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Kraft Foods (KFT - Free Kraft Stock Report), the marketer of such iconic brands as Oreo cookies and Maxwell House coffee, recently disclosed that rising input costs clipped some $490 million from base-business results in 2010 (excluding newly-acquired Cadbury). The story was much the same throughout the entire grocery aisle, as commodity-related cost inflation had major food processors shelling out more money for everything from key ingredients, such as flour and corn sweetener, to packaging materials, including aluminum (for cans) and petroleum-based resins (for shrink wrap and the like).

The input-cost environment is generally expected to remain challenging this year. Indeed, Kraft expects commodity costs to increase as much as $800 million in just its North American business alone. Meanwhile, cereal maker Kellogg (K) recently increased its estimate for annual input-cost inflation to 7% (up from 5%-6%). 

The sharp rise in commodity costs partly reflects reduced supply. Corn prices, for example, have doubled, to $7.25 a bushel, in just the past eight months (since 6/30/10), as inclement weather across key growing regions has reduced crop yields and several nations have imposed export curbs. Increased demand is, no doubt, exerting upward pricing pressure, as well. With personal incomes on the rise in fast-growing economies like China and India, many more people are able to afford protein-rich diets of grain-fed beef and chicken. In the U.S., meanwhile, approximately 40% of the domestic corn crop is now being used to make ethanol and other bio-fuels. For all intents and purposes, the bio-fuel industry didn’t exist just ten years ago.

So, how should investors approach what is likely to remain a very challenging input-cost environment for the major food processors? The common prescription is to seek out companies with above-average pricing power that can pass along a good portion of higher costs to consumers. Towards that end, prospective investors are generally advised to stick with manufacturers that enjoy strong brand loyalty and whose products are, therefore, less likely to experience deterioration in demand amid further price hikes. Within the increasingly tough cereal category, General Mills (GIS), for example, is a good choice. The Minneapolis-based company continues to spend more money (as a percentage of overall company sales) on brand building (i.e., marketing and advertising) than its major peers. Product innovation should further reduce the risk of consumers crossing the company’s cereal and noncereal brands (i.e., Cheerios, Yoplait, Haagan Daz) off of their shopping lists.

Investors are also advised to focus on those product categories, in which demand is generally less affected by manufacturer price moves. A recent study, for example, indicated that sales of certain microwaveable meals and chocolate candy tend to hold up relatively well to price hikes. On the other end of the spectrum, demand for ready-to-serve soups and peanut butter was shown to be more “price elastic.”

Over the near term, most manufacturers don’t expect price increases to fully cover ongoing input cost inflation. As such, investors may be well served by considering food processors that can make up the difference elsewhere. The aforementioned Kraft, for one, expects to ultimately realize $750 million in cost savings related to its acquisition of Cadbury. The Hershey Company (HSY), meanwhile, stands to benefit from the replacement of inefficient, century-old manufacturing facilities.  

Assuming input costs do eventually reverse course, the major food processors should be better positioned in terms of pricing and profit-margin expansion. That’s because they tend not to lower prices once consumers grow accustomed to paying more at checkout. If and when input-cost inflation turns into deflation, however, remain big question marks.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.