By TOM ORLIK
China's food manufacturers are suffering from indigestion. The cause? Sustained high prices for agricultural products and government controls on retail prices.
At the end of 2010, Beijing was claiming success in the fight against rising food prices. Months later, they remain stubbornly high. The Ministry of Agriculture's index of wholesale food prices has ticked down only slightly from a holiday-induced peak at the end of January.
That's bad news for Beijing as it struggles to stem inflation. Food is the largest component of the consumer price index, and if March's reading goes above 5%, as expected, food will have played a large role.
Higher agricultural prices, and the government's attempt to control them, are also bad news for food manufacturers. Tingyi (Cayman Islands) Holding Corp, China's largest producer of instant noodles, and Want Want China Holdings Ltd, a major producer of snack foods, both saw gross margins shrink in 2010 due to rising input prices.
Tingyi announced plans to increase retail prices on its instant-noodle product by 14% as of April 1. But the powerful National Development and Reform Commission has signaled manufacturers to go slow. Prices for cooking oil and flour were capped at the end of last year. Now Tingyi and some other manufacturers of household goods, including Unilever, have delayed plans to raise prices.
Direct controls on prices don't address the problem of excess demand. Indeed, they make it worse, encouraging consumption while eroding incentives to increase supply. But in the short term they do have a certain brutal effectiveness, which makes them appealing to politicians keen to be seen on the side of the consumer.
The question for investors is whether the increase in input prices for food manufacturers is the result of a supply-side blip-gone with the next harvest-or a long-term effect of rising demand.
The answer is, the latter.
Higher incomes in China and other emerging markets will increase demand for processed food, helping expand the market for manufacturers. Both Tingyi and Want Want, as prestige brands, can expect to take market share from less glamorous competitors.
But the same higher incomes will also drive demand for the grains that are the main input for processed food products. Normally, the rising cost for these raw materials would be passed through to consumers. But with that outcome politically unacceptable, it is food processors' profit margins that will take the strain.