Our Outlook for Consumer Stocks

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• Consumer packaged goods firms seek ways to contend with deflationary pressures, rising input costs, and pervasive competition
   
• Cable networks and Google remain well-positioned in an ever-changing media landscape
   
• Promotional activity and difficult comparisons imply only modest top-line growth for retailers, putting merchandise margins at risk

Although we believe the worst is likely behind us, the third quarter lent additional credence to our view that consumer spending will likely remain volatile. Amid macroeconomic projections that range anywhere between double dip to cautiously optimistic, perhaps the only certainty is that consumers will remain more discriminating in their purchases over the foreseeable future.

Middle- to upper-income consumers have demonstrated a willingness to spend, but they continue to take cues from asset market movements, particularly home and equity values. Basic-need consumers, on the other hand, remain squarely fixated on value as they struggle with obstinately high unemployment rates and stagnant wage growth. With companies unlikely to accelerate near-term hiring activity due to rising cost pressures on several fronts, consumers continuing to balance spending with personal debt obligations, and the absence of government stimulus initiatives, we believe it will be difficult for consumer spending to sustain any trend over the next quarter and beyond.

Generally speaking, we believe consumer stock valuations appropriately reflect our turbulent spending outlook. However, pockets of value can still be found across our coverage universe. A name like  Procter & Gamble (PG), which has fallen out of favor as it attempts to recapture lost market share, strikes us as a worthwhile investment idea. The company possesses several of the investment criteria we look for during uncertain economic times: meaningful structural advantages, pricing power to offset softer volumes, ample resources to extend its brand reach, and exposure to higher-growth emerging markets.

Even with our cautious near-term outlook, we're also optimistic that cyclical laggards such as grocers and restaurants could offer an attractive investment opportunity for long-term investors. The market has either written off many of these names or regards them as value traps, but we view many of the headwinds weighing on results to be temporary, and we expect improving fundamentals as consumer demand gradually ratchets upward. We'd also be on the lookout for buying opportunities across much of the consumer space during the final months of 2010 if fading top-line momentum and margin pressures drive stock prices downward.

In contrast to our cautious outlook for consumer spending, we believe that consumer companies are eager to exploit higher-return opportunities for cash balances after two years of anemic returns and limited organic growth prospects. Acquisitions should remain a consistent theme, as consumer products firms continue to build out their brand portfolios, increase stakes in joint ventures, or bring overseas licensees in house. Double-digit dividend increases and sizable share repurchase programs have also become commonplace among consumer firms, often backed by low-interest debt issuances. Armed with large pools of undeployed capital, we also expect buyout firms to frequently target consumer names in the near future, especially names that meet the leveraged buyout profile of strong free cash flow and manageable debt obligations.

In the report that follows, we discuss prevalent themes in several consumer-driven industries and end with our most compelling investment ideas.

Consumer Packaged Goods
As consumer packaged goods (CPG) firms come to grips with the realization that historical spending levels are not likely to return in the near term, a familiar theme is prominent in their results: Increased promotional activity is required to encourage consumer brand loyalty.

Large retailers such as  Wal-Mart (WMT) are pressuring CPG firms to offer price discounts in order to drive store traffic, and  Kroger (KR) reported 1.8% deflation among its center of store categories in its most recent quarter. The deflationary impact of these promotions, which have hurt manufacturers' revenue and profitability, has been particularly evident in a several commodified categories.  Kellogg's (K) North American cereal sales plummeted 13% during the most recent quarter, which was in line with results reported by  General Mills (GIS) and  Ralcorp .

 

Household products categories have also seen their fair share of deflationary pressures, as  Colgate-Palmolive's (CL) Europe/South Pacific business segment suffered a negative 2.5% impact to top-line sales from pricing, coupons, and trade incentives. With the U.S. unemployment rate still stubbornly high, we suspect promotional spending will continue to be the primary crutch that drives volume growth in the coming months. The longer this challenging environment continues, the greater the risk for CPG firms that consumers become accustomed to lower prices and make fewer impulse purchases.

Compounding deflationary pressures at retail are steadily rising input costs. The prices of commodities such as coffee, wheat, and cocoa are at multi-year highs, and given the intensely competitive retail environment, we think it is unlikely that manufacturers will be able to pass through the cost increases to customers in the short term.

