Our Outlook for Consumer Defensive Stocks

• Margins are likely to remain constrained as commodity cost pressures persist.
• A pronounced uptick in spending among developed-market consumers is likely several quarters off, but emerging markets provide an opportunity for growth.
• Spin-offs could also become acquisition targets in 2012.

 

Margins are likely to remain constrained, as commodity cost pressures persist.
While the rate of commodity cost inflation has moderated relative to the first half of 2011, the prices for several raw materials remain considerably above the level of just two years ago. Green coffee spot prices, for instance, are still up nearly 34% over the prior year (which is the slowest rate of year-over-year inflation in 17 months), while beef is 18% above where it was trading last October. Corn--a vital component of livestock feed--is 17% higher and up more than 50% compared with two years ago. Additionally, even though the global supply of agricultural commodities (such as wheat from Russia and cocoa from the Ivory Coast) is recovering from geopolitical shocks, we believe raw material prices could tick up once again in 2012 as energy costs force prices higher and weather patterns remain erratic. Further, demand in emerging markets could keep raw material prices elevated over the long term.

This has not gone unnoticed by several consumer product firms we cover. In fact, Hershey (HSY) recently disclosed that it anticipates higher input costs heading into fiscal 2012, despite the fact that cocoa prices in October are 8.5% less than the year-ago period. ConAgra's (CAG) management also raised its full-year expectation for commodity costs recently to 9%-10% (from 7%-8% previously), while General Mills (GIS) is forecasting 10%-11% higher costs in fiscal 2012 after incurring mid-single-digit inflation in fiscal 2011, indicating to us that these pressures are unlikely to subside over the next several quarters.

In our opinion, offsetting these cost pressures with higher prices may continue to hurt volume growth, particularly in markets where stubbornly high unemployment and elevated gas prices continue to plague an already-fragile consumer. For example, while price increases helped to push Crisco total dollar sales higher for J.M. Smucker (SJM) in the recently reported quarter, price sensitivity was evident as volume plunged 10%, supporting our view that the company could face fierce competition in oils from other branded and private-label offerings.

On the other hand, McCormick (MKC) increased prices an average of 5% in the fourth quarter, which is the first time in at least 10 years that the firm is raising prices during this critical selling period, according to management. Historically, the fourth quarter has accounted for about one third of McCormick's consolidated sales and is when branded sales tend to account for a larger proportion of its revenue base. However, given the pricing power inherent in McCormick's business and the fact that the firm dominates the domestic spices and seasonings aisle as the largest branded and private-label player, we expect only a modest hit to volumes as a result of these higher prices.

While many firms in the industry have increased prices in order to offset higher input costs, few have been able to preserve margins entirely. Still, margin contraction has been less pronounced among firms that hold a more meaningful degree of pricing power. For instance, significantly higher corn and soybean prices have hindered profitability at Tyson Foods (TSN) and Hormel Foods (HRL) lately; however, Hormel's gross margin contraction of 120 basis points to 16.0% from 17.2% a year ago was markedly better than Tyson Foods' whopping 430-basis-point contraction to 4.7%. Differentiated, value-added products allow Hormel to charge premium prices, generate wider margins, and absorb cost pressures better than peers, and we believe Hormel can produce higher earnings in the years to come even if cost challenges linger. At the same time, we expect earnings growth to be much more difficult for Tyson. Although Tyson's move into value-added products could help improve profitability, it still generates a majority of its revenues from raw-meat products. Supply-chain efficiencies may help preserve margins, but cost-cutting initiatives have limits; without significant pricing power, we believe the commodity cost environment will have a disproportionate impact on the firm's operating results.

Even with commodity headwinds expected to ease in coming quarters, gross margins are unlikely to snap back to pre-2011 levels in the household product sector in 2012, as foreign exchange translation and transaction benefits may also ease off. Moreover, promotional activity has been fueling sales for more than a year, pressuring product profit margins as well. For the most part, household product firms are doing well driving their top lines and controlling overhead costs, but greater stability on gross margins will be the focus for these firms through the first quarter, in our opinion. Given questions about whether price increases will stick, the timing of any decline in input costs, and foreign exchange tailwinds tapering off, it's tough to gain much visibility on the potential for a gross margin recovery in the coming quarters.

However, unlike other areas of the consumer defensive sector, the alcoholic spirits category is relatively immune to today's input cost pressures, as the multiyear maturing process means that recent commodity inflation will not hit the income statements of spirits makers for several years. For instance, with around one third of its volume derived from maturing products, it will be many years before rising input costs affect Diageo's (DEO) income statements, making them somewhat insulated from these higher costs. As a result, we contend that investors wanting to garner some protection from potentially higher costs should look to the alcoholic spirits space.

