10 Food Stocks With Tasty Potential

Shuanghui International's $7 billion deal to buy Smithfield Foods, Inc. ( SFD ) isn't just about the pigs.

The big drivers here are China's need to increase food supplies as a growing population demands a better diet, and China's recurring scandals over food safety - whether it's melamine in powdered milk and baby formula, or rat meat being sold as lamb, or excessive levels of antibiotics in chicken.

(In March 2011, Shuanghui itself apologized for illegal additives found in its meat, apparently because farmers in Henan fed an additive to their pigs and then sold them to a company slaughterhouse.)

Large numbers of Chinese consumers simply don't trust domestic food suppliers, and will go to astounding lengths to buy overseas products that are thought to be safer.

Chinese food companies know they have a problem. They can see it in their sales numbers. For example, China Mengniu Dairy Company Limited (HKG:2319), the country's largest dairy producer, saw sales drop 3.5% in 2012 and operating profits fall 16%. The company blamed the decline on food safety problems in China.

The stakes are really, really high. China's baby formula market grew 29% last year to $15.4 billion. International sellers controlled half of the baby formula market, but that's expected to rise to 55% in 2013, as Chinese consumers with rising incomes demand safer (and better) foods.

Of course, a problem for Chinese food suppliers is an opportunity for overseas food companies. Here are the stocks of ten companies that look likely to turn this opportunity into profits for investors.

1. Danone

You can certainly see why China Mengniu would want to partner up with France's Danone SA (OTCMKTS:DANOY). The Chinese company has 17% of China's yogurt market, but also has persistent safety problems with its milk (melamine, a plastic, in baby formula, for example) that have hurt the company's reputation and sales.

What's in the recent deal for Danone? Yogurt sales in China are projected to grow 57% to $11.6 billion by 2015. Danone has just 1.6% of that market today, and derives 6% of its sales from China, the company's fourth-largest market.

The tie-up with China Mengniu Dairy is one of Danone's two recent deals in China. The company has also formed a joint venture with state-owned Cofco (Mengniu's largest shareholder). Danone will hold 49% of the joint venture, and thus indirectly own 4% of China Mengniu.

The New York-traded ADRs for Danone trade at 18.7 times projected 2013 earnings per share.

2. Mead Johnson Nutrition

You get a good sense of the opportunities in selling baby formula to China by visiting any convenience store in one of New York City's Chinese neighborhoods.

Along Main Street in Queens, for example, shop windows are stacked full of cans of infant formula for sale to customers traveling back to China, or for shipping by locals back to relatives in China. That reflects just how much demand there is in China for overseas brands of infant formula that promise safety.

In 2008, six babies in China died and 300,000 became ill because of melamine contamination in infant formula. In 2010, Chinese authorities seized another 64 tons of contaminated raw dairy materials.

Last year, 75% of Mead Johnson Nutrition Co's ( MJN ) revenue came from sales of nutritional products for infants, children, and expectant mothers outside the United States. China alone accounted for 30% of sales. (China/Hong Kong is now the company's No. 1 market, with the US second and Mexico third.)

The company's sales in China/Hong Kong have doubled over the last three years-and the sales breakdown has shifted: premium nutrition products now make up more than half of sales.

Mead Johnson's five-year return on capital is 41.3%, compared to 11.2% for its industry as a whole and 9.9% for the stocks in the S&P 500 (INDEXSP:.INX). The shares trade at 24.7 times projected 2013 earnings per share.

3. Nestle

With its purchase of Pfizer Inc's ( PFE ) infant nutrition unit, Nestle (OTCMKTS:NSRGY) became the biggest player in the infant nutrition business. It didn't hurt that Pfizer's group generated 85% of its sales from emerging markets.

Nestle has been working hard to increase its sales from faster-growing emerging markets, which now account for 45% of company sales. In the most recent quarter, Nestle's sales in these markets grew by 8.4%, while sales in developed markets increased by less than 1%.

But Nestle isn't just infant formula. The largest packaged food company in the world has top-tier market share - 20 of Nestle's brands generate more than 1 billion Swiss francs ($1.08 billion) a year in annual sales - in products from coffee to bottled water.

The category that interests me the most going forward is bottled water, where Nestle, remarkably, has been able to fight off The Coca-Cola Company ( KO ) and PepsiCo, Inc. ( PEP ). The name of the game here is getting primary shelf space in stores, and Nestle's brand clout lets the company do that.

Its ADRs trade at 17.5 times projected 2013 earnings per share.

4. Abbott Laboratories

AbbottLaboratories (ABT) is the closest thing to a value play that you'll find in the infant nutritional space. Nutritionals made up about 30% of company sales, on a pro forma basis, after the breakup of the company. (Abbott recently spun off its pharmaceuticals business, now called AbbVie Inc (ABBV).)

That segment turned in 9% sales growth in the first quarter, but even with 45% of sales in that business coming from emerging markets, Abbott's margins in that segment trail its competitors.

Management's goal is to raise operating margins in the nutritionals unit by 5 full percentage points by 2015. That, plus a company-wide goal of raising emerging-market sales to 50% of total sales (from 30% now) by 2015, should help fix the company's extremely low return on invested capital - 10.2% for the last five years. (That figure is for the pre-breakup Abbott. The figure for Abbott Laboratories recently has been just 2%.)

The shares trade at 18.05 times projected 2013 earnings per share. Abbott Laboratories is a member of my Jubak's Picks portfolio .

5. Dean Foods

The Smithfield deal suggests that some Chinese food companies - perhaps with state prodding - may apply the same resource-acquisition model to food that Chinese companies have applied to strategic commodities such as oil.

