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VOL. 123 | NO. 156 | Monday, August 11, 2008

Food Giants Race to Pass Rising Costs to Shoppers

By SCOTT KILMAN | The Wall Street Journal

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Companies throughout the food chain are changing the way they do business in response to soaring grain costs, and consumers are likely to bear the brunt in the form of rising food prices.

Farmers are making the broadest cuts to their livestock herds in decades, meaning meat at the supermarket will likely cost more in coming years. Middlemen are trying to shorten the duration of supply contracts to 90 days from one year so they can pass on higher costs more quickly. And food brands are shrinking the contents of their packages, from ice-cream cartons to beverage containers.

"Everyone's adjusting," Brenda C. Barnes, chief executive of Sara Lee Corp., said Thursday after the company reported a $695 million loss for the quarter ended June 28. That included an $850 million after-tax charge, mostly for writing down the value of bakery businesses hit by soaring wheat costs.

The Downers Grove, Ill., food giant, whose stable includes bread, cheesecake and hot dogs, is winnowing its product lineup and reducing the amount of meat in its Hillshire Farm deli packages, among other steps. Sara Lee expects its commodity and energy costs to climb an additional $500 million in its fiscal year ending June 2009, following a $350 million increase in fiscal 2008.

Nestle SA, which on Thursday reported a strong profit for the first half of the year, has raised its prices on thousands of products in recent months, passing at least some of its higher costs on to consumers.

Before the grain markets stirred in the summer of 2006, the price of corn had stayed below $3 a bushel for a decade. In the space of two years it surged as high as $7 a bushel. Soybean and wheat made similar moves.

Global grain demand has outstripped production for much of this decade, draining supplies to unusually low levels. Strong economic growth in the developing world is giving hundreds of millions of people the means to afford richer diets, such as grain-fed meat. High oil prices on top of aggressive government mandates, meanwhile, are stoking production of corn-derived ethanol fuel. U.S. ethanol makers, while still struggling for profitability, are forecast to consume one-third of the corn now growing across the Midwest - double their appetite of just two years ago.

In the past month, the speculative fever has eased. The corn futures contract for September delivery rose 14.25 cents a bushel to settle at $5.22 a bushel Thursday. Still, the efforts by ranchers, bakers and meatpackers to shift the burden of higher grain prices show they think their raw-material costs aren't returning to their old levels soon.

"They know prices aren't going backward," says David A. Schawk, chief executive of Schawk Inc., a Des Plaines, Ill., firm that designs packaging for companies. He figures that up to 5 percent of grocery products are shrinking, a level he calls unprecedented.

The grain-price rally is adding billions of dollars to the U.S. food industry's annual costs, creating new winners and losers. Many companies that help farmers grow crops are riding high. The stock price of fertilizer maker Mosaic Co. has climbed about sevenfold since the grain boom began two years ago. Monsanto Co. stock is up about 140 percent on rising sales of its genetically modified seed. Deere & Co. stock is about 90 percent higher on strong demand for the company's farm equipment.

Many food processors, meanwhile, are slumping because they're having a hard time passing along their costs. Pork giant Smithfield Foods Inc.'s stock has slipped 10 percent since August 2006, while the stock of meat rival Tyson Foods Inc. has lost 24 percent of its value over the past year. The stock of dairy-products giant Dean Foods Co. dropped 5.7 percent Wednesday despite reporting stronger second-quarter earnings because it warned of "continued volatility and inflationary pressure."

Food companies with strong brands are having the most success passing higher costs to consumers. The stock price of cereal maker Kellogg Co. is up 11 percent since the grain-price rally began.

"I think we are in the early stages of this," said Paul D. Ridder, chief financial officer of Tasty Baking Co., a Philadelphia maker of snack cakes, which raised prices of its single-serving items by 8 percent during its second quarter ended June 28.

During the first six months of 2008, the consumer-price index for food compiled by the U.S. Bureau of Labor Statistics rose at a seasonally adjusted annualized rate of 6.8 percent, with retail prices of breakfast cereal, bakery products and cooking oil among the fastest climbers. That six-month inflation rate is far higher than anything U.S. consumers have had to stomach in 18 years.

In another measure, the cost of the groceries that the federal government suggests middle-class families buy to have healthy diets rose 8.6 percent in June compared with the same month a year earlier.

