One of the most important aspects in fundamental analysis for me is understanding the underlying industry dynamics. Questions one should be asking include where is the value captured in the chain, what really drives demand, what really drives the costs, and so on. One thing that is very helpful to know is industry pricing dynamics. Of course, there are many parts to this puzzle, but by and large, you want to invest in companies that have their finger on pricing (just think, with relatively inflexible demand, every $1 extra in pricing is an extra $1 in pre-tax profit: all the costs are already incurred).
First up, Sara Lee (SLE). SLE produces a wide range of products, including Jimmy Dean sausages (listen to this customer call, hilarious), BallPark franks, Kiwi shoe polish, and, of course, the eponymous bakery items, both fresh and frozen. The fresh bread business in the US is dominated by a handful of companies: SLE, Interstate Bakeries, Flowers Foods (FLO) and Bimbo/George Weston. They make both branded and private label products and have extensive DSD (direct store delivery) systems. There has been some promotional activity in the space now that wheat costs have eased up.
Eric Katzman - Deutsche Bank Securities
On the bakery, I guess there’s been a lot of commentary as to like who shot first and I just wondered if do you think that you’re, like some people say that you’ve been the most promotional in the category. Some say that it was initially Interstate Hostess. You know Flower says that they’re kind of reacting to everybody. [etc]
Brenda C. Barnes
...you probably will find most people are guilty... And to the extent that any of us drive the price to low, the retailer hurts, too. So I just expect there’ll be a little bit more rationality on everybody’s part.
Got that? Sara Lee's CEO is saying that pricing should be more rational (=higher) going forward. She also does not like that everyone jumped in and started competing on price. Will rational pricing happen? Something to keep an eye on as you're reaching for your turkey- provolone- chipotle mayo on whole wheat.
Next up, Spectrum Brands (old: SPC, new: SPEB). Spectrum is a Chapter 11 case that emerged last August but is still OTC. They had too much debt but now they think they've got it under control. SPEB makes a broad range of products within three general lines: batteries/personal care, pet supplies and home/garden products. Brands include Rayovac, Remington shaving, and Repel insect repellents. The battery business is a tough business: private label share is high, retailers left and right have been cutting the branded offerings, and, perhaps most importantly, consumers have been spending less on toys and, on top, have no idea if one brand is better than the other as battery lives are not easy to compare. The big branded players there, besides SPEB, are P&G (Duracell) and Energizer Holdings (ENR).
Karru Martinson - Deutsche Bank
And we've been hearing a lot from other consumer product companies about how there's increased trade spend, a very competitive environment. What are you guys running up against as you go to market?
Kent J. Hussey
Our business model has always been to win the consumer at the shelf...So we will take whatever steps are appropriate to maintain the value positioning of our products. That's most notable right now in the battery category...[answering another question]... Some of the step up in promotional activity that we're seeing right now in the marketplace will probably have a little bit of a dampening effect on the, call it the value growth in the category. But I personally think that's just a temporary phenomena, and as the overall economy begins to recover I think we'll go back to a more normal retail environment...[answering another question]...Of late we've seen competitors add two free batteries to their eight packs. Whether it's promotional or permanent I can't answer that. I think it's promotional. And one of our ways of competing is to typically give the consumer more batteries for the same price as a way of providing significant value. And so, during this particular cycle of promotional activity we'll increase the number of our batteries to main the value positioning, the value spread between us and the premium brands.
So what is happening here? This is signaling of a slightly different kind. One, Spectrum is saying that the ongoing trend of putting more batteries per pack is "promotional". This should be read as "we would like it to end some time", may be when the market stops shrinking. The second part, which we did not see with the SLE segment, is the threat that SPEB will continue to respond with lower prices if the competition continues to lower their prices (whether directly or by adding batteries to the packs). Some consumer products are priced based off the "premium" being a 100, and the value being somewhere lower, and this is the "spread" he refers to. For example, Tide detergent is the 100 in the category and, say, Cheer brand is an 86. I do not know what the battery indexing is.
On to the last signaling example, Sanderson Farms (SAFM). SAFM is a large chicken producers. Proteins in general are another tough business to be in. There are substantial swings in commodity input costs (i.e. corn) as well as in the output prices. In other words, these already low-margin businesses can have both the input and the output prices move against them at the same time. The results are not pretty. PPC (Pilgrim's Pride) just emerged from Chapter 11 last fall and serves as a direct proof of the dangerous mix low margins- commodity input/output volatility- leverage. Besides SAFM and PPC, the other big poultry player is Tyson (TSN).
What those volumes are is a restoration of our normal slaughter schedule. Last year during January, February, March, April and part of May we had that cut back in place and we’re not going to do that this year. We’re going to be at our normal, a little bit less than normal at our Big Bird operations, but we are going to run at close to normal capacity. We feel like that with cutbacks that the industry has that we won’t be in as near the challenging environment that we were a year ago.
Christine McCracken – Cleveland Research
So you’re not expecting any improvement in demand, but you expect the competition to kind of stay rational?
Again, let's read between the lines. If feed prices are high, operators sometimes produce too much, lowering output prices and shooting themselves in the foot. SAFM is not increasing production (trying to avoid the word "slaughter" here) and, more importantly, suggests that the competition does not do anything silly. Compare this to the battery business: there are no price wars or anything. Since the businesses are price-takers and cannot use other differentiators ("two gizzards for the price of one"?), SAFM is communicating regarding output quantities as a proxy for optimizing the industry-wide price/volume mix.
With that, we are wrapping it up for the day. This sort of pricing analysis is obviously not applicable to every industry. Points to remember: coordinated higher pricing = good, price wars = bad, and listen to what management says about pricing. Are they cutting prices, and why? Do they worship "share" disregarding profitability? Or do they say "we did pricing actions across the board earlier this year, most of it stuck, and we'll continue to be rational in today's tough environment"?
(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)