In August 2002, the European food sector hit a 30% P/E premium to the European market, the biggest f...
In August 2002, the European food sector hit a 30% P/E premium to the European market, the biggest for a decade, but has since come crashing back to earth.
It seems the high beta rally in the fourth quarter of 2002 has continued into the first quarter of 2003, strange given that the sector is underperforming a falling market. This has resulted in the 30% premium being eroded to less than 5%.
We think this is unjustified given that the sector fundamentals have arguably improved in the intervening period.
While external factors like foreign exchange, higher commodity pricing and a tougher retailer environment may be less favourable in 2003, we think this is more than offset by stock-specific factors that point to a better year ahead.
Improving cost control, resilient restructuring savings and solid top-line and cash generation are positives.
Three market concerns seem to be overhanging the sector: pension risks, higher commodity prices and downgrades for foreign exchange relating to the weaker US dollar and sliding Latin American currencies.
These issues are outside the control of the sector's management teams. We think pension and commodity risk has been overplayed, while foreign exchange downgrades are a genuine concern.
The decline in equity markets has led to a fall in the value of assets carried by companies' pension funds. This has raised the concern that companies will need to dramatically increase their contributions to employee pension funds.
Furthermore, there is a concern that liabilities in the balance sheet are grossly understated. Our evaluation of this liability leads us to conclude the net 'value at risk' for the big food companies is not material.
While the fall in equity markets combined with new reporting regulations will affect results going forward, we do not expect a significant impact on earnings or cashflow. Overall, we believe while pensions remains a challenging issue, it is a manageable one for the big European food companies.
Commodity prices are higher than they have been in the recent past. Furthermore, packaging costs are expected to rise with increases in fuel costs.
We expect higher input costs for food companies in 2003. However, we expect the bulk of this increase to be recovered through price increases. This is also the view of Cadbury and Danone when recently questioned. In 2002, cheaper raw materials had a benign impact for NÃ©stlÃ©, with higher cocoa and packaging costs offset by milk and coffee benefits.
The net effect on earnings is not significant. However, if macroeconomic conditions deteriorate and price increases in branded consumer products are curtailed, our forecasts would face downgrades.
The large-cap food stocks face fresh pressures in 2003 from the continued slide of the US dollar and the rout in key Latin American currencies. However, we have seen a significant increase in the proportion of US dollar-denominated debt across the sector over the past few years.
We estimate 70% of the sector's debt held on the balance sheet is in US dollars. This provides a natural hedge at the earnings level, even if the hit to the top line is significant.
Improved cost control boosted companies.
Pension risk has been overplayed.
Dollar denominated debt hedges earnings.
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