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Our Outlook for Consumer Defensive Stocks

We see continued margin pressures, emerging-market opportunities, spin-off acquisition targets, plus some pockets of value in the sector.

Erin Lash,R.J. Hottovy, 12/27/2011

--Margins are likely to remain constrained as commodity cost pressures persist.

--A pronounced uptick in spending among developed-market consumers is likely several quarters off, but emerging markets provide an opportunity for growth.

--Spin-offs could also become acquisition targets in 2012.

Margins are likely to remain constrained, as commodity cost pressures persist.
While the rate of commodity cost inflation has moderated relative to the first half of 2011, the prices for several raw materials remain considerably above the level of just two years ago. Green coffee spot prices, for instance, are still up nearly 34% over the prior year (which is the slowest rate of year-over-year inflation in 17 months), while beef is 18% above where it was trading last October. Corn--a vital component of livestock feed--is 17% higher and up more than 50% compared with two years ago. Additionally, even though the global supply of agricultural commodities (such as wheat from Russia and cocoa from the Ivory Coast) is recovering from geopolitical shocks, we believe raw material prices could tick up once again in 2012 as energy costs force prices higher and weather patterns remain erratic. Further, demand in emerging markets could keep raw material prices elevated over the long term.

This has not gone unnoticed by several consumer product firms we cover. In fact, Hershey HSY recently disclosed that it anticipates higher input costs heading into fiscal 2012, despite the fact that cocoa prices in October are 8.5% less than the year-ago period. ConAgra's CAG management also raised its full-year expectation for commodity costs recently to 9%-10% (from 7%-8% previously), while General Mills GIS is forecasting 10%-11% higher costs in fiscal 2012 after incurring mid-single-digit inflation in fiscal 2011, indicating to us that these pressures are unlikely to subside over the next several quarters.

In our opinion, offsetting these cost pressures with higher prices may continue to hurt volume growth, particularly in markets where stubbornly high unemployment and elevated gas prices continue to plague an already-fragile consumer. For example, while price increases helped to push Crisco total dollar sales higher for J.M. Smucker SJM in the recently reported quarter, price sensitivity was evident as volume plunged 10%, supporting our view that the company could face fierce competition in oils from other branded and private-label offerings.

On the other hand, McCormick MKC increased prices an average of 5% in the fourth quarter, which is the first time in at least 10 years that the firm is raising prices during this critical selling period, according to management. Historically, the fourth quarter has accounted for about one third of McCormick's consolidated sales and is when branded sales tend to account for a larger proportion of its revenue base. However, given the pricing power inherent in McCormick's business and the fact that the firm dominates the domestic spices and seasonings aisle as the largest branded and private-label player, we expect only a modest hit to volumes as a result of these higher prices.

While many firms in the industry have increased prices in order to offset higher input costs, few have been able to preserve margins entirely. Still, margin contraction has been less pronounced among firms that hold a more meaningful degree of pricing power. For instance, significantly higher corn and soybean prices have hindered profitability at Tyson Foods TSN and Hormel Foods HRL lately; however, Hormel's gross margin contraction of 120 basis points to 16.0% from 17.2% a year ago was markedly better than Tyson Foods' whopping 430-basis-point contraction to 4.7%. Differentiated, value-added products allow Hormel to charge premium prices, generate wider margins, and absorb cost pressures better than peers, and we believe Hormel can produce higher earnings in the years to come even if cost challenges linger. At the same time, we expect earnings growth to be much more difficult for Tyson. Although Tyson's move into value-added products could help improve profitability, it still generates a majority of its revenues from raw-meat products. Supply-chain efficiencies may help preserve margins, but cost-cutting initiatives have limits; without significant pricing power, we believe the commodity cost environment will have a disproportionate impact on the firm's operating results.

Erin Lash, CFA, is a senior stock analyst with Morningstar.
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