Our Outlook for Consumer Defensive Stocks
As inflation becomes more pronounced, look to consumer defensive stocks for opportunities.
While the worst appears to be over for most consumer defensive firms, we believe the road to pre-recession fundamentals will be drawn out. We are confident that most consumer packaged good companies will continue on the path to top-line recovery in 2011, but inflationary cost pressures, rising gas prices, and anemic wage growth remain threats to the spending power of lower- and middle-income consumers, many of whom have become more sensitive to pricing during the benign inflationary environment of the past 18 months.
Supply shocks and growing demand from Asia have resulted in an unprecedented surge in year-to-date commodity prices, so it's not surprising that the central focus among consumer defensive companies is navigating these headwinds over the coming months. As hedges against input costs expire throughout the year, manufacturers will undoubtedly be forced to raise prices or swallow cost increases themselves. Based on the rapid increase in the cost of certain inputs, traditional 2% to 3% price increases may not be enough to offset cost pressures in 2011.
Not surprisingly, we're particularly interested in consumer defensive firms' pricing plans for 2011. Although we expect consumers to tolerate some price increases this year, we've also sensed overconfidence in the ability to pass on rising input costs to retailers and consumers during our recent conversations with some management teams, especially given the unprecedented awareness about prices among today's consumers. As such, we believe price increases could be a bitter pill for consumers to swallow, making 2011 margin improvement goals difficult for many consumer packaged good companies.
Looking beyond North America, we've been monitoring trends among European consumers, as we don't think the full impact of austerity measures have been felt. Additionally, with emerging and developed markets behaving so differently, we are analyzing consumer firms' plans to grow the top line in mature markets and capture incremental share in emerging markets, whether it be through organic growth initiatives or acquisitions.
Private label remains a key area of interest to us. If trading up continues in 2011, we would expect branded product manufacturers to benefit. However, with the quality of private-label products having improved in recent years, manufacturers of packaged goods may find it difficult to wean consumers off private label. Consumer perception of a product's value proposition will remain a critical factor in purchase decisions for several months to come.
Merger and acquisition activity should remain a prevalent theme in the consumer sector during 2011, following Kraft's (KFT) acquisition of Cadbury and the consolidation of bottlers among both soft drink giants. With consumer companies such as Sysco (SYY), McCormick (MKC), and Heinz sitting on sizable cash positions, we believe that the opportunity for small tuck-in deals either at home or abroad are strong possibilities this year. We also would not rule out another blockbuster deal like Kraft/Cadbury, as credit markets appear to have thawed enough to support larger transactions over the near future.
Consumer discretionary stocks have had a tremendous rally over the past six months, but we expect investor sentiment to cool as top-line momentum stagnates and margin pressures become more pronounced. As such, we find more pockets of value in the consumer defensive universe, including several companies that have developed wide economic moats. We like companies possessing a combination of economies of scale, pricing power in categories where perceived differentiation matters, resources to extend brand reach, and exposure to emerging markets. In particular, we believe today's prices offer opportunistic entry points for wide-moat names such as Avon Products , Procter & Gamble (PG), and Colgate (CL), which appear undervalued despite their competitive advantages, footholds in developing markets, and excess returns on invested capital.
Unlike other consumer defensive categories, the second half of 2010 was notable for a slow improvement in the U.S. spirits market. Diageo (DEO) (DGE) CEO Paul Walsh described the economic recovery in the U.S. as "not a snapback, but a clear trend," and said that a trend toward premium products has slowly returned due to heavier traffic at on-premise locations and greater hotel bookings. We doubt that this trend will ever return to the levels of 2008, when consumers were paying a heavy premium for the same product with higher-end packaging, but the recent trends of improving on-premise consumption bode well for alcoholic beverage volumes and pricing power, particularly in categories such as rum and tequila, which are heavily reliant on traffic at bars.
