Food deflation good for consumers, but pinching grocers

From breakfast to dinner, your favorite meals at home may be coming down in price, but that's bad news for food retailers as deflationary conditions pinch sales and create added competitive threats.

Grocery spending likely fell for the third-straight quarter, said Zachary Fadem, an analyst at Wells Fargo Securities.

"Near-term headwinds are likely to persist for U.S. grocers, as renewed uncertainty around household finances, heightened promo, competition and food deflation continue to weigh on the industry," said Fadem, who remains cautious on the sector.

Last month, the U.S. Department of Agriculture updated its food price outlook for 2016 and predicted the cost of food at home would edge up 0.25 percent to 1.25 percent. That compares with 1.2 percent food-inflation rate in 2015 and the 20-year historical average of 2.5 percent.

By category, the forecast shows the most deflation in meats, poultry, eggs and dairy products. That worries some grocers as lower prices for protein can hit them hard. That's the category that tends to drive shoppers to the supermarket, and falling prices can spark competitive price cuts.

"We know eggs are in excess around the country," said Whole Foods President A.C. Gallo during the company's earnings call last week. "Egg prices are flat to deflationary."

Egg prices in June were down on average nearly 27 percent from the same period a year ago and fell 6 percent from May levels. The government expects egg prices will drop 14 percent to 15 percent on average this year, coming after a nearly 18 percent jump in 2015, when the avian influenza hurt supplies.

The egg supply has recovered but demand has been soft this year and egg prices recently were hovering around 10-year lows. The summer months tend to be a slower period for egg demand, and business tends to pick up in the fall months.

"Based on our analysis of USDA and Food Marketing Institute data, we estimate protein food products (meat, poultry, fish and dairy) are responsible for about 52 percent of the more volatile perishable food category sales and for about 30 percent of total grocery sales," said S&P Equity analyst Joseph Agnese in a report last month.

According to Agnese, "Food inflation volatility in the first half of 2016 restricted food retailer sales growth and negatively impacted margin performance. However, we expect these pressures to ease in the second half of 2016 in a more favorable commodity environment."

This week, BMO Capital Markets analyst Kelly Bania cut the rating of Kroger to "market perform" from "outperform," citing these deflationary issues. She also cut her target price for the stock and lowered earnings estimates.

"We believe the magnitude of the grocery deflation pressures … are too hard to ignore and make share price outperformance difficult, given the pressure on same-store sales and associated deleveraging impact on the income statement," Bania said.

As for beef, prices fell an average of 6.7 percent in June on a year-over-year basis, and slipped 0.6 percent from May. The government sees prices this year falling 3 percent to 4 percent. The move follows two years of inflation in the category. Beef prices were up an average 7.2 percent in 2015 and jumped 12.1 percent in 2014.

In the case of beef, the decline in price — particularly for hamburger meat — may not be such a bad thing for retailers.

"Meat had been inflationary for so long, retail prices have gotten to a point where people stop buying as much and price points are now more attractive and people are buying more," Kroger CFO Mike Schlotman said at the Jefferies Consumer Conference in June.

The USDA's price of retail ground beef was $3.73 per pound in June, down about 12 percent from $4.22 a year earlier. Price declines for top steak cuts were more modest.

As for pork, prices were down an average 1.4 percent in June from a year ago, but were up 1.2 percent from May. The USDA is looking for pork prices to fall between 0.5 percent and 1.5 percent this year, a moderation from the 3.9 percent average decline tracked in 2015. Pork prices over the last 20 years have seen inflation on average of about 2.5 percent.

Poultry prices fell an average of 3.4 percent in June from the year-ago period and dropped 0.5 percent from May. The government sees poultry prices flat to down 1 percent in 2016, below the category's 20-year historical average of 2.6 percent inflation.

Tyson Foods is scheduled to report its fiscal third-quarter earnings Monday, and analysts estimate its poultry division sales will be down slightly from a year ago due to pricing declines, reflecting in part lower breast meat prices.

Stephens analyst Farha Aslam estimates that chicken breast prices in the June quarter were averaging down more than 20 percent on a year-over-year basis. Chicken wing prices averaged more moderate price declines in the quarter, although the wing prices are likely to take flight again.

"Wing prices are expected to head higher as we near the beginning of football season," said Aslam in a note Tuesday. "Prices are expected to peak around the Super Bowl and will likely be supported through March Madness reflecting the typical season trends."

In the dairy aisle, prices fell an average of 2.2 percent in June from the year-ago period and around 0.6 percent from average prices in May. For the year, the USDA is forecasting dairy prices will decline on average between 0.5 percent and 1.5 percent. Last year, dairy prices fell on average 1.3 percent compared with the category's 20-year historical average for inflation of 2.7 percent.

Dean Foods, the nation's top milk producer, is set to report second-quarter results on Monday and analysts expect sales will be down 8 percent, in part due to lower milk pricing.

A USDA retail dairy report released Friday found even the single-most advertised dairy item — a container of conventional Greek yogurt — was slightly lower in price during the latest survey week compared with the prior week. Greek yogurt is a top-selling product within the dairy aisle.

Not all food is going lower, particularly when it comes to fresh produce.

Fresh fruits and vegetables are forecast to show price inflation this year of 2 percent to 3 percent, according to the government. In 2015, the category averaged a 0.5 percent decline.

Fresh vegetable inflation is seen slightly higher than fruits this year, and that is consistent with 2015 trends when the average prices of fresh fruits were estimated to be down 2.2 percent.

Even processed fruits and vegetables are forecast to have price inflation this year, between 1 percent and 2 percent. Still, that is below the 20-year historical average of 2.6 percent price inflation for the category.

(CORRECTION: An earlier version of this story misspelled Zachary Fadem's name.)