Advertising costs are on the rise as well, both due to the need to invest in brands and to rising advertising rates. For example, P&G suffered a 22% decline in operating income in its Fabric Care and Home Care business during the second quarter, as the firm stepped up its commercial spending in an effort to defend market share. To some degree, P&G is playing catch-up and trying to recapture market share lost earlier in the recession, but if category growth rates remain sluggish, heightened spending and promotional discounts will devastate profitability across the industry, in our view. We expect gross margins over the next two quarters to be flat to down slightly (exclusive of various cost-savings initiatives) for most of the household product firms that we cover. Should input costs continue to rise or if CPG firms pull back from promotional support, they'll need to take care not to reverse course too quickly, as margins could suffer at the hands of shoppers that continue to balk at higher prices.

While CPG firms are feeling the pinch of weak consumer spending, we think the competitive environment among grocery stores has stabilized, a welcome sign following intense competition last year. Grocers have been dealing with lower prices for over a year, and continued top-line pressure should persist as the year progresses considering that CPG firms remain so focused on promotional activity. However, we are seeing signs of improvement in other areas, as grocers have been successfully passing through modest price increases in other areas like dairy and meat.

The performance dichotomy between emerging and developing markets was evident again in the third quarter, and was particularly prevalent in the beverage industry. Both  Coca-Cola (KO) and  PepsiCo (PEP) reported double-digit growth rates in India and China as they continue to reap the rewards from investments in those countries. We believe both companies have the potential to achieve long-term revenue and profitability growth in regions such as Asia and Africa due to growing per capita consumption and lower distribution costs as a result of improving infrastructure. Conditions in the North American market, however, are much more challenging. Industry volumes have been falling as consumers cut back on impulse purchases, and the shift to non-carbonated drinks is likely to continue to create an unfavorable long-term mix shift. Against this unattractive backdrop, PepsiCo continued to underperform Coke in North America in the most recent reported quarter, with a 1% beverage volume decline compared to Coke's 2% increase, albeit against weak comps a year ago.

For several quarters we have been predicting that pricing in the tobacco industry would become more rational, and our industry thesis played out in the second quarter. After adjusting for trade inventory movements,  Altria's (MO) cigarette volume fell 3.5%, in line with the industry's long-term rate of decline. Marlboro's market share increased 1.6 percentage points, which we think was supported by the introduction of new line extensions earlier in the year. Nevertheless, this impressive share gain appears to confirm our expectation that competitors like  Reynolds American  have become less aggressive on price promotions and that trading down to discount brands has moderated. Although there are further challenges ahead, including an FDA ruling on the future of the menthol category by March 2011, we think that rational pricing will prevail in the industry in the long term, and we expect the major domestic players to continue to be able to raise prices at a faster rate than volumes decline for many years to come.

Cash is building up on companies' balance sheets, and we expect M&A activity, share buybacks, and dividend increases to be on the horizon in the consumer staples industry.  Nestle (NSRGY) has around $20 billion in cash to spend following the sale of  Alcon  to  Novartis (NVS), and its balance sheet could support further leverage for a major acquisition.  Danone (BN),  Mead Johnson  and even General Mills could all be potential takeover targets for the firm. Nestle increased its dividend by 16% earlier this year and in the second quarter announced a CHF 10 billion ($9.5 billion) share repurchase program. PepsiCo also announced a $15 billion share repurchase program, a move we support because we believe the shares are slightly undervalued. Additionally, tobacco giants Altria and  Philip Morris International (PM) both raised their dividend at a double-digit rate in the second quarter.

In general, we think CPG firms are fairly priced. However, investors still have an opportunity to buy a few quality names at discounted valuations. Wide-moat household and personal care giant Procter & Gamble looks particularly undervalued, as near-term concerns over volume growth trends cloud the market's view. Grocers  Supervalu  and  Safeway  also appear undervalued. Despite the challenges retailers face in driving traffic in a period of sluggish consumer spending, we think these stocks are undervalued because the market is pricing in too pessimistic an outlook for the long term. 

 

Media
Media companies continue to remain selective in distributing television content outside of their traditional cable, satellite, and telecom distribution partners, and we expect this trend to continue. There are several video-based devices all competing for a spot in the living room, including  Apple (AAPL) with its recently released version of Apple TV that allows video streaming. For now, Apple's television content is light, reaching an agreement with  Disney (DIS) and  News Corp  for ABC and Fox network episode rentals for 99 cents each. Apple reportedly has tried to get content owners to work with them on a bundled TV subscription. However, media firms want to protect the valuable pay television business model and keep their current distribution partners happy. Therefore, they have been careful about making cable network shows available outside existing distribution channels. On the other hand, content owners have been more willing to experiment with programming from their broadcast networks relative to cable networks, with Hulu as a prime example with its predominance of network shows.