We believe several alcoholic beverage names offer a potential safe haven from commodity cost pressures. For instance, commodities such as wheat and barley represent just 4% of Diageo's sales, with packaging and distribution accounting for much of the rest of the cost of goods sold. Of the commodities exposure it does have, Diageo is fully hedged for 2011 and 20%-30% hedged for 2012. In addition, one-third of its portfolio is positioned in maturing categories such as whisky, in which the distillation and aging processes can take many years. In order to be branded as "scotch," whisky must be aged for at least three years, and most of Diageo's scotches are matured for a period of at least 12 years. Consistent with International Financial Reporting Standards, Diageo records cost of goods sold on an actual usage basis, meaning that it will be at least another decade before some of today's commodity cost inflation feeds through to Diageo's income statement.
Emerging markets are likely to continue to be the growth drivers for alcoholic beverage companies in 2011 and beyond. Beer is often the entry point for alcohol consumption, so international brewers with a strong foothold in fast-growing developing markets--such as SABMiller (SAB) and Anheuser-Busch InBev (ABI) (BUD)--should continue to benefit from growth in Asia, Latin America, and Africa. Fundamental trends in these regions are strong: Both GDP and population growth are expected to materially outstrip global growth rates, and some of the fastest-growing economies over the next four years (according to the IMF) can be found here. SABMiller and Anheuser-Busch are well-positioned to exploit these trends and will become even more so as they expand their low-end product portfolio in an attempt to capture the growing numbers of drinkers entering the branded beer market for perhaps the first time. Over time, as disposable incomes grow, alcoholic beverage firms should be able to migrate these consumers to increasingly higher price points. At the other end of the pricing scale, there are also emerging-markets opportunities in the premium category. The expanding middle class in South Africa should allow the premium category to take significant share from mainstream brands over the next few years. Latin America is a similar story, and we believe there are opportunities to gain share by targeting female consumers and by expanding into non-beer malt beverage categories.
M&A activity is rarely off the agenda while talking about the alcoholic beverages industry. Although we regard this as one of the riskier strategies to achieve growth, a company like Diageo has been fairly disciplined in its approach to acquisitions. The recent purchase of Mey Icki in Turkey at less than 10 times trailing EBITDA is an example. We would like to see Diageo use acquisitions to fill out its portfolio in emerging markets. The acquisition of LVMH's MC beverage brands would be ideal, as the Hennessy cognac brand has strong growth potential in China, but Fortune Brand's Jim Beam may also be appealing given the absence of a strong bourbon brand in Diageo's portfolio.
Although we like the stories of Diageo, Anheuser-Busch, and SABMiller, we would not be buyers at current levels. With Diageo trading at 15 times 2011 earnings, Anheuser-Busch at 18 times, and SABMiller at 17 times, we think the growth opportunities of each firm are appropriately priced into the stocks. For an opportunity in the alcoholic beverages industry, we recommend value investors look at Molson Coors (TAP), which is trading at a low-double-digit multiple due to the sluggish markets in which it operates, despite the opportunity to grow operating income at a high-single-digit rate as the firm slashes operating costs by reconfiguring its North American distribution. A fall in the rate of unemployment could provide a catalyst for the stock, which has suffered as Coors drinkers have been disproportionately affected by the recession.
Restaurant traffic--and subsequently sales at food-service distributors--continued to show some signs of life in the most recent quarter, but food cost inflation have plagued profitability at Sysco and other food distributors. A modest level of food inflation (2%-3%) is ideal for Sysco, as the firm is able to pass these higher costs along to its primary customers (restaurants) without a major impact on volume, but a rapid spike in food costs could pressure the firm and its clients--as it is currently.
The degree to which food costs are rising is particularly notable compared with the year-ago quarter, when Sysco and its customers were operating in a deflationary environment (food cost deflation amounted to 3.5%). We don't believe these pressures will subside over the near term, as supply constraints and increasing demand for inputs in emerging markets are placing upward pressure on commodities. Sysco shares look attractively priced to us, but concerns about food inflation may continue to weigh on the stock price over the near term.
Competition for consumers' dollars at the grocery aisle remains fierce. Food price inflation has not flowed through operators' results as quickly as we had anticipated, and we believe this is due to a continued focus on price to drive traffic, particularly among consumer packaged goods firms. We believe all grocers will be forced to raise prices in 2011 to mitigate rising prices from manufacturers, but in the short term, they may be forced to swallow some of the impact from food inflation to maintain store traffic. As a result, gross margin may come under pressure over the next few quarters. Grocers' outlooks for the near-term remain muted, and we expect that current conditions will persist, without a material worsening or improvement in upcoming quarters. Nonetheless, we expect a focus on price to remain prevalent in the near term as consumers remain extremely sensitive to value propositions.