A pronounced uptick in spending among developed-market consumers is likely several quarters off, but emerging markets provide an opportunity for growth.
Prices throughout the grocery store are trending higher, and there is only so much that consumers in developed markets are going to be able to absorb in light of macroeconomic pressures. As a result, we believe competitive pressures from traditional grocers (which have been pushing their private-label offerings to drive traffic in their stores) and mass merchants (including Wal-Mart (WMT), which has committed to $2 billion in price investments over the coming quarters) will persist. Absent an uptick in promotional spending, we don't expect improved volume trends in developed markets until macro conditions improve. In addition, some of the price increases that consumer product firms are charging have yet to show up on the shelf, and as a result, volume weakness into next year is highly plausible as consumers trade down or trade out of categories in response to these higher prices.

We are especially skeptical of firms that expect developed-market growth to remain robust. For instance, Estee Lauder (EL) posted impressive double-digit growth in the U.S. in the most recent quarter, but we question whether this growth will prove sustainable. When asked, Estee Lauder commented that because the firm is bringing new mass market consumers into the fold, this growth should persist. We are not convinced, however, as we've seen few other external signs that there is sufficient spending optimism to support this type of growth for a premium brand portfolio.

However, we think the wealth and spending power of consumers in emerging economies will continue to grow, leading to increased per capita consumption. Emerging markets with young and growing populations that have increased disposable income are likely to offset sluggish developed-market growth for many consumer goods manufacturers, and we believe that the market rewards exposure to these faster-growing regions.

We have already started to see this play out, as emerging-market strength masked developed-market headwinds in the most recent quarter for Nestle (NSRGY), which posted stellar growth in emerging markets (internal growth of 13.1%) that far outpaced sluggish growth in the firm's mature developed markets (4.0%). Further, Pepsi (PEP) reported that snack volumes grew 31% in China, 26% in India, and 22% in Turkey. Despite this, emerging markets will face increased competition as consumer product manufacturers seek the same pockets of opportunity in regions where product categories are growing, implying that further investments will be necessary. As an example, SABMiller recently announced another $260 million investment in Africa to fund capacity expansions and a $295 million investment in Peru. In both of these markets, per capita consumption of beer continues to increase.

With a greater share of the spending shifting to premium brands in emerging markets, consumer product firms have also looked to acquisitions to build out their presence. In the quarter, Unilever , which already derives about 50% of its consolidated sales from emerging markets, put its cash to use to expand its emerging-markets presence, acquiring 82% of Kalina, a leading Russian beauty-care firm, for about EUR 495 million (a forward price/sales multiple of 2.0 times and an enterprise value/EBITDA of 11.7 times, which seems reasonable to us). This deal supports our sentiment that wide- and narrow-moat companies with substantial cash piles are taking advantage of opportunities to build out product portfolios and gain footholds in key emerging markets through smaller tuck-in acquisitions.

SABMiller's acquisition streak also continued in the fourth quarter with its deal for Foster's Group. The $10 billion deal represents a trailing 12-month EV/EBITDA multiple of 13 times, which is just slightly above the 12 times EV/EBITDA that Heineken (HINKY) paid for the beer business of FEMSA (FMX) in 2009. We view the price as reasonable for this attractive asset. Scale is critical to gaining a cost advantage in the global brewing industry, and we expect that SABMiller will leverage the Foster's brands (including the namesake brand, Carlton, and Victoria Bitter) by introducing the brands into international markets, particularly emerging markets, through its own distribution platform. Going forward, the acquisition of LVMH's (MC) beverage brands could also be an interesting development (particularly for Diageo), as the Hennessy cognac brand has strong growth potential in China.

Following on recent deals including Kamis in Poland and Kohinoor in India, McCormick says it is considering potential opportunities in South America, and is targeting to generate about 12% of its consolidated sales from these faster-growing regions by 2012, which is double the level of sales derived from the regions in 2006. We expect that the leading domestic spices and seasoning firm will expand its presence in these markets through both acquisitions and joint ventures with local firms in 2012, but it will tread lightly, due to the challenges created by regulatory hurdles as well as unstable economic and political conditions.

Spin-offs could also become acquisition targets in 2012.
Management teams continue to take a hard look at their product portfolios in an effort to unlock value, so spin-offs are likely to remain center stage in the consumer products arena.

Beyond this, with ample cash on hand and minimal debt, we expect M&A activity will stay heated. In October, Beam began trading independently after the spin-off of Fortune Brands Home & Security (FBHS). We believe the separation will prove valuable, as Fortune's legacy segments offered little or no cross-divisional synergy. Although management appears committed to leveraging the benefits of its refocused operations, we believe considerable upside could present itself, especially if other large competitors express an interest in acquiring Beam--a scenario that could play out given its leadership in the premium bourbon category, as well as its large presence in several other spirits markets. Although firms like Diageo and Pernod Ricard (RI) have yet to publicly express an interest in the portfolio, we believe Beam's strong presence in a number of categories, as well as its market leadership for bourbon products, would fit well into competitors' current mix of products. Based on a five-year median enterprise value/EBITDA takeover multiple in the premium alcohol beverage market of about 16.2 times, we believe investors could benefit should a bidding war ensue. Applying a takeover multiple of around 16 times to our 2012 EBITDA estimate of around $752 million, we estimate that Beam's portfolio of brands could collectively be worth as much as $66 per share.

