HSY, MJN 16.5 13.6 14.1 14.0 14.6 15.1 16.5 Average 16.7 14.2 14.5 15.3 16.0 16.2 18.2 1. Kellogg's P/E multiple rerates 1.0x lower beginning 2014 due to pension accounting change Source: FactSet Consensus estimates as of 1/7/14 After outperforming in the first half of 2013, food stocks went out of favor in the back half when a spate of companies cut guidance. The large cap food stocks finished the year up 22% on average, quite a bit below the S&P 500 but essentially in-line with consumer staples peers. Valuation multiples compressed from their mid-year highs, but remained elevated due to the expectation that falling commodity prices will lead to an earnings rebound in 2014. 2014 Packaged Food Preview 4 09 January 2014 Exhibit 2: Food Stock Rose Significantly In 2013, Essentially In Line With Staples Peers Food CS Rating 12/31/2012 12/31/2013 % Change ConAgra Neutral $ 29.50 $ 33.70 14% Campbell Neutral $ 34.89 $ 43.28 24% General Mills Neutral $ 40.42 $ 49.91 23% Hershey Outperform $ 72.22 $ 97.23 35% Kellogg Underperform $ 55.85 $ 61.07 9% Mondelez Outperform $ 25.45 $ 35.30 39% Kraft Outperform $ 45.47 $ 53.91 19% McCormick Neutral $ 63.53 $ 68.92 8% Mead Johnson Outperform $ 65.89 $ 83.76 27% Smucker Neutral $ 86.24 $ 103.62 20% Average 22% Household Products Church & Dwight Outperform $ 53.57 $ 66.28 24% Colgate Outperform $ 52.27 $ 65.21 25% Clorox Underperform $ 73.22 $ 92.76 27% Estee Lauder Outperform $ 59.86 $ 75.32 26% Kimberly Clark Underperform $ 84.43 $ 104.46 24% Procter & Gamble Neutral $ 67.89 $ 81.41 20% Average 24% Beverage Coca Cola Enterprises NA $ 31.73 $ 44.13 39% Dr.
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