Our Outlook for Consumer Defensive Stocks

--Wide economic moats will be more important than ever in the consumer defensive space as the global economy slows again.

--Amid market turbulence and uncertainty, the consumer defensive sector offers relative stability.

--Break-ups, not takeovers, may dominate the headlines over the coming months, as activist investors have led a charge toward creating value in the consumer staples space.

Wide economic moats will be more important than ever in the consumer defensive sector as the global economy slows again.
Although we've been optimistic about the resiliency of our consumer defensive coverage universe over the first nine months of the year, we've still remained cautious about the significant macroeconomic headwinds facing these companies and held steady in our belief that the U.S. was poised for a multi-year period of anemic growth.

Retail sales have continued to hold up quite well--year-to-date same-store sales across our coverage universe are up an average of 5% through August--but in recent months, we've seen price increases from consumer goods manufacturers overtake transaction growth as the primary top-line driver for most retailers.

GDP growth slowed in the second quarter (up only slightly from the revised first-quarter number), and the employment situation hasn't improved in the last three quarters. Meanwhile, the average gasoline price at retail is up 32% year-over-year (to $3.58 per gallon), which has also undoubtedly placed additional pressure on consumers.

Finally, elevated fears surrounding fiscal austerity measures in Europe and domestically suggest that it will be more difficult for consumer goods firms to accelerate growth at a time when an increased number of consumers may be paring back spending.

Sentiment among low-income consumers, the lifeblood of consumer staples volumes, depends heavily on employment. Unfortunately, unemployment still sits above 9% (at 9.1%) in the U.S., and the U-6 or "underemployment" rate is hovering near 16%. The unemployment rate for those with less than a high school diploma has increased 1% even as the rate for the entire population has fallen. In the near term, our outlook is even bleaker. More than 3.5 million Americans receiving extended unemployment benefits will see eligibility roll off during the coming months, potentially putting a dent into an already cash-strapped consumer at the low end of the spectrum. With the U.S. government already running at a deficit of $1.4 trillion, we're skeptical that benefits eligibility will be extended past the current 99-week period. Additionally, we've seen a number of states recently curb the maximum number of weeks that jobless workers can receive unemployment insurance to less than 26 weeks.

In our view, any meaningful improvement in the U.S. employment numbers is contingent on an upturn in the housing market, a turnaround in business capital investments, a sustained recovery in the manufacturing sector, and/or increased government spending. Unfortunately, each of these key indicators appears to be heading in the wrong direction. While there has been some encouraging manufacturing data--nonresidential construction growth and job creation within the sector--the weak dollar is surely providing a temporary fillip, and we suspect manufacturing growth will slow when a stronger dollar makes imports appear to be a relatively better value than domestic manufactured goods.

And while we welcome Congress' deal on the debt ceiling and regard the measures to reduce the U.S. budget deficit as necessary to preserve the nation's relative economic stability, the timing could not be worse. As the economy struggles to rebound from the great recession, public sector spending cuts present a major risk to economic growth. Government spending is a major component of the aggregate demand curve, representing 40% of GDP in 2010 according to the Bureau of Economic Analysis, and it has doubled from its proportion of GDP since the late 1940s. Government spending provided a great deal of support to the economy during the downturn through increased entitlement spending, and while few names in our coverage universe are directly exposed to government spending, a reversal of that support could have a negative impact on job creation for low-income consumers over the next few quarters.

Having entered into hedging contracts at high asset prices, many consumer goods manufacturers have stated that they intend to raise prices in the latter part of the year, but we think consumers may balk at any further price increases. We believe that there is a three-month time lag for changes in the Producer Price Index (PPI) for food (the wholesale input prices of food) to feed through to the Consumer Price Index (CPI, the retail price of food). The spread between the CPI and the PPI measures of food inflation turned positive in May 2011 (for the first time since December 2009) and likely peaked in August. The soft economic data could force consumers to once again become more laser-focused on price, which could in turn make the environment too difficult to raise prices at the retail level, forcing the CPI down. In short, consumer staples manufacturers and retailers could be forced to swallow some of the recent cost inflation if consumers resist higher prices in the final months of the year. In some instances where input costs have reversed materially, consumer staples firms may also be looking at price cuts, similar to Smucker's SJM recent 6% price decrease for coffee products. Looking into next year, as manufacturers' hedges roll off, cost of goods sold should moderate slightly, and the pressure on margins should ease. That will be just as well if the pricing environment remains so challenging.