The break-up of Ralcorp , Sara Lee , and Kraft (KFT) are all slated to commence in 2012. From our perspective, there was a strategic rationale to split up Sara Lee, and we expect that the segments could be acquisition targets. More specifically, we think that Hormel might be interested in Sara Lee's domestic meats business, while Smucker could look to acquire its international coffee operations. However, we question the rationale to spin off the Post brand from Ralcorp. From our perspective, Post would need to garner 9.5 times adjusted EBITDA for shareholders to break even on any transaction, which seems rich for a third-tier brand in a highly competitive category. We expect the realized value to be closer to $1.5 billion-$2 billion, or 6 times EBITDA, which would mirror KKR's (KKR) deal for Del Monte last year. We also aren't convinced that Post's competitive position will improve as a stand-alone operation, particularly given that Kellogg (K) and General Mills are intently focused on enhancing their position in this highly competitive category.

In our view, Kraft's motivation leans more toward unlocking a higher multiple for the faster-growing snack business, which was being unappreciated when combined with the more mature North American grocery brands. Plus, in Kraft's case, we doubt that either of the firm's business units will garner much interest from potential acquirers as the sheer size of the units (with global snack revenue of about $32 billion and North American grocery revenue of $16 billion) makes them unlikely targets. From our perspective, following the spin-off, investors with a thirst for growth in the packaged food sector may be interested in the global snack business, while income-seeking investors may want to consider the North American grocery business, as management has stated that dividend payments would be a priority for cash for the more mature grocery segment.

As we've discussed previously, other high-profile divorces could come to pass, and rumors of a PepsiCo split persist. In November, news surfaced that activist investor Nelson Peltz's investment firm, Trian Fund Management, has been buying Pepsi stock, purchasing 2.35 million shares or 0.15% of shares outstanding. We note that his Trian fund built up a significant stake in Kraft a few months before that company announced a split, and some speculate that the same thing could happen at Pepsi. Adding further fuel to the fire, a New York Post article has claimed that some Pepsi board members may be interested in splitting the company in two.

While we are unsure if the New York Post's unnamed sources are really "in-the-know," we estimate that a breakup of PepsiCo would deliver significant upside to Pepsi. However, Pepsi CEO Indra Nooyi has remained steadfast in the belief that the combined firm benefits from the "Power of One." Consequently, we believe that any decision to split the company into two would have to come from the board room. As recently as Oct. 12, during the firm's third-quarter conference call, Nooyi said, "Over the past few months, our Power of One initiative has been the topic of speculation, largely fueled by a number of high-profile corporate split-ups. I firmly believe that PepsiCo's value is maximized as one company. It was created as an integrated snack and beverage business and its success is tied to this combination. This has been true in the past and will remain in the future."

Top Consumer Defensive Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/FV
Reckitt Benckiser		GBX4,046	Narrow	Medium	0.79
Sysco		$36.00	Wide	Medium	0.80
Kellogg		$59.00	Narrow	Medium	0.83
PepsiCo		$76.00	Wide	Low	0.85
Campbell Soup		$36.00	Wide	Low	0.91
Data as of 12-18-11.

Reckitt Benckiser (RB.)
Reckitt Benckiser's pharmaceuticals business, which is devoted to drugs for opiate dependence, grabs the headlines, and admittedly the health insurance reimbursement cycle can make for some choppy results in the segment. Management has made some smart choices about managing this profitable business for the long term, however, and in the meantime the firm has moved its household product portfolio toward higher-margin OTC categories. We think the company's unique offerings give the shares stability as well as potential growth.

Sysco (SYY)
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.

Kellogg (K)
Kellogg is the leading domestic producer of cereal, with more than 33% share due to its portfolio of leading brands. Around one-third of the firm's sales and one-fifth of profits result from its international sales and distribution network. Finally, the firm is committed to returning cash to shareholders, paying a quarterly dividend since 1925 (raising it in 46 of the past 50 years), and we believe that its cash generation will continue to support these payments.

PepsiCo (PEP)
The market is fixated on Pepsi's underperformance in beverages, but we think investors should own the stock for the snacks business, which represents around two-thirds of the top line. Pepsi has sustainable competitive advantages in snacks through its vast global distribution and dominant market share, and with around one-third of Pepsi's revenue being derived from emerging markets, this is also a growth-markets story. However, the catalyst for the stock is likely to come from improvement in unemployment, share gains from rebranding, and/or splitting-up the beverage and snacks business, which could deliver upside in 2012.

Campbell Soup (CPB)
Despite coming off a tough year plagued by rampant cost inflation and intense competitive pressures, we're encouraged that fiscal 2012 appears to be a year of brand reinvestment at Campbell Soup. In our view, its unrivaled scale leads to margins in the domestic soup segment that far exceed other areas of the consumer products space. If the stock trades down on concerns related to aggressive competition or rising input costs, we'd look to build a position in this wide-moat packaged food firm.

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