Chocolate 2.0

By Stephen D. Simpson, CFA | September 16, 2010 AAA

Perhaps humanity has seen the first step towards a long-held dream. No, not a manned mission to Mars, a cure for cancer or a solution for world peace; those would pale in comparison to the promise of healthier, cheaper and tastier chocolate.

Scientists from Mars (the chocolate company), the U.S. Department of Agriculture and IBM (NYSE:IBM) have announced that they successfully sequenced the cacao plant. Although this is merely the first step, it opens up the door to a lot of potential changes. Though there will no doubt be howls of protests about the grim spectre of "Franken-chocolate" ruining the candy aisle forever more, agricultural companies and chocolate producers could ultimately forge a more sustainable crop and a healthier, tastier end-user product.

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A More Stable Price?
Cacao beans are a global commodity, with standard futures contracts trading on NYSE Euronext and ICE. Although the beans can be stored for years, prices can be volatile, as the trees themselves are somewhat finicky and demanding. Perhaps even more concerning, production is highly concentrated with Cote d'Ivoire and Ghana producing about two-thirds of the world's crop. As cocoa bean futures have not generally been among the more liquid commodity contracts, prices have been volatile - and that situation was brought to light with the huge speculative purchase that Armajaro made in July of this year.

This volatility has been a headache for major candy producers like Mars, Hershey (NYSE:HSY), Nestle (Nasdaq:NSRGY), Tootsie Roll (NYSE:TR), Kraft (NYSE:KFT) Cadbury and Rocky Mountain Chocolate Factory (Nasdaq:RMCF) that all count cacao (in some form or another) as a significant cost input. While companies can hedge the price risk for any given year, it is harder to hedge the risk of supply shortfalls - a disease outbreak 20 years ago decimated Brazil's cacao industry and it has still not fully recovered .

In theory, the sequencing of the cacao tree genome should allow for a more durable crop. Companies like DuPont (NYSE:DD) and Syngenta (NYSE:SYT) have used genetic information about crops like corn and soybeans to produce versions with enhanced desirable traits - including, for instance, resistance to certain weed killers and insects. It is not hard to imagine, then, that similar steps could be taken to produce more rugged and consistent cacao trees. (For more, see Wine And Chocolate: A Sweet Deal For Investors.)

A Better Product?
At this point, it is anyone's guess as to who will attempt to take this information and run with it. Mars et al made the sequence public, and that could have ramifications on whether agriculture technology companies can patent future hybrid varieties. That, in turn, could reduce the incentive for the likes of Archer Daniels Midland (NYSE:ADM) to get into the fray.

All that being said, the advantages of a "better bean" will probably carry the day, and it stands to reason that Mars, Hershey and Kraft would love to produce a better-tasting, healthier and perhaps cheaper chocolate if at all possible. Given that Hershey appears to spend more on advertising to convince people that its chocolate is better than it does on the cacao itself, that is not a minor point.

The Bottom Line
Companies like Illumina (Nasdaq:ILMN), Life Technologies (Nasdaq:LIFE) and Bio-Rad (NYSE:BIO) will likely also be involved in one way or another. Certainly, the development of Cocoa 2.0 is not a reason to own any of these stocks, and it will not be big enough to even be a blip in the biological science market. Nevertheless, the point stands as a reminder that whatever the ups and downs of particular discoveries in life sciences, there is always a demand for tools and technologies to exploit them.

Even if chocolate 2.0 is on the way, it will probably be a decade or more before it makes any difference to the candy companies. In the meantime, volatility in inputs like cocoa beans, milk, sugar and packaging is likely to continue. That suggests that investors would do better to focus on long-term returns on capital and valuation than the wiggles and waggles of the commodity markets. (For more, see The Perfect Investment For Chocolate-Lovers.)

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