Given the risks associated with more cautious consumer spending, and austerity measures likely lasting throughout the remainder of the year (and possibly into next), we believe recent market volatility could present investors with an opportunistic entry point for several best-in-class names. We've identified several wide- or narrow-moat names that should offer investors value and relative stability in a volatile market, including Anheuser-Busch BUD, Kellogg K, and Pepsi PEP. Generally speaking, we like companies possessing a combination of economies of scale, pricing power to counterbalance a slowdown in volume growth, exposure to emerging markets (particularly China), resources to extend brand reach, and strong dividend growth potential.

Amid market turbulence and uncertainty, the consumer defensive sector offers relative stability.
Despite Congress' ratification of the debt ceiling bill in August, the $2.4 trillion in spending cuts proposed in two stages by the bill fell far short of the $4.0 trillion that Standard & Poor's was looking for, and the credit rating agency downgraded its long-term outlook for U.S. creditworthiness to AA+ from AAA.

However, we doubt the downgrade will have a material lasting impact on the U.S. economy. The other major credit rating agencies do not appear to have followed suit, so the U.S. still maintains the highest credit ratings with both Fitch and Moody's. The financial markets were likely to pass their own judgment on the political impasse in Washington anyway, which would most likely have resulted in higher interest rates. In addition, the pledge by the Federal Reserve to keep interest rates close to zero until mid-2013 and buy $400 billion of long-dated Treasuries financed by the sale of bonds with maturities less than three years ("Operation Twist") should help offset some of the widening of rates, although the Fed can do little to control spreads. However, if interest rates rise at a faster rate than other countries' rates or concerns about eurozone credits linger over an extended period, capital is likely to flow to dollar-denominated assets in greater volumes, acting as a self-correcting mechanism and providing support to the greenback.

In reality, only those firms with the lowest credit ratings are at risk. Estimates on the interest rate impact range from an increase in rates of 10 basis points to 75, and early evidence from the bond market suggests that a 10-basis-point increase across the yield curve is fairly accurate. While the Federal Reserve has said it will hold rates close to zero for almost two years, the Fed cannot control credit spreads, and we believe the U.S. credit rating downgrade will be immaterial.

We've estimated the impact of a 10-basis-point and 50-basis-point increase in interest rates on some of the most highly leveraged companies in our coverage universe. Our analysis assumes an immediate and parallel upward shift of the yield curve, with credit spreads remaining constant. The conclusions of the analysis are clear: The debt downgrade is not likely to affect our valuations through higher interest rates. At 10 basis points, the impact to 2012 EPS is negligible, and zero for the tobacco firms on the list. Even at a 50-basis-point yield curve shift, a low-probability and worst-case scenario, only Ralcorp RAH, Anheuser-Busch InBev, Supervalu SVU, and Dean Foods DF are materially impacted.

Those firms with the lowest credit ratings are likely to suffer disproportionately high interest rate increases. For example, some of the mature tobacco manufacturers are quite highly leveraged. Altria MO had an above-industry-average debt/EBITDA ratio of 1.9 times at the end of 2010, and we've assigned the firm a credit issuer rating of BBB. It could face slightly higher rates when it rolls some of its $2.1 billion in maturing debt over in the next 18 months. However, Altria has $2.0 billion in cash on its balance sheet and untapped revolving credit facilities of $3.0 billion, so while it may suffer a few basis points being added to its new issuance interest rates, it is highly unlikely to face a liquidity crisis.

The same is true for the majority of companies in our consumer defensive coverage universe, as most have ample cash and capacity on their credit facilities to cover near-term maturities. Even Dean Foods, one of the most highly leveraged consumer staples names (debt/EBITDA was 6.0 times at the end of 2010) is under no immediate threat. The firm has only $474 million in debt maturities between now and 2014, holds $116 million in cash on hand and has around $350 million available on its revolving credit facility. With still some cushion on its debt covenants, we believe the credit market volatility is likely to have dissipated by the time Dean is forced to turn to the debt markets. We assign Dean an issuer credit rating of B+.

Proving the sector's resilience, even in the face of widening credit spreads, the new issue market was very receptive to food, beverage, and tobacco issuers over the past quarter. Within our sector coverage, seven issuers raised $8 billion of new debt this past quarter. Over the fourth quarter, we anticipate significant new issuance as corporations lock in remarkably low coupon levels, and we expect consumer defensive names will find the greatest receptivity until credit spread volatility abates.

Breakups, not takeovers, may dominate the headlines over the coming months.
Activist investors have led a charge toward creating value in the consumer staples space over the past year by breaking companies up. First, Bill Ackman's Pershing Square Capital bought an 11% stake in Fortune Brands FO in October 2010. Two months later, the firm announced that it was going to sell its golf business, and split its beverages and home and security segments into two separate businesses in early October. In August 2011, Kraft Foods KFT announced that it plans to split into two firms: a global snacks business and a North American grocery business, essentially reversing its acquisition of Cadbury 18 months earlier. Vocal investors such as Ackman, Warren Buffett, and Nelson Peltz own Kraft's shares. Carl Icahn appears to be trying to drag Clorox CLX in play with a $10.2 billion takeover offer. Finally, though not necessarily due to shareholder pressure, Sara Lee SLE is breaking up into standalone domestic and international segments, having sold off a number of its brands in recent month.