We remain optimistic that several names in the late cycle category could offer attractive opportunities for investors with long-term horizons. In particular, we see value in supermarket names like Safeway and Delhaize (DELB), as we believe the tepid near-term outlook is weighing disproportionately on shares.
Household and Personal Care
Surprisingly, the magnitude of cost inflation and the level of price increases that household and personal care firms are expected to be able to push through in 2011 don't appear to be significant, providing some good news for consumers. So far, the runup in costs hasn't been as significant as the increase the firms experienced in late 2007 and 2008, so the price increases won't be as dramatic. These are list price increases, however, so for the most part they will be across the board, but they likely won't be as much as the 3% increases expected in the food space.
The basket of agricultural commodities--including corn, coffee, and wheat--has risen faster and more dramatically than the inputs affecting household products such as diesel costs, pulp, chloric acids, resins, enzymes, and natural gas. Additionally, while the cost increases haven't been as striking as in 2008, the fact that the costs have increased quickly in the last six months has at least forced the companies to recognize that they need to take pricing. Slowly rising commodity costs that result in a "commodity creep" can do more damage than costs that rise quickly since companies can be slow to react. It's also clear that private-label manufacturers will need to take this pricing as well, so we doubt that we'll see many meaningful price gaps in the coming months. The upshot is that while higher prices are coming, they aren't the big story that we expected, and in developing markets, Procter & Gamble CFO Jon Moeller theorized that wage inflation will match food inflation, keeping steady the discretionary dollars available for non-food items such as soaps, shampoos, and toothpastes.
As a result, the overall message from household product firms on the pricing front has been rather muted: Price increases are coming (P&G's will be announced in the coming weeks, for example) but they will be closer to low-single digits with some select categories possibly seeing greater increases. Additionally, Clorox (CLX) pricing will be "more frequent but in smaller bites." In a bit of a strange twist, Energizer will be taking pricing on C, D, and 9 volt batteries. With fewer consumers demanding these batteries, and less trade spending behind the SKUs, the remaining specialized demand is relatively price inelastic.
Given the planned slow step change in pricing, there seemed little concern that volumes would suffer, but we'll see how this plays out. It's rare that weaker volumes don't result, if only for a few quarters. Promotional activity has died down in several categories, but we continue to see examples where list price increases are being countered with promotional "give backs," which aide the consumer and make the increases more palatable for the retailers.
Brazil has become an increasingly important market for household and personal care firms. There are obvious reasons for this: a fast-growing middle class with increasing disposable income, proximity to other Latin American markets where some of the firms have been competing for decades, and a culture that is even more accustomed to spending on beauty care products than in other Western countries. We think it's important to note a few broad points about Brazil that pertain to how well companies perform in the region. First, the consumer is a mass market consumer. Estee Lauder's (EL) CEO Fabrizio Freda recently stated that there wasn't a market for premium products there. Building one will be costly. Second, Brazil is very much a direct-sales culture. Consumers are much more accustomed to buying products through this channel than in the U.S. or Europe. Obviously this hasn't prevented Avon from struggling in the country, but it's important to note--and we continue to educate ourselves on--how the companies competing there aim to position themselves given these channel differences.
We find several attractively priced stocks in the household and personal care space, including P&G and Colgate. P&G has been undervalued for some time, but the company's analyst day in December revealed how "on message" the firm seems to be. The company seems more integrated operationally than it has been in some time. Moeller announced that third-quarter operating profit will be weaker as some of the firm's pricing initiatives won't have taken effect, but the second half of fiscal 2011 on the whole should be stronger than the second half of fiscal 2010. We still expect sales growth to increase just over 4.0% in fiscal 2011, which is at the low end of guidance. Over the longer term, we think P&G can increase sales 4.5% on average. We're also holding our gross margin steady as the company has already announced that input costs will be a $1 billion aftertax headwind for the year.
