Should Investors Snack on Packaged-Food Stocks?

Just as investors started heading out for their holiday breaks, Campbell Soup (CPB) made its largest acquisition in the company's 148-year history, buying snack food company Snyder's-Lance (LNCE) for $6 billion.

That same day, Hershey (HSY) announced  it was buying Amplify Snack Brands (BETR), maker of the second-leading ready-to-eat popcorn brand Skinny Pop, for $1.6 billion.

Two acquisition announcements in a single day in the traditionally staid packaged food industry may seem like a coincidence, but it really isn't surprising: M&A activity is the norm these days among packaged-food-makers. According to food industry publication Just-Food, an abundance of major global deals occurred last year, including  Post (POST) buying British cereal maker Weetabix for $1.76 billion and  Tyson Foods (TSN) acquiring AdvancePierre Foods for $4.2 billion. And just recently, Nestle (NSRGY) announced that it was selling its U.S. confectionary unit to Ferrero.

More deals are on the horizon, says Matt Brill, comanager of Invesco Corporate Bond (ACCBX), which earns a Bronze fund analyst rating from Morningstar.

"M&A was actually down in 2016 and 2017 because there were questions around the U.S. election and then tax policy," he says. "Now that we know what's in the policy, we expect M&A to pick up. We've already seen that happening."

Juicing Growth in a Mature Sector
All this activity is making the typically slow-growing and ultracompetitive food industry that much more interesting. Although returns are underperforming the broader market--the S&P Global 1200 Packaged Foods and Meats subindustry index is up 12.6% over the last 12 months as of this writing, compared to a 22% gain for the S&P 500--some individual names have seen their shares climb. For instance, Tyson Foods was up 33% in 2017, while takeover target Snyder's Lance jumped 32% last year.

Industry watchers aren't surprised by the acquisition activity that has taken place over the last few years--and they expect it to continue. Traditionally, the packaged food sector has been a steady cash flow-generating industry that can be relied upon for decent dividends and long-term growth. Today, however, top-line growth is hard to come by, and cost cutting for margin improvement has been mostly exhausted.

"It's a more mature industry," says Sarah Henry, an analyst at John Hancock.

While organic growth is still important, companies are looking for new ways to boost returns and improve margins, especially in a world dominated by  Amazon (AMZN) and  Wal-Mart (WMT), says Henry. If a company can buy another business, cut costs at the acquired company, apply its own processes to the new business, and then bargain with the big retailers for better deals, that's ultimately beneficial to the top and bottom lines of the acquirer.

"The big names on the distribution side can get food to people in a big way and move the needle for companies," says Henry. "So, scale is a benefit to a big packaged foods company."

Competition among food companies is also fierce. Consumers have more food choices than ever before, with cereals, yogurts, snack bars, organic foods, and other items all competing for their dollars. Quick service restaurants and healthy company cafeteria options are also impacting packaged food industry market share. The result? Some companies have decided to take the "if you can't beat them, join them" adage to heart and have chosen to buy competitors rather than face them head on.

M&A activity is most predominant in the snack and organic categories, says Erin Lash, consumer sector director for Morningstar. In an effort to boost growth, larger companies are typically looking at smaller operations in faster growing categories and that can expose the buyer to different distribution channels. One of the best examples of this occurred in 2014, says Lash, when General Mills (GIS) bought Annie's, a natural and organic food company.

"General Mills wasn't selling through a lot of natural and organic channels and there was potential for revenues and synergies," she says.

Organic and snacks are still important areas of growth for companies, but mergers don't transform the acquiring company overnight. In fact, at least in the packaged food industry, a single deal will likely have little impact on the buying business overall.

"Usually these deals have not moved the needle in terms of financial performance, as they're too small," says Lash. That's why most of the larger packaged goods companies don't stop at one deal--rather, they'll make multiple small deals over time, which can eventually add up.

Be Aware of M&A, but Don't Bet on It
While most financial experts expect M&A in the sector to continue, there is one risk at hand: valuations. As with most stocks these days, packaged food companies are pricey, and acquirers may wait until targets become less expensive, says Lash. And because equity is so valuable these days, it's likely we’ll see more all-stock deals getting done, which is welcome news to debt-watchers like Brill.

"We're anticipating more stock for stock transactions rather than cash and debt," he says. "Now businesses can get more cash flow and broader diversification and they don’t have to use any debt to do it."

For individual investors, M&A activity is something to mindful of, but not to bet on. Shareholders of smaller companies could see a big payday if a company they own gets acquired, but it's always difficult to know what will get bought next. Henry doesn't recommend that investors buy companies in this sector for their appeal as possible takeover candidates. Instead, she thinks the main reason to buy these businesses--despite rising valuations and modest top-line growth--is for their reliability.

Some of these operations pay and grow dividends­­--Campbell Soup yields more than 3%, while Mondelez International (MDLZ) yields around 2%, for instance, which is key for Henry. She also wants to see strong cash flow from operations, rising free cash flows, and a track record of responsible adding or jettisoning other operations. 

Most packaged food companies look expensive according to Morningstar's metrics today. There is one undervalued name trading in 4-star range: Mondelez International. The global snack giant was spun off from the former Kraft Foods' North American grocery business in 2012, and the stock has struggled during the past 12 months in part because of intense competitive headwinds and muted global growth. Moreover in August, Warren Buffett made it known that Kraft Heinz (KHC) isn't interested in buying the company (Buffett's Berkshire Hathaway (BRK.A) (BRK.B) is Kraft Heinz's largest shareholder), and that caused its stock price to dip. With a still-strong market-share position, Lash thinks the company can rebound.

"Its current playbook of extracting costs and reinvesting behind brands has resulted in some fair and solid profit improvement," she says.

Several other packaged-foods companies carry 3-star ratings, suggesting that they're fairly valued, but they are worth keeping on a watch list. Those with economic moats (or competitive advantages that should allow them to continue to produce strong returns on invested capital) include wide-moat General Mills, narrow-moat Hormel Foods (HRL), and narrow-moat JM Smucker (SJM).

Even if the packaged foods company you own doesn't get bought out, owning brand-name companies in this sector--preferably ones on the lower end of the industry's valuation spectrum--should provide decent growth and protect on the downside if the market takes a turn.

"We've been through a cycle where growth has been highly prized," says Henry. "At a certain point investors will want to see what else is out there, and these stocks can neutralize some of the risks. Maybe these stocks don't grow 30% in a year, but maybe they grow 7% in each of the next four years. That's acceptable in a portfolio."

Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.