03/26/17 08:25 AM EDT

CONSUMER STAPLES ROUNDUP (GIS, SFM, KR)

Howard Penney

Shayne Laidlaw

BIG FOOD GETTING LESS BIG (GIS)

Zero-based budgeting (ZBB) is selective when choosing its victims, as it has widely varying levels of success across the industry. 3G, the trailblazer, has found success, which in our opinion has been somewhat driven by the relative simplicity of their products, it doesn’t take a lot of merchandising to sell a bottle of Heinz ketchup. While others such as CPB and GIS, which compete in more competitive sections of the store, have fared far worse.

We believe there is significant evidence that GIS’s top-line has been a victim of its ZBB practices. The management comments from Ken Powell in the press release say it all, “our net sales declined due primarily to gaps in pricing and promotional activity in key U.S. businesses.” The way we read this, is that the actions that needed to be made fell through the cracks which have been created by a smaller staff and a greater focus on cost cutting versus brand building. Marketers are more focused on cutting funds out of their budget versus getting out in front of the consumer. This just doesn’t work in hypercompetitive categories such as yogurt. They keep on saying they are going to increase investment to grow the top line, but when is it actually going to come to fruition?

This investment, whatever it may be, may start to put pressure on margin growth as well, especially if the investments don’t result in volume. Looking deeper into the ZBB issue, it has hampered GIS’s and others ability to innovate as well, which is why we have seen a flourishing environment for food startups. This is leading to the bigger companies just acquiring the innovation once the product has proven itself in the market.

We still think there is some weakness ahead for GIS, as we are not sold on their ability to drive meaningful volume growth, without coming up short of their FY18 margin target goal. Looking 6-9 months from now, these periods of poor performance make for easy comps, but easy comps are only easy if you change the way you do things in order to improve your position. We need to see that improvement in order to have faith in the GIS’s ability to drive the top-line into FY18 which will have “easy comps.”

BEST IDEAS LIST HIGHLIGHTS / ADJUSTMENTS

Sprouts Farmers Market (SFM) – We are removing SFM from our short bench. Typically when there is this much smoke there is a fire, so we are removing ourselves from the situation. We originally added SFM to the short bench as part of our WFM deck, saying that expectations were still too high on the company, and comp guidance as well as unit openings had to come down significantly. We still think that to be the case, but we may not be able to see it come to fruition if it is in fact acquired. Thinking about how this potential deal affects the food retail industry more broadly. Whether SFM is a standalone company, or part of a bigger private company, it doesn’t change the fact that the industry has enough stores, so our projected growth trajectory of the company doesn’t change. From a synergy perspective, they will be part of a larger buy which could give them slightly more preferential pricing. Although the natural and organic farmers have caught up to some extent with demand, they aren’t out there on the corner selling produce for penny’s on the dollar either, so it’s questionable how big of a benefit this would be. And then of course you have the back office synergies, but are they going to drop that to the bottom line or invest in price? That’s the question. The deal with Albertson’s is not a done deal either, with the word out it is likely others will start circling the deal.

Kroger (KR) – KR is currently on our SHORT bench. KR was upgraded to a buy by another analyst on Thursday, sending the stock up +1.0% (it was negative for the week). We can understand his improving macro conditions call, we are on that call too, but to say that KR has “superior structural advantages” is completely out of line. We don’t believe that they have a solid grasp on multiemployer pension plans (MPP), and the implications for KR being a heavy participant in them. We’ve heard the story before, “they are just going to get bailed out.” With what money? Trump is cutting budgets left and right and focused on way bigger issues right now. We have calculated that KR’s off-balance sheet withdrawal liability associated with MPP’s amounts to as much as $25B (roughly the equity value of the company), while they estimate their share of current underfunding to be $2.9B in 2015, which represents an increases of $1.1B versus 2014 (we get the 2016 number in a week or so when the 10-K comes out). Bottom line is that we do not believe improving macro conditions are enough to keep KR afloat with MPPs weighing them down.

NOTABLE STOCK MOVES WE HAD OUR EYE ON

There was a lot of turmoil in the markets last week driven by the on again, off again healthcare bill vote, that was eventually pulled. Although outperforming the S&P, XLP was down -0.5% last week, while the S&P was down -1.4%. Protein processing companies led the pack in our tracker up +2.2%, led by SAFM which reacted positively to the concerns with Brazilian poultry which would be positive for US exports.

Food Retail (WFM – KR): Our food retail sub-sector had median performance of -1.5%. Food retail was driven by a few upgrades/downgrades last week. But not even an upgrade was strong enough to keep KR in the green for the week, as it finished the week down -1.5%. WFM was downgraded to a sell by a competitor, with sent the stock down -2.0% for the week. Outside of those two which our on our best idea list, the two worst performers were the small caps, NGVC and IMKTA, which were down -5.8% and -4.5%, respectively. While SVU (upgraded) and SFM (potential takeout) were the leaders of the pack, up +7.5% and +2.5%, respectively.

Food Distribution (USFD – PFGC – UNFI): There is more interesting dynamics in the distribution space than some give it credit for. USFD (best idea long) was up +1.7% last week, after a rough stretch over the last month, while PFGC, which is on our long bench was up +0.4%. The two worst performers in our sub-sector were CORE and UNFI, which were down -9.2% and -3.7%, respectively. We recently published a black book regarding our UNFI short thesis, ping us if you want us to send it over.

A LOOK INTO NEXT WEEK