Even as the cost of pay television has risen, a monthly subscription is still relatively cheap on a per hour of consumption basis, especially with the average U.S. household watching over eight hours of TV per day according to Nielsen. Additionally, consumers have become accustomed to having a wide variety of content available within a basic video subscription. Eventually, we believe content owners and pay TV distributors will allow authenticated customers to access content on multiple devices.  Time Warner  has been a strong proponent of this concept, dubbed "TV Everywhere," and its HBO Go service allows subscribers to access HBO content through its proprietary website. Subscribers will be able to stream programming on portable devices in about six months.

In the lucrative search market,  Google's (GOOG) strong competitive position remains intact even as the  Yahoo  and  Microsoft (MSFT) alliance moves forward. Organic search results for the two firms in the U.S. and Canada are now being powered by Bing, Microsoft's search engine. The next step in the process is transitioning all of Yahoo's advertisers and salespeople to Microsoft's advertising platform. At that point, Microsoft will also start delivering paid results (ads) to Yahoo's search pages. While both sides hope to complete the transition this fall, any hiccups along the way will likely result in the transition being delayed until after the crucial holiday season.

We expect the Microsoft-Yahoo search alliance to create modest headwinds for Google in the short to medium term as incremental marketers are attracted to the reach of the combined platform (about 28% market share of search queries, which still trails Google's 65%). However, we think the secular growth of search advertising will more than offset any temporary headwinds for Google. Additionally, the company's competitive advantages, such as brand and scale, may lead to more market share gains over time, reducing the attractiveness of advertising with Microsoft/Yahoo altogether.

Retail
Much like their CPG counterparts, a highly promotional environment and event-focused advertising has driven transaction growth for many retailers--but could also keep margins in check over the foreseeable future. We continue to forecast increased sales volatility over the next several months, particularly as comparable-store sales trends become noticeably more difficult in September. Lackluster economic data also point to a slower-than-expected U.S. recovery, suggesting consumers will remain focused on value and will likely continue to take a conservative approach to spending over the coming quarter.

Department store shares rallied following a stronger-than-expected August comparable store sales report, which has somewhat reduced our appetite for exposure to the sector. Macro trends such as unemployment and hours worked have either stabilized or improved sequentially, but many are still down on a year-over-year basis.

We still remain concerned about consumer headwinds and more difficult comparisons in the coming months, but we believe that some department stores,  Macy's (M) and  Nordstrom (JWN) for example, have been successful with pricing strategies this summer. While a focus on lower price points resulted in a slight dip in average unit retail, these firms saw increased conversion and traffic trends as consumers sought value.

Although many department store stocks trade at or near their respective fair value,  J.C. Penney  is one undervalued name, though it's likely facing a longer road to recovery. Our checks suggest that the company was even more promotional than usual, particularly during the end of August and beginning of September, which gives us pause; however, we focus on a multi-year margin recovery story and the potential sales catalyst led by the new Liz Claiborne rollout.

Women's apparel retailers such as  Chico's  and  Ann Taylor  reported an uptick in inventory levels at the end of second quarter, largely driven by merchandising misses. While these problems are likely one-time in nature and we believe that these retailers could easily adjust their merchandise mix in the upcoming quarters, we think this phenomenon highlights the importance of a retailer's ability to stay in-tune with consumers' changing preferences and tweak products swiftly based on demand.

The teens apparel market continued to be plagued by weak spending trends, as unemployment among 16- to 19-year-olds remains high (26.3% as of August). Therefore, price wars among teen apparel chains were prevalent during the second quarter, with  Abercrombie & Fitch (ANF) cutting prices as much as 50% on some items, which is a rare occurrence for this premium-priced retailer. However, this was still insufficient to clear excess inventory in the system (up about 52% from the prior year), and the firm alluded that it will continue to run aggressive discounts in the near term even if it means tolerating some gross margin erosion. In our view, this spells trouble for other teen apparel chains such as  American Eagle (AEO) and  Aeropostale , which have already begun to cut prices on some products, placing significant downward pressure on selling prices, as well as margins.

And as consumer confidence continues to falter, we see no signs that these price cuts will abate anytime soon, and we expect a very promotional back-to-school and holiday season in 2010. Nonetheless, we think retailers like  Urban Outfitters (URBN) and  Limited Brands (LTD), which consistently provide consumers with something fresh and unique, will outperform peers in the near term, especially since post-recession consumers remain very selective with their purchases. Given solid sales volume and tight inventory management, both companies entered the third quarter with minimal excess merchandise, suggesting minimal markdowns, which will help preserve margins. Additionally, we think Macy's and Nordstrom's move to introduce more products with lower starting prices, instead of selling higher-priced goods that will be discounted later, could prove to be a more efficient way of driving traffic and maintaining margins, especially given consumers' continued focus on value.

