Which Consumer-Products Firms Can Overcome?

Morningstar's equity analyst consumer team recently attended the 2008 Consumer Analyst Group of New York conference (CAGNY) in Boca Raton, Fla. The importance of this annual conference should not be underestimated, as it draws not only executives from 24 premier consumer-products companies, but also representatives from their competitors and analysts from all over the world. In the first of a four-part series of consumer-focused articles, I would like to share some big-picture thoughts about the issues facing these companies today and also put current challenges into some historical perspective. In the coming weeks, you will hear from my colleagues about key insights they drew from the conference and the impact these insights have on their long-term outlooks for the variety of consumer-products firms we cover at Morningstar.

How the Business Has Changed
It seems like it was ages ago when many consumer-products firms were thought of as the perfect blend of dependable profit margins, cash flow, and steady growth--an enviable combination that generally led to long-run market outperformance. According to professor Jeremy Siegel in The Future for Investors, 11 of the top-20-performing surviving S&P 500 firms from 1957-2003 were consumer-products companies. As we hear over and over in the investment world, past performance does not guarantee future results. Unfortunately, the consumer-products landscape has changed markedly and not to the benefit of many of these firms. The cost of doing business has increased dramatically.

Up until the early 1990s, consumer-products companies enjoyed a significant amount of power, and could protect margins and increase business by pushing steady price increases through to willing retailers. The emergence of  Wal-Mart (WMT) changed that dynamic. First, Wal-Mart pushed back on pricing and created more competition for shelf space; through its entry into the grocery space, it became the largest and most important domestic retailer for consumer-products companies. Second, consolidation in U.S. mass retail has concentrated influence in the hands of other large players, from the likes of  Costco (COST) in the wholesale segment, to  Kroger (KR) in groceries and  Walgreens (WAG) in the drugstore space.

All of these firms look to differentiate themselves from one another, and one common means today is through private-label (or store name) products. Private-label products were at one time a retailer's best attempt to develop a copycat product and gain some extra profit margin. However, these products have emerged as a way to help a retailer build its brand image. Costco's Kirkland brand and O Organics for grocer  Safeway  are two examples of strong private-label brands.

As power has shifted more toward the retailers, consumer-products firms have stepped up spending behind their brands, ramping up marketing expenditures and increasing their investments in research and development to spur innovative new products and packaging formats. While these costs continue to increase faster than sales, companies are now grappling with a more severe cost problem: sky-high input costs.

Wheat, corn, oil, dairy, you name it--prices for commodities are rising at precipitous rates. In the good old days, steady price increases were the norm but the magnitude of the price increases these companies require today just to try to offset commodity costs puts them in a precarious position. Can they increase prices enough to cover their costs without significantly eroding sales volumes? At CAGNY,  General Mills (GIS),  ConAgra (CAG), and  Kellogg (K) all cited that they expect input costs to rise in the high single digits this year. This is a worrisome outlook, given that these companies are striving for mid-single-digit revenue growth.

How Companies Can Respond to Cost Pressures
The presenting firms were peppered with questions about how they can offset these costs, spend more on brand-building efforts, and raise prices--all in a difficult macroeconomic environment. In tough times, won't consumers tend to trade down to private label?

The answer from pretty much every company was a resounding "no." The only suggestion that consumers were making changes to their purchasing habits came from management at  Anheuser-Busch (BUD), which admitted they were seeing a mix change toward their "subpremium" brands such as Busch and Natural Light. Interestingly, a number of the supermarkets and drugstores that I follow--which obviously weren't a part of the CAGNY conference--have commented that there is more trading down. We'll keep an eye on this apparent disconnect and see how it plays out this year.

Nevertheless, higher commodity costs and greater expenditures to support brands and compete for shelf space present tremendous challenges to these firms. The ability to generate dependable earnings growth in this type of environment is quite an achievement, and the firms that seem to be more consistent tend to be the ones that we were most impressed with at CAGNY, such as  Proctor & Gamble (PG), Kellogg, and  PepsiCo (PEP).

Perhaps most importantly, most consumer-products companies don't anticipate commodity cost pressures abating any time soon. What does this mean for investors? Hedging these costs can only accomplish so much. In our view, margins for many of these companies are going to be much more volatile than in the past--and in all likelihood, their stock prices will mirror this greater volatility.

Striving, or Stretching, for Growth
Most of the consumer-products firms presenting at the conference generate the bulk of their revenues in mature markets, such as the United States and Western Europe. So it was no surprise that many of these companies spent a great deal of time discussing opportunities in emerging markets.  Campbell Soup (CPB) devoted a considerable portion of its presentation to addressing investments in China and Russia. Even companies such as  Sara Lee  and  Unilever , which are already grappling with significant undertakings to improve their cost structures, made it clear that they plan to be opportunistic in developing markets.

Striving for growth and spanning the globe quickly inevitably leads to mergers and acquisitions. Building distribution in these fragmented retail markets is expensive, time-consuming, and risky. Additionally, not all food products travel well, and there are cultural barriers to their acceptance in many parts of the world.

We've already seen a step-up recently in transactions for international firms as well as growth brands in mature markets.  Coca-Cola (KO) acquired Glaceau in the U.S. and Mexican juice maker Jugos del Valle, and  Kraft (KFT) expanded its international sales and distribution footprint by acquiring Groupe Danone's biscuit business. A number of the presentations touted the potential of future M&A activity in the consumer-products space, so it will certainly be something to watch in the coming years.

Which Stocks Look Attractive?
Input cost pressures, a tough consumer environment, and the need to ratchet up spending behind core brands are common challenges facing consumer-products firms. Although consumption growth in emerging markets and acquisitions are opportunities to increase sales and leverage higher costs across a larger revenue base, they bring their own risks. Despite a much more difficult landscape for consumer-products companies, we see opportunities for investors in this space, as we think some companies are much better positioned than others.

Check back in the coming weeks as my colleagues share their impressions of CAGNY and offer up some of the best investment ideas among the stocks they cover:

March 14: Gregg Warren--Packaged Foods/Nonalcoholic Beverages

March 21: Lauren DeSanto--Household and Personal Products

March 28: Ann Gilpin--Alcoholic Beverages