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The Packaged Food Industry: Nothing to Feast On

We contend that this sector isn't attractively valued right now.

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Consumer behavior has changed rapidly throughout this global economic slowdown, affecting both discretionary spending, as well as consumers' purchases of everyday staples such as food. That said, we still believe there are some names in this space that are worthy of investors' attention. In this article, we'll take a brief look at the current dynamics of the packaged food space, and review our top two picks.

Savvy Consumers Seek to Save Money
With continued uncertainty surrounding today's economic environment, cash-strapped consumers have been adjusting their shopping behaviors in an effort to rein in their spending. For example, consumers are increasingly opting for lower-priced private-label (nonbranded and store-branded) alternatives or value-branded goods, as shown in the chart below.

While private-label products cost 30% less (on average) than branded products (according to IRI), why has the response to private label been different this time around? In our view, the major discrepancy between the current environment and the past is that the quality of these lower-priced products has improved dramatically. Supermarket chains (like  Wal-Mart (WMT) and  Kroger  (KR)) have invested heavily in their store brands to offer a better value to their customers. In addition to choosing value offerings more often, consumers are also making out their shopping lists ahead of time to minimize unplanned purchases and shifting their shopping trips to discount channels as a means to tighten their purse strings.

Packaged food firms have not been blind to this shift, modifying their strategies in light of these changing consumer purchasing trends. For instance, packaged-food firms are increasingly touting the value proposition they believe they provide consumers as a means to offset private-label offerings' rising share. As an example,  Kraft (KFT) notes that a consumer can eat a Kraft grilled cheese sandwich and a bowl of tomato soup for only $1. Further, as consumers entertain more at home,  ConAgra (CAG) suggests that its Orville Redenbacher popcorn should appeal to value-conscious consumers at $0.75 a bowl. Beyond enhanced marketing messages, some packaged food firms have increasingly used promotions to make the value of their offerings resonate with consumers.

Premium Offerings Not a Thing of the Past
In our opinion, even in a challenging economy, consumers aren't willing to give up on all of their indulgences. Their loyalty to certain brands remains sticky. We contend that it is more likely that consumers will pay up for innovation in the packaged food space, which is in contrast to the household and personal care sector, as well as increase their spending on food, assuming the quality supports the higher price tag. For instance,  Unilever (UN) (UL) is marketing its Bertolli Italian entrees in this fashion, by promoting the restaurant quality food consumers can receive without the restaurant price. Further, while many consumers have been trading down to lower-priced private-label alternatives, we believe that consumers will eventually trade back up to branded products over the next several years as the economy improves.

Challenges for Packaged Food Firms Don't End There
Beyond soft consumer spending, unprecedented increases in commodity costs over the past several years have been a headwind for firms throughout the packaged food industry, but more recently, moderating input costs have created a tailwind. We expect that input cost inflation will return, particularly because of increased demand for commodities in emerging and developing markets.

Although packaged food firms have passed through price increases to offset a portion of this cost pressure, these price hikes have not fully captured the costs these firms have had to absorb. Even though we believe that large price cuts are unlikely, if the price gap with private label becomes too large, branded firms may be forced to cut prices or risk substantial volume declines. Further, while sales have benefited from higher prices, we expect that as the firm laps prior-year price increases, volumes could remain sluggish, weighing on near-term sales.

Stocks Worthy for Investors' Radar
Without a doubt, packaged food firms face a broad array of challenges, but we take comfort in the fact that the firms we like in the packaged food space have successfully navigated through recessionary periods in the past. For those investors looking for some exposure to the packaged food sector, we would recommend a closer look at the following stocks.

Although we don't have any 5-star stocks in our packaged food coverage universe following the broad market's recent runup, we believe these two firms are well-positioned. To see our full Analyst Research Reports, fair value estimates, and uncertainty and moat ratings on these and more than 1,800 other stocks, take a free Premium Membership trial today.

 General Mills (GIS)
Uncertainty Rating: Low| Price/Fair Value Estimate: 0.99 | 3 stars

We contend that General Mills' extensive distribution network and its continued investments in product innovation and marketing have enabled it to stand out in the packaged food space. While consumers are increasingly opting for lower priced private-label offerings, we do not believe this heightened competition will erode General Mills' competitive advantages, as the firm operates with a portfolio of leading brands in categories that should appeal to consumers eating more meals at home. Our fair value estimate of $72 per share implies forward fiscal-year price/earnings of 17x, price/cash flow from operations of 12x, and enterprise value/EBITDA of 10x. At a market price of $70 per share, we believe the stock is about fairly valued, but we believe the firm would make a solid investment at our Consider Buy price of $58 per share.

 PepsiCo (PEP)
Uncertainty Rating: Low | Price/Fair Value Estimate: 0.90 | 4 stars

Pepsi's direct-store-delivery system, its scale, and its dominance in the U.S. snacks industry (which accounts for two-thirds of the firm's consolidated sales) all contribute to the firm's wide moat, in our opinion. Further, the firm has strong brands such as Frito-Lay and Doritos that dominate less powerful brands in the snacks business. We believe continued investment in marketing by Pepsi will enable the firm to maintain the status quo in the long term, and we do not see an end to Pepsi's dominance of the snacks market in the near future. Our fair value estimate of $68 per share implies forward fiscal-year price/earnings of 20x, price/cash flow from operations of 15x, and enterprise value/EBITDA of 10x. At a market price of $61 per share, we believe the stock is undervalued, but we'd wait for a slightly larger discount before purchasing the shares.

Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.