Inflation: A Real Risk to the Consumer and Margins

Meredith Contente | July 16, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

While large monthly CPI prints suggest that cost increases are being passed through to the consumer, recent results from Conagra Brands (CAG – Baa3 (p)/BBB-/BBB-) and PepsiCo (PEP – A1/A+) tell a bit of a different story.  Wage costs skyrocketed as workers found they could make more in unemployment benefits coupled with government stimulus implemented during the pandemic. Cost inputs such as edible oils and proteins also increased, as well as packaging and transportation, which have forced packaged food and beverage companies to raise prices. There remains a delicate balance between raising prices to offset input costs and not pushing customers to abandon national brands for private label or pull back from buying altogether. It’s likely that packaged food and beverage companies will have to absorb some of the cost inflation, which will lead to margin erosion in an effort to post organic growth.

US CPI continues to move higher, as certain categories that were significantly impacted by the pandemic rebound.  June CPI was up 0.9% month-over-month, the third consecutive significant increase and the largest monthly rise since 1982 (Exhibit 1).

Exhibit 1. US CPI MoM (2015-YTD 2021)

Source: Bloomberg

CAG Increases Cost Inflation Guidance

CAG management noted on its last earnings call that we are currently experiencing an “atypical” inflationary environment, with the highest level of inflation that the company has witnessed that they can recall.  That said, management sees cost inflation of 9% for this fiscal year, 300 bp higher than previous guidance, and nearly double the rate seen in the last fiscal year.  According to CAG, a typical year of inflation is closer to the 3% level.  While CAG raised prices in the last fiscal quarter, clearly there is a profit lag effect.  That said, CAG saw its adjusted operating margin contract roughly 300 bp year-over-year (to 14.0%). Management expects its next round of price increases to be implemented at the end of the current fiscal quarter (ending 8/31/21) and will focus on products that are most impacted by higher edible oil and protein costs.  CAG noted they will “aggressively” pull margin levers to minimize the inflation-related profit lag.  This includes capitalizing on any further synergies not extracted from the Pinnacle acquisition and cutting back on discretionary spend while looking for ways to optimize fixed cost leverage.  CAG will also consider further acquisitions and divestures if they are accretive to margins.  However, despite trying to aggressively manage costs, CAG revised its full year adjusted operating margin and EPS guidance downward.  The company now expects the adjusted operating margin to be roughly 16% and EPS to be approximately $2.50, which is down from previous guidance of 18%-19% and $2.63-$2.73, respectively.

Exhibit 2. CAG Updated Fiscal 2022 Outlook

Source: CAG Fiscal 4Q21 Earnings Presentation

Pepsi Maintains Guidance but Gross Margins Contract

While PEP posted quarterly results that exceeded expectations on both organic revenues and EPS, the impact of inflation was quite evident.  On both a quarterly and year-to-date basis, PEP witnessed a gross margin decline of 180 bp and 140 bp, respectively.  While PEP has been able to insulate themselves somewhat with forward buying and reduced SG&A/sales, management made note that they expect to see increased inflation pressure in the back half of the year.  In response, PEP plans to help offset the increased input costs with price hikes as well further investments in restructuring initiatives.  Back in February 2019, PEP implemented a Productivity Plan and has now expanded and extended that plan through the end of 2026.  Under the Productivity Plan, PEP plans to leverage new technology to simplify and automate processes, re-engineer their go-to-market information systems, and optimize their manufacturing and supply chain footprint.  As such, management has extended their target to deliver at least $1 billion in annual savings through 2026.

Exhibit 3. PEP Quarterly Gross Margin vs. SG&A/Sales (1Q18-2Q21)

Source: PEP Earnings Presentations; APS

However, a real threat to the back half of the year for PEP and beverage peers remains the steep increase in corn-based sweeteners, as the price of corn (USD/bushel) is up nearly 50% year-to-date and at levels we have not seen since 2011. While corn prices have retreated from the highs witnessed at the end of May, a nearly 50% increase will further impact gross margins.  Price hikes are likely evident for PEP but may come at the expense of top line growth.  Furthermore, SG&A may be a bit harder to manage in the back half of the year, particularly as PEP is looking to increase marketing and advertising spend now that the food service industry is back on the rebound and growing faster than the stay-at-home channel.