In its new report analyzing the impact of higher global food prices on the Saudi Arabian food sector, NCB Capital believes that the inability to fully pass on higher costs to consumers will exert pressure on the margins of food companies.
Global food prices increased sharply in 2007/08 as well as over the past 12 months due to various structural reasons including growing demand, increased use of crops for bio-fuels and falling efficiency gains in terms of land use.
"Although we expect food prices to fall in 2012, we believe over the longer term, inflation will be the norm," said Farouk Miah, acting head of equity research.
The Food and Agriculture Organization (FAO) believes that the prices of soft commodities over the coming decade will on average be 15-30 percent higher than over the past decade.
The report highlights that Saudi Arabia depends significantly on imports to meet its food requirements with food imports set to more than double to SR132 billion by 2020 from SR63 billion in 2010.
The reliance on imports is set to remain given that domestic production is restricted due to the scarcity of water and unfavorable weather conditions. Between the 1970s and 1990s, the Saudi government policy was for self-sufficiency in key crops.
However, this has been abandoned with the current aim to work alongside countries which have fertile land but lack the financial investment required to benefit from this.
"Any rise in global food prices remains a key concern for Saudi Arabian food companies due to their exposure and reliance on this as a key raw material," added Miah.
"The recent rise in global food prices has seen the profitability of Almarai and Savola, the two largest listed players in the Saudi food sector, severely impacted."
Margins of both companies declined in 2008 and 2011e by an average of 200bps YoY due to higher raw material costs.
COGS account for a major share of revenues for Almarai (61 percent) and Savola (84 percent).
On the whole, Saudi food players have historically been able to pass on cost inflation to end consumers. However, with overall Saudi inflation remaining relatively high, this has become increasingly difficult.
In July 2011, Almarai increased prices on its 2 liter milk bottle from SR7 to SR8, however a week later it was forced to abandon this due to government intervention.
"If this is a sign of a change in government policy, this could make it harder for local food companies to mitigate food inflation by passing it on to end consumers, thus hurting their profit margins. Companies will have to be innovative and efficient in their use of raw materials, as well as cut costs elsewhere in order to protect margins," Miah stated.
NCB Capital expects inflation exposure for Saudi companies to be high.
The increase in global food prices remains a key concern for Almarai.
The company's direct material cost accounts for around 42 percent of revenues (68 percent of COGS); ingredients account for 42 percent of this, followed by feed-related cost (33 percent) and packaging expenses (25 percent).
Sustaining margins is a concern due to the recent increase in feedstock and commodity costs. In addition, restrictions on increasing prices of end products prevent Almarai from passing on the burden to consumers.
Hence, Almarai has been witnessing a decline in profit margins despite a CAGR of 26.4 percent in its top line over 2005-10.
"Government subsidies of SR212 million during 2008-10 have provided Almarai some respite," explained Miah.
"However, rising food prices necessitate other measures to control costs and sustain margins. Accordingly, Almarai has been continuously focusing on improving efficiency and expanding into higher margin segments such as bakery, juice and poultry."
Recently, Almarai announced plans to invest SR4bn in an integrated poultry business. With high growth rates and increasing market shares, the poultry and bakery segments are set to play an increasingly important role at Almarai.
By 2013, contribution of the poultry and bakery segments to total sales is expected to increase to 9.3 percent and 13.2 percent respectively, from 3.2 percent and 11.8 percent in 2010.
On the other hand, share of the fresh dairy segment to total sales is likely to decline to 39.9 percent from 45.7 percent in 2010.
The report highlighted that higher input costs could hurt Almarai's revenues from the juice segment as most raw materials (fruit pulp) are imported.
Almarai has been undertaking various measures to control costs through innovative packaging techniques (involving efficient use of raw materials) and aggressive marketing initiatives.
This would indirectly pass on the increase in costs to consumers.
The report also highlighted the impact of food inflation on Savola.
According to NCB Capital, exposure to rising global food prices is severe for Savola.
COGS account for approximately 84 percent of revenues with Savola depending heavily on imports to meet its raw material requirements.
Thus, although in the coming 12 months Savola should benefit from lower food prices, over the long-run, any increase in the prices of raw materials such as edible oil and sugar will have a negative impact on margins.
The FAO sugar index has averaged 378 YTD in 2011 against 302 in 2010 (up 24 percent).
Similarly the average for the FAO oils index YTD is up 31 percent against the average for 2010.
The company's retail segment witnessed margin pressure due to higher buying costs associated with food products.
All of this combined has led to margin pressure in the past 12-18 months.
In addition, the difference in the prices of raw and refined sugar exerts pressure on the company's sugar segment.
Savola uses raw sugar as the input and turns this into refined sugar.
Thus, any shrinkage in the premium of refined sugar over raw sugar could dent margins.
NCB Capital believes that the restrictions on increasing prices of end products (to pass on input cost hikes to consumers) poses a challenge for Savola in the manufacturing/wholesale and retail segments.
In addition, Savola's 28 percent stake in Almarai exerts further pressure on its margins as it exposes it to the dairy segment which is also experiencing margin pressure due to increased prices of feedstock.
According to the report, the Saudi government faces the challenge of limiting inflation amid a spike in global food prices.
"Food prices account for a 26 percent weight in the consumer price index used to measure inflation in the Kingdom, thus any increase in food prices substantially impacts overall inflation in Saudi Arabia. To counter this challenge, the government has undertaken different measures," said Miah.
The Saudi government has been actively tracking retail prices of key food products such as barley, milk, wheat, sugar and flour.
This is done by continuous inspections and imposition of penalties on retailers that increase prices without a valid reason.
Also, in May 2011, the government penalized 10 barley importers for pricing the subsidized commodity higher than the profit margin specified by the Council of Ministers.
Finally, the Saudi government has been providing subsidies to food companies to mitigate higher raw material costs.
Such subsidies provide some respite, but are inadequate to completely absorb higher raw material prices.
This exerts pressure on margins of food companies, the report highlighted.
"Some of the mentioned measures prevent companies from fully passing on increased raw material costs to consumers. The Saudi government restricted food inflation to 5.4 percent in August 2011 despite a 26 percent rise (according to the FAO food price index) in global food prices," said Miah.
