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By Jeremy Glaser and Erin Lash, CFA | 03-07-2013 12:00 PM

Consumer Product Firms See Innovation as Key

Given the less than robust outlook for the global consumer spending, consumer packaged goods companies are turning to product innovation to drive growth, says Morningstar's Erin Lash.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Erin Lash. She is a senior equity analyst at Morningstar, and she recently came back from the CAGNY conference, which covers consumer goods. We'll talk about the state of the global consumer and if there are any opportunities in the sector.

Erin, thanks for joining me today.

Erin Lash: Thanks for having me, Jeremy.

Glaser: So let's start with the consumer. There's been a lot of concern, both in the U.S. and abroad, that in the U.S. maybe things like the payroll tax are slowing down consumer spending, Europe is obviously having a hard time economically, that emerging markets are slowing. Listening to the different management teams of some of these big consumer product companies, what are their views on consumer spending and their expectations for 2013?

Lash: You know, overall I'd say the outlook is not overly robust, but not dire, either. I think that their management groups are expecting that consumer spending levels will remain about the same or pick up gradually over the next several quarters. Obviously there still are impending headwinds. Gas prices have been quite elevated. The payroll tax that you mentioned. Unemployment levels are still high and austerity measures in Europe are nothing to balk at. That said, consumers are making purchases and are continuing to buy a lot of these essential items that consumer product firms sell. So, overall it doesn't seem like we're on another eclipse.

Glaser: So, when we look across regions, are there some that they are expecting to be stronger than others or really kind of static across all…

Lash: It seems more static. I mean obviously emerging markets are going to continue to drive growth relative to the mature developed markets. But even growth in developing markets has slowed over the past few quarters.

Glaser: So with this flat or maybe slightly up outlook, what are the companies doing to drive people to different product categories, to try to keep their sales growing?

Lash: You know there are a couple of things that they're doing. Obviously product innovation was a huge topic at this year's conference. Every company I think mentioned different product innovation initiatives that they're undergoing and those differentiate their offerings from private label. They also build brand loyalty and can prompt consumers to trade up. Clorox's CEO mentioned recently that premium Glad trash bags, the ones that include Febreze or OdorShield, are actually doing better than base trash bag business, which is a category that has a high level of private-label penetration.

Beyond that, companies are reducing the pack sizes, so selling smaller pack sizes for a consumer that has less dollars in their pocket. And finally they're trying to get their outlets where consumers are shopping. So for instance, in the U.S. that means having an additional set of SKUs that you are selling through the dollar store channel or more instant consumption-type channels.

Glaser: So when you look at the different types of consumers, you mentioned some of those premium products are doing better than basic products. Do you see a big differentiation between wealthier consumers and maybe low- and middle-income buyers?

Lash: We have seen, and a lot of the companies did talk about that, that middle-income consumer has been squeezed and it's trending into that lower-income bucket. The wealthier consumer has continued to hold up fairly well, but even that lower-income consumer is looking for value, and if they feel that they're getting value from a particular product, they are showing a willingness to pay up for it.

Glaser: Let's turn to consolidation. There was big news earlier this year with Berkshire Hathaway and a Brazilian private equity firm taking Heinz private. Do you think that we're going to see more M&A activity in this space?

Lash: That deal that was announced just a few weeks ago with Heinz was just another value-enhancing transaction that we've seen in this space over the recent past. We've seen marriages and divorces, mergers and acquisitions, splits, divestitures. So this was just another notch in that playbook, from our perspective. But given that it happened so close before the conference there was a lot of talk about that and how it will continue to progress.

We don't think that we're on the verge of another leveraged buyout boom, but we do think that continued consolidation or value-enhancing transactions will continue to persist throughout this space.

Several of the firms mentioned that they're pursuing smaller bolt-on transactions particularly to build out their footprint in faster-growing emerging and developing markets, which we think is smart, given that tastes and preferences vary in these countries, and given that the distribution and sales environment is different--teaming up with the local player that understands the market and the consumer is a wise move. Those transactions aren't likely to drive meaningful differences in terms of the valuation or the financial performance, but ultimately should enhance a company's scale and distribution.

Glaser: So, if management teams are shying away from maybe some transformational deals, what are they going to do with their cash on the balance sheet? Are we going to see more dividends? What's happening there?

Lash: Obviously, consumer product firms generate a ton of cash, and so we've seen them put it to use to a certain extent with M&A. We've talked about earlier reinvesting in the business, product innovation, marketing support to tout those new offerings in front of consumers. And then finally, these companies tend to be significant dividend payers. I think the average dividend yield on a lot of these stocks right now that presented at the conference is around 3.5%, sometimes closer to 4% or 4.5% for some of these higher-yielding players, and so we think that dividend payments and returning excess cash to shareholders will remain a top priority.

Glaser: Are there any good buys in this space right now?

Lash: Obviously, this has been a sector that has gotten a lot of interest, given the more stable and consistent cash flows that the business generates. That said, there are still a couple of names that we would suggest investors keep their eye on.

One is Sysco. It's a North American food distributor that maintains a significant amount of scale and dominance in its home market, and we think the company is appropriately investing to take further costs out of the business to enable it to go after more customers profitably. In addition, it pays a decent divided, and so we think that Sysco should be one that investors keep on their radar.

Beyond that, Kraft Foods Group, which is the North American grocery operation of the former Kraft business that was spun off back in October. We think that there is potential and that the market's underestimating the cash flows that that business generates. The dividend yield is between 4% and 4.5%. They're investing behind brands that were previously utilized as cash cows to fund growth in the global snacks business, and we think that by doing so, they are going to realize some pretty decent growth despite the fact that they compete in a mature market.

Glaser: Erin, thanks for your insights today.

Lash: Thank you for having me.

Glaser: For Morningstar, I'm Jeremy Glaser.

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