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Quarter-End Insights

Our Outlook for Consumer Stocks

Performance in this sector ranged from merely poor to truly horrific.

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The fourth calendar quarter of 2008 was a terrible one for the consumer sector. Economic fundamentals, including rising unemployment, tightening credit standards, ongoing weakness in home sales, and a relentless stream of downbeat headlines kept consumers out of stores, and when they did shop they tended to buy less and to trade down.

Additionally, consumer products companies, having battled higher commodity costs throughout the year, now face a more tight-fisted consumer just as many were pushing through a new round of price increases. These companies were up against an unattractive choice; either take a hit to gross margins or sell fewer products. And although commodity prices actually fell in the second half of 2008, consumer product firms hedge a good portion of their input costs and have locked in higher prices that will pressure profitability into 2009.

Valuations by Industry
With the exception of alcoholic drinks, the performance of the industries that make up the consumer sector ranged from merely poor to truly horrific.

 Consumer Goods/Services Valuations
Segment

 Price/Fair Value*

Three Months
Prior
Change
(%)
Alcoholic Drinks 0.78 0.76 3
Apparel Makers 0.64 0.90 -29
Appliance/Furniture 0.77 0.79 -3
Auto Retail 0.81 0.89 -9
Beverage Manufacturing 0.73 0.90 -19
Clothing Stores 0.55 0.86 -36
Dept Stores 0.49 0.74 -34
Discount Stores 0.85 0.99 -14
Food Manufacturing 0.73 0.89 -18
Groceries 0.70 0.72 -3
Household/Personal Prod 0.75 0.94 -20
Online Retail 0.57 0.77 -26
Recreation 0.75 0.90 -17
Restaurants 0.77 0.85 -9
Shoes 0.68 0.90 -24
Specialty Retail 0.71 0.80 -11
Tobacco 0.70 0.85 -18
Data as of 12-15-08. *Market-Weighted Harmonic Mean

Clothing store and department store stocks were slaughtered during the quarter. Mall traffic fell substantially, and despite retailers' efforts to prune back inventory levels to respond to falling demand, stores were still forced to resort to rampant discounting in order to move products off the shelves. Apparel makers suffered as well, due to their dependence on the department stores and tightening credit markets, which exacerbated the woes of the more leveraged players.

At first glance, restaurant and discount store valuations appear to have held up relatively well. However, that is somewhat of an illusion. The data above is market-cap weighted, and two strong performers-- Wal-Mart (WMT) and  McDonald's (MCD)--make the aggregate numbers look much better than they actually are.

Consumer Goods/Services Stocks for Your Radar
Given that the U.S. could be headed toward an extended economic downturn, we are focusing on a combination of lower-risk firms that lean more toward consumer staples and that have dominant brands, and slightly higher-risk firms with better long-term growth opportunities.

 Stocks to Watch--Consumer
Company Star Rating Fair Value Estimate Economic
Moat
Fair Value Uncertainty

P/FV

Avon $44 Wide Medium 0.52
Colgate-Palmolive $79 Wide Low 0.83
PepsiCo $74 Wide Low 0.72
Procter & Gamble $77 Wide Low 0.78
Yum Brands $49 Narrow Medium 0.61
Data as of 12-23-08.

 Avon (AVP)
Given this firm's long history of managing through global economic disruptions, and the fact that it is more focused than ever on controlling costs and empowering its sales representatives around the world, we believe Avon will find a way to successfully navigate through the current crisis. With an infrastructure capable of supporting long-term growth, bright international prospects, and a business model that generates strong returns on invested capital, we believe that Avon will continue to reward investors over time. (For more on Avon, see our recent in-depth Stock Strategist Industry Report.)

 Colgate Palmolive (CL)
This company is likely one of the best-positioned consumer products firms around. Not only is it less exposed to input cost inflation because of its product categories, but its core toothpaste category is less sensitive to private-label threats as consumers tend to be highly brand loyal in oral-care products.

 PepsiCo (PEP)
Despite the head winds created by rising commodity costs and global economic weakness that PepsiCo is likely to face over the next couple of years, we continue to believe that the company will weather the storm much better than its peers. With a portfolio full of strong brands, a solid track record of product innovation and differentiation, and a direct-store-delivery network that has few peers, PepsiCo remains the gold standard for the consumer products industry.

 Procter &Gamble (PG)
P&G is the largest consumer products manufacturer in the world, with 24 brands that each earn more than $1 billion in sales. Procter & Gamble built its moat with product development and marketing, but the firm's strengths go beyond skills in brand building. The company consistently reinvents itself and refocuses on improving its capabilities where it sees opportunity.

 Yum Brands (YUM)
Narrow-moat rated Yum Brands (parent company of KFC, Pizza Hut, and Taco Bell) looks like an attractive investment to us. The stock is trading at about 60% of our fair value estimate. We believe the company is in the early innings of a tremendous growth story in China. Yum also has a strong presence in Japan, Great Britain, Canada, and Australia and is expanding further in continental Europe, India, and Russia. Yum should ultimately be able to turn around its U.S. business, as well. Altogether, Yum has the potential to deliver double-digit earnings growth for many years to come.

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Joseph Beaulieu does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.