(Although the Shuanghui International acquisition could be a one-off, since it looks to be a private-equity deal that involves the purchase of Smithfield Foods by a shell company based in the Cayman Islands. The actual Chinese pork producer, Henan Shuanghui Investment and Development, will have only a tenuous call on the profits that will flow to the separately owned Caymans shell company.)

Dean Foods Co (DF), a purely domestic US milk processor, could make an interesting target for a Chinese dairy industry that has been snapping up overseas dairy assets in high-quality markets such as New Zealand. (See Shanghai-listed Bright Dairy& Food Co., Ltd.'s (SHA:600597) 2010 purchase of a 51% stake in New Zealand milk processor Synlait, for example.)

The US milk processing market has significant overcapacity, and Dean has growing free cash flow - $125 million by 2014, according to projections by Credit Suisse - that could be used to finance a deal or to pay out a significant dividend to an acquirer.

The possibility that Dean would use that free cash to pay a higher dividend to shareholders even without a deal makes this stock a potentially interesting dividend-income play. The company, Credit Suisse projects, would be able to pay a dividend yield of 9.2% in 2014. (The company last paid a dividend in April 2007.)

The shares trade at 18.3 times projected 2013 earnings per share.

6. WhiteWave Foods

A somewhat related pick: Now that Dean Foods has completed the spin-off of almond milk and soy milk producer WhiteWave Foods Co (WWAV), I think the company is ripe for an acquisition bid.

The bid is more likely to come from a US food company such as General Mills, Inc. (GIS) than a Chinese food company, but in the current global shuffling of food assets from developing to emerging economies, you never know. (Dean Foods continues to own 20% of WhiteWave, about $600 million in stock, after spinning off the rest of the company in an IPO to shareholders.)

WhiteWave's overweighting of almond milk versus soy milk in its product portfolio had been a drag on the company, as growth in household almond milk consumption had been coming largely from the cannibalization of soy milk consumption. But in the first quarter of 2013, the company said that growth in almond milk consumption is increasingly coming from dairy consumption.

In the first quarter, WhiteWave reported record US household penetration of plant-based beverages. (And, yes, that is a product category.) That comes on top of last year's 3-percentage-point increase in household penetration for plant-based beverages.

The company estimates that current projects to increase production capacity and to build new warehouses will expand operating margins by 0.5 to 0.75 percentage points annually for the next three years. The stock trades at 24.3 times projected 2013 earnings per share.

7. Industrias Bachoco

Of course, not all food - not even all protein - is produced in the United States. Industrias Bachoco, S.A.B. de C.V. (IBA) is Mexico's largest poultry producer (and its No. 2 producer of eggs), with a 35% share of the Mexican chicken market and a 10% share of the egg market.

In 2011, the company bought OK Industries, a US chicken producer, to increase its market share in the United States. In the first quarter of 2013, revenue grew by 7% but operating margins fell to 7.6% from 8.3% in the first quarter of 2012, as the company took a one-time charge as a result of an outbreak of avian flu (influenza H7N3).

Net income fell 3.6%. Largely as a result of this drop in net income, the company's American depositary receipts remain relatively cheap, at 10.2 times projected 2013 earnings, despite a 65% gain over the last 12 months.

8. BRF

BRF SA (BRFS) is Brazil's second largest food company by revenue, and the tenth largest food company in the world. In the first quarter, this producer of poultry (34% of sales), pork and beef (9%), dairy (9%), and processed products (40%) grew revenue by 14% year over year.

But what puts the company on this list is the 31% growth in exports. (Exports make up 43% of company sales.) The company owns two of the best brands in Brazil, Sadia and Perdigao, and one of the few nationwide refrigerated distribution systems.

Like all Brazilian stocks, this one has sold off in the current retreat in the Sao Paulo market, with the New York-traded ADRs down 12.2% from May 14 through June 12. The ADRs trade at 21.9 times projected 2013 earnings per share.

9. McCormick

Even this venerable maker of spices and flavorings (the company was founded in Baltimore in 1889) is getting in on the China acquisition act.

On May 31, McCormick& Company, Incorporated (MKC) announced that it had completed its acquisition of Wuhan Asia-Pacific Condiments, the maker of the DaQiao and ChuShiLe brands of bouillon products. The products have a leading position in the central region of China, the company says, and as such go with McCormick's product portfolio in the coastal region.

What's impressive about that announcement is the company's recognition that it has to customize its product offerings, not just for China but also for China's very different regional palates.

McCormick's revenue took a hit in late January when in its fourth-quarter earnings report the company announced lower sales to a major quick-service restaurant chain in China - Yum! Brands, Inc. (YUM). But from a low of $61.23, the shares rebounded to $74.74 on May 15. They've dropped only 4.5% in the recent market retreat.

The shares trade at 22.3 times projected 2013 earnings per share.

10. Unilever

The June 6 announcement from the world's second-biggest consumer-goods company that it will start manufacturing food seasonings in Myanmar and invest $660 million there over the next decade tells you pretty much all you need to know about why - at the right price - you want to own a stake in Unilever plc (UL):

  • Patience: The company has been selling in Myanmar through third-party distributors.

  • Discipline: A tested road map for approaching a developing economy by going deeper in a few categories, such as seasonings, shampoos, and laundry products.

  • An eye for growth opportunities: The number of people in Myanmar with sufficient income for discretionary spending could rise to as many as 19 million in 2030 from 2.5 million now, according to a report by McKinsey Global Institute. (The population is 60 million.)

Unilever's ADRs trade at 17.9 times projected 2013 earnings per unit.

Editor's Note: This article was written by Jim Jubak of MoneyShow .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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