Michael Swanson, an economist at Wells Fargo & Co., thinks the food inflation rate could rise as high as 6 percent next year. Paul Prentice, president of Farm Sector Economics, Colorado Springs, Colo., said he expects retail food prices to rise about 7.5 percent in 2009.

The U.S. Department of Agriculture sees food prices climbing 4.5 percent to 5.5 percent this year and 4 percent to 5 percent in 2009. Even under this more conservative forecast, the average family of four would see its annual food costs hit $9,800 in 2009, up about $1,200 since 2006.

Meat is a big reason economists think food inflation has legs.

Grain is such a big part of the cost of raising livestock that many farmers big and small are losing money on every chicken, steer and hog they sell this summer. As a result, the livestock industry is beginning what could be its biggest contraction since 1982. By next year, the supply of beef, pork and poultry available to U.S. consumers is expected to shrink by five pounds per person, according to the Livestock Marketing Information Center in Denver.

Joe Jennings, who raises cattle with his brother near Lazbuddie, Texas, is shrinking his family's feedlot operation to 2,000 cattle - half last year's level and their smallest herd since the 1970s. The brothers have lost roughly $100 on some steers because the cost of fattening them on grain has climbed nearly 60 percent in two years.

"It is getting pretty precarious," said Mr. Jennings, 60 years old.

Feedlots are buying fewer cattle from ranchers, who in turn are selling their breeding cows for slaughter, which means fewer calves in the future. James Mintert, a Kansas State University economist, expects the number of U.S. cattle to sink as low as 90 million by January 2010, down 6.7 million from January 2008.

Smithfield, which reported a 94 percent drop in its earnings for the fourth quarter ended April 27, is shrinking the size of its breeding herd by 5 percent, or about 50,000 sows.

Poultry processor Pilgrim's Pride Corp., which saw its poultry-feeding costs leap $266 million, or 41 percent, during its fiscal third quarter ended June 28, figures the wholesale price of chicken breasts needs to climb roughly 60 percent for the company to cover its costs. The company is cutting chicken production during the current quarter by 8.7 percent.

"American consumers should brace themselves for sticker shock in the meat case over the next 12 months," Pilgrim's Pride Chief Executive Clint Rivers said last week during a conference call with analysts.

Chris Hurt, a Purdue University agriculture economist, said retail pork prices will probably jump by more than 10 percent late this year. Retail beef prices will probably begin to accelerate in 2009, jumping by more than 10 percent in some months, then will continue to climb through 2011, he said.

Food executives also are trying to find ways to pass along costs more quickly. Meat companies have long sold much of their meat to food-service customers under contracts that fix the price for a year or longer. Executives of Pilgrim's Pride and Tyson Foods said last week they're trying to modify their contracts so they can adjust prices every 90 days or so.

"We're in a new era of ratcheting up food costs," says Larry Marcucci, president of Alpha Baking Co., which is paying twice as much for wheat flour as a year ago to make the bread and buns it sells to restaurants and supermarkets.

Before the grain boom, the family-owned Chicago firm adjusted its prices annually. Now its customers know prices might change quarterly. "Things are so hectic now, it's hard to get a handle on things," said Mr. Marcucci.

Many food manufacturers are retooling assembly lines to produce smaller versions of everything from cereal boxes and ice-cream cartons to mayonnaise jars, margarine tubs and cheese packages. By giving consumers less for roughly the same price, food executives hope to keep consumers from moving to cheaper brands.

Consider General Mills Inc.'s Cheerios cereal. When the American Farm Bureau Federation sent members into supermarkets to conduct its second-quarter food-price survey, the 10-ounce box of Cheerios had vanished. So the volunteer shoppers turned to the box nearest in size, 8.9 ounces.

The smaller box cost $2.98 on average, up from $2.86 charged by the stores for the bigger box a year earlier. On a per-ounce basis, the retail price of Cheerios jumped 17 percent to 33.5 cents in the second quarter from 28.6 cents a year earlier.

General Mills spokesman Tom Forsythe said moves by the Minneapolis company can't alone explain the big retail-price jump. It's possible that supermarkets, which set the retail price, are taking advantage of an opportunity to add some margin of their own.

David Mackay, Kellogg's chief executive officer, said in an interview last week that his company has shrunk about 10 percent of its U.S. breakfast-cereal boxes by an average of 2.4 ounces. With the company's input costs climbing 9 percent this year, Mr. Mackay said he doubts grain prices will ever drop back to where they were just a few years ago.

Julie Jargon contributed to this article.

Copyright 2008 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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