For Colgate, we still see the shares as modestly undervalued on lower mid-single-digit earnings growth for fiscal 2011. We expect growth to return to high-single-digits or low-double-digits by fiscal 2012, and an incremental $300 to $500 million in savings from its Funding the Growth plan, which is focused on gross margin, should help offset higher input costs. Management still has a mid-60s gross margin target within the next five years. However, we think this is aggressive. Colgate has pushed this target further out several times already, and our valuation does not assume Colgate reaches much over 60% over the next five years. Despite this, we've been impressed by how unfazed CEO Ian Cook has seemed by increased competitive activity. He acknowledged that the cost of doing business in Brazil, for example, has increased, but he questioned the sustainability of P&G's full-court press of spending behind its oral care brands in Brazil. He said the test will be how well P&G's current market share inroads hold up over the next two to three years.
An interesting dual has been taking place between the leaders in the non-alcoholic beverage industry, Coca-Cola (KO) and PepsiCo (PEP). Coke continues to execute well across the globe, taking market share in North America while still growing per caps in emerging markets. Coke is outspending Pepsi in developing markets and looks set for a sustained period of growth. Coke's per capita consumption globally is 89 eight-ounce servings per year, 394 servings in the U.S., but just 11 in India and 34 in China, suggesting that the firm has a solid runway for growth.
Pepsi, on the other hand, has struggled to gain share in the North American beverages market. We would prefer that Pepsi conceded second place to Coke in beverages and concentrated on its strength in snacks. Pepsi is essentially a snacks business, in our view. Two-thirds of its 2010 revenue was generated in snacks, and the firm has dominant market share in most geographic markets, well beyond that of Coke in beverages. Our investment thesis for Pepsi is based upon its positioning in snacks, and we think the market continues to be distracted by the underperformance in soft drinks. With Coke trading at 17 times forward earnings, and Pepsi at just 14 times, we think the multiple gap should contract over time as the economy slowly recovers and Pepsi returns to growth in North America.
With regard to the packaged food space, it's no secret that competitive pressures, from lower-priced private-label products and other branded offerings, remain intense. And given that unemployment levels are still stubbornly high, packaged-food firms have utilized promotional spending over the past year to drive sales and volumes. However, several competitors have been forthright in their assessment that recent promotional spending wasn't an effective or efficient means of driving incremental sales. As a result, a focus on brand building--to reignite sales growth and differentiate offerings from other branded and private-label alternatives--has been at the forefront of recent comments from packaged food firms.
For instance, Kellogg's (K) main emphasis has been regaining momentum this year, particularly with a greater focus on new product launches that resonate with consumers. Management is forecasting a 25% increase in products from innovation this year and expects that 15% of annual net sales will be derived from new products over the long term. Although we're encouraged by this renewed focus, we don't expect measurable improvements overnight. Kellogg recently reaffirmed its guidance for fiscal 2011, but raised its long-term revenue forecast from low-single-digit annual growth to 3%-4% growth annually, which management attributed to how the firm has actually performed in the past. However, this revised guidance is in-line with our current outlook--reflecting higher prices on products and new product introductions--and our fair value estimate remains in place. We agree that product innovation is what will ultimately drive increased sales within the packaged-food industry, but manufacturers must tread lightly, in our opinion, as consumers are not in a position to pay up for new offerings if the added value is not apparent.
Beyond competitive pressures, input cost inflation is also rearing its ugly head once again. For instance, ConAgra (CAG) management expects input cost inflation of at least 5% in fiscal 2011 which ends in May, followed by 7% higher costs in fiscal 2012. In light of these costs, ConAgra has increased prices on more than half of its portfolio and expects additional price increases to hit supermarket shelves over the next several quarters. Despite this, we haven't heard anything from management that would lead us to believe that consumers won't balk at these higher prices. The firm recently lowered its expectations for long-term earnings per share growth to 6%-8%, down from 8%-10%, which we believe reflects the fact that ConAgra operates with a portfolio of second- and third-tier brands and lacks the brand strength of its peers. Despite management's updated earnings per share targets, we don't intend to make any changes to our long-term assumptions as we had already taken a more conservative outlook.