We still have a favorable long-term view of the home improvement stocks and believe that both  Home Depot (HD) and  Lowe's (LOW) remain on track to deliver low-single-digit revenue growth and solid margin expansion in a "year of transition." There are several moving pieces to the macroeconomic puzzle, which have been driving these stocks in recent months, and the coming quarters are still likely to be choppy. However we believe long-term fundamentals at both firms have been excessively discounted by the market, and we see a path to multiyear revenue and margin recovery as residential construction and consumer sentiment trends normalize over time.

Looking ahead to the fall and holiday seasons, we expect the "value" theme to remain top-of-mind with consumers and retailers, and while we believe consumers will be willing to spend, they remain extremely price-sensitive. We remain concerned about aggressive discounting and price deflation at many retailers, which, while driving transactions, could ultimately lead to margin pressure.

 

Travel & Leisure
The travel and leisure industry remains in recovery mode after a multi-year slump. Hotel operators' second-quarter results reflected increased occupancy levels and small growth in average daily rate.  Marriott International (MAR) reported the first rate increase in nearly two years for the firm. Although room rates remain below pre-recession levels, we are encouraged by the return of pricing power, however modest, as it indicates that trends are moving in the right direction.

Larger increases are coming primarily from the luxury category, which comes as no surprise considering that it was the hardest hit in the downturn. Hotel operators with higher-end brands should see more robust operating results, while those weighted more heavily toward economy brands should experience less of a rebound since lower-end brands were more resilient during the downturn.

On a regional basis, emerging markets have recovered faster than developed regions. According to Smith Travel Research, revenue per available room in July 2010 increased 20% and 22% for Asia Pacific and South America, respectively, compared with 8% in North America. We expect these trends to prevail through the remainder of the year, especially considering that there are still relatively easy comparisons to lap in the third quarter. Fourth quarter comparisons become more challenging, however, so the magnitude of improvement may slow. Additionally, the shape of the recovery in the travel market still largely depends on general economic conditions, which remain in a precarious position.

Our Top Consumer Picks

Top Consumer Sector Picks
	Star Rating	Fair Value Estimate (USD)	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Supervalu		25.00	None	High	0.45
Lowe's Companies		36.00	Wide	Medium	0.58
Safeway		30.00	None	Medium	0.68
Procter & Gamble		77.00	Wide	Low	0.79
Netflix		43.00	None	High	3.27
Data as of 9-20-10.

 Supervalu 
Supervalu started on less advantageous footing compared to peers, as it acquired a portfolio of underinvested and uncompetitive stores from Albertsons. We expect improvement in gross margins as 2010 progresses, driven by SKU rationalization and a focus on increasing private-label penetration. We also anticipate less top-line pressure in the form of moderating deflationary trends.

 Lowe's (LOW)
Despite a shaky macro environment, Lowe's has remained profitable and continues to generate significant cash from operations. The market's pessimism reflects persistent fears over housing and consumer spending. However, catalysts should arrive in 2010 as consumers gain confidence and resume investing in their homes, relieving overblown market fears on the stock. The removal of homebuying stimulus and higher interest rates could present mild downside risks in the short term.

 Safeway 
Focus on a premium store experience put Safeway in a tough position once the downturn hit. The firm has worked to lower prices, and volume trends are improving as a result. A deflationary environment may turn slightly inflationary in the back half of 2010, providing a benefit to the top line. Additionally, freshly renovated stores limit capital expenditures over the next few years, boosting cash flow.

 Procter & Gamble (PG)
P&G has stepped up promotional and ad spending in an effort to reclaim lost market share. While the shares have languished, and shopper frugality persists, there are reasons to be optimistic longer term. The firm's brands still have expansion opportunities in developing markets, P&G has a healthy lineup of new products backed by significant support, and from an operational standpoint, there is still fat to trim in the firm's overhead. With an average 7.0% cash return, we expect patient shareholders will be rewarded.

 Netflix (NFLX)
Over the next few years, we expect more digital distribution of movies as online speeds and interfaces improve, allowing studios to partially offset falling DVD sales. This should cause Netflix's distribution and cheap content advantages to fade, leading to lower profitability over time because there are more competitors in the space, and digital content redistribution laws are less favorable than for physical media. In the short-run though, fundamentals will be strong, potentially pushing the stock higher before it moves lower.

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