Given the high-profile divorces in consumer staples, speculation may now mount regarding which other consumer firms may be in the crosshairs of activist shareholders, but we do not believe breaking up will work for all companies. We think that firms with scale across multiple product lines within the same distribution channels would best perform by remaining whole. However, some companies may be able to unlock value by breaking up into their component businesses. Our sum-of-the-parts analysis shows that both PepsiCo and Unilever UL could unlock value by breaking up into their component businesses, which we describe in greater detail below:

• Pepsi: We estimate the breakup value of PepsiCo using a sum-of-the-parts methodology, and we believe there would be significant upside to a breakup. In our sum-of-the-parts calculation, we assume Pepsi splits into two businesses: SnacksCo and DrinksCo. SnacksCo comprises the Frito-Lay North America, Quaker Foods, and the Latin America Foods businesses, together with 67% of the Europe and AMEA segments. Meanwhile DrinksCo comprises PepsiCo Americas Beverages and 33% of Europe and AMEA. We assume that $2 billion in incremental SG&A is assumed in the form of duplicated back-office functions, which represents 10% of Pepsi's 2010 SG&A expense. We assign a multiple of 11.0 times 2010 EBITDA to SnacksCo, in line with Kraft, and 13.0 times for DrinksCo, a 15% discount to Coke KO. Our valuation at these multiples is $76 per share, an implied EV/EBITDA ratio of 13.4 times and a 16% premium to the current market value.
   
• Unilever: Based on a sum-of-the-parts valuation, we assume that the packaged food segment garners an EV/EBITDA multiple of 10x, slightly more than our fair value for General Mills GIS but less than Nestle NSRGY and Kellogg K. We estimate the household and personal care unit to be valued at an EV/EBITDA multiple of 12 times, below our fair value for P&G PG but in line with Colgate CL and Reckitt Benckiser. After taking into account negative synergies of EUR 750 (about 10% of SG&A), our valuation is EUR 27 per share, which implies 12 times EV/EBITDA and a 17% premium to the market price.

Top Consumer Defensive Picks

Dean Foods DF
While Dean Foods is in a very tenuous position, we believe that the market is extrapolating the dairy processor's recent difficulties over the longer term--an unlikely outcome. A few more quarters of depressed profitability are probably in the cards, but Dean's efforts to realize additional cost savings have probably intensified in the face of these pressures, in our view. At just 9.5 times our 2012 earnings per share estimate, Dean is trading at a significant discount relative to industry multiples and our $15 fair value estimate.

Avon Products AVP
Fixated on short-term weakness in consumer spending, the market is currently valuing Avon at more than 40% below our fair value estimate. However, the firm's direct salesforce of more than 6.2 million distributors and low-cost operating model give Avon a wide moat, in our opinion, and restructuring efforts are allowing it to realize the benefits of its global network. Direct selling is inherently a low-cost business model that is easy to expand into new markets since it requires little startup costs.

Kroger KR
Despite trading at higher valuations on a P/E basis than Safeway SWY and Supervalu, we believe Kroger offers investors the best risk/reward profile because we see the least relative downside risk to sales, earnings, and cash flows. Kroger continues to not only defend but gain market share, while Supervalu and Safeway have not posted positive identical-store sales excluding fuel since 2008. Because of the ability to consistently drive share, Kroger has the best chance among its peers to be left standing to reap the rewards of margin expansion inherent after the industry moves beyond the consolidation phase.

PepsiCo PEP
The market is fixated on Pepsi's underperformance in beverages, but we think investors should own the stock for the snacks business, which represents around two-thirds of the top line. Pepsi has sustainable competitive advantages in snacks through its vast global distribution and dominant market share, and with around one-third of Pepsi's revenue being derived from emerging markets, this is also a growth markets story. However, the catalyst for the stock is likely to come in beverages, and improvement in unemployment and/or share gains from rebranding could deliver upside later this year.

Reckitt Benckiser
Reckitt operates in slightly niche categories (toilet bowl cleaners, air fresheners, fabric care additives, etc.), but the firm is also rebalancing its portfolio via acquisitions with more OTC categories that are faster growing longer term. Introducing a new product in its pharmaceuticals business is also helping, but the market is concerned about turnover of both the CFO and CEO in less than a year. We think this is short-term thinking as Reckitt seems to us to be positioning itself well in categories where consumers are less price sensitive.