While firms throughout the industry have announced their intentions to raise prices to offset a portion of higher input costs, we continue to believe that there is only so much that today's fragile consumer is going to be able to absorb. As a result, firms that possess a solid brand portfolio like Hershey (HSY) are best positioned to charge higher prices. More specifically, the lack of private-label penetration makes the confectionery category highly attractive. This is particularly pronounced in the U.S. chocolate segment, where Hershey maintains leading share, controlling 43% of the market, versus just 1% for private-label offerings. As a result, we believe that Hershey should be able to take pricing in the face of rising costs without detrimentally affecting volumes. The resilience of this category (and Hershey's positioning within it) is supported by the fact that despite the decline in promotional spending as a percentage of sales (from 15.0% in 2008 to 13.5% in 2010), Hershey's sales momentum continued (with sales growth of 7% in fiscal 2010, on 4% higher volumes), even though the consumer spending environment has been fragile.
Finally, packaged food firms tend to generate a significant amount of cash, and over the past few years these firms have tended to clean up their balance sheets. We also believe that packaged food companies will use their cash balances for acquisitions over the near future. With minimal debt and ample cash on hand, we believe that Smucker (SJM) is very open to pursuing acquisitions. While small bolt-on acquisitions are most likely, the firm has shown an ability to integrate larger brands (such as the acquisition of Folgers a few years ago). In addition, Hormel (HL) commented that it would be comfortable assuming up to $1 billion of debt if the right acquisition opportunity arose (which could include Sara Lee's North American retail meats business down the road).
Despite headwinds from higher taxes, smoking bans, and tightening regulation, tobacco industry fundamentals have improved significantly over the last nine months, and we expect these trends to continue as 2011 progresses. In the U.S., Reynolds American has pulled back from its strategy of implementing temporary price promotions, and this has created a more rational pricing environment, easing the competitive pressure on major competitor Altria (MO). However, high unemployment levels and rising gas prices are likely to continue to weigh on traffic in the convenience-store channel, where over two-thirds of cigarette sales are made, although with unemployment trends beginning to improve, we expect this pressure to fade as the year progresses.
There are still several headwinds in international markets. Excise tax increases in late 2010 in Japan and several markets in Eastern Europe are likely to weigh on results in the first half of 2011. Nevertheless, trading down appears to be moderating in Eastern Europe, and rebounding markets in Asia are likely to provide a boost to the larger international players Philip Morris International (PM) and British American Tobacco (BATS) (BTI) in the second quarter.
Consumer Defensive Stocks for Your Radar
|Consumer Defensive Stocks for Your Radar
| Fair Value
| Fair Value
Price/ Fair Value
|Procter & Gamble
Data as of 3-25-11.
Molson Coors (TAP)
Molson Coors' earnings growth potential is strong with the MillerCoors joint venture in the U.S. in its fold, but the market continues to be spooked by lackluster top-line growth at the firm. We don't expect Molson Coors to generate robust sales growth in the near future, but given its potential $210 million in cost savings from MillerCoors, its two-year earnings growth potential and long-run cash generation trajectory are being undervalued by the market. Plus, job growth could provide an upside catalyst.
Although rising gas prices, tepid confidence among lower-income consumers, and unemployment rates are near-term headwinds, we do not expect current conditions to last forever. Even assuming that revenue does not return to growth until fiscal 2012 (and even then very sluggish growth), and that operating margins remain well below historical norms of around 5%, the stock appears undervalued based on the value of its future cash flows. Additionally, freshly renovated stores limit capital expenditures over the next few years, freeing cash flow for other shareholder-friendly activities.
We believe management's focus to expand Sysco's distribution platform, improve supply-chain efficiency, and increase salesforce productivity will be driving forces behind the firm's growth over the next year. Although the company's results have softened over the past year as consumers eat more meals at home instead of at Sysco's primary customers (restaurants), we don't agree with the market's take that these pressures will eat away at Sysco's competitive advantages.
Procter & Gamble (PG)
P&G has stepped up promotional and ad spending in an effort to reclaim lost market share. Although 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.
The market appears fixated by Pepsi's underperformance in beverages. True, great rival Coca-Cola is executing remarkably well, and its dominance in the on-premise channel will make it difficult to dislodge from the number 1 spot in beverages, and its recent performance justifies a higher multiple. However, Pepsi is essentially a snacks business, and we think it should be trading at a higher multiple than the 14 times 2011 earnings the market is currently assigning.
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