Our Outlook for Consumer Defensive Stocks

• The rate of input cost inflation is moderating, but foreign exchange headwinds are kicking up.
• Europe remains just as uncertain as it was this time last year, while the U.S. less so, and now the Middle East is a wild card.
• Success with pricing has been all over the map.

 

Input Cost Inflation Moderating, but Foreign Exchange Headwinds Kick Up 
Although it may be a quarter or two before higher input prices are in the rearview mirror, most firms are planning for some stability on this front in 2012. At the same time, a strengthening U.S. dollar will curb earnings expectations for U.S. manufacturers. These aren't new challenges, but if commodity prices only stabilize, and don't ease, the twin forces of negative FX and still high costs will threaten margins.

 Kellogg (K) recently stated expectations for currency headwinds in 2012, while  Coca-Cola (KO) guided for currency translations to adversely affect first-quarter results and to have a negative, mid-single-digit impact on full-year operating income growth. Although these headwinds could hurt profitability in the near term, we think firms with an internationally diversified portfolio, and meaningful exposure to emerging markets in particular, will still benefit in the long term. More specifically, if these companies are able to establish or enhance their distribution networks in emerging economies, volume growth should allow for scale economies and could lower per unit costs. If these firms can also differentiate their products and raise prices, ideally at a faster rate than local inflation, currency-neutral revenue growth in emerging markets should outpace developed markets. Consequently, as companies seek to adjust their currency exposure throughout the year, currency challenges are not expected to be a material headwind in the medium term.

Europe Still Uncertain; Middle East a Wild Card
With unemployment still high in Europe and austerity measures more broadly taking hold, details on how consumers are performing in mature markets--both for more discretionary items and for staples--will be important. European lawmakers may have averted a disorderly default in Greece in the near term, but consumers in debt-laden countries still have little to cheer about, as the pain of deleveraging is expected to linger for some time. For example,  Coca-Cola Hellenic --Coca-Cola's Eastern European bottler with operations in countries such as Greece, Italy, and Ireland--reported substantial volume declines (volumes in Greece were down over 28%) in its fourth quarter, serving as a reminder that even best-in-class brands such as Coke will have to confront what could be a challenging economic environment in Eastern Europe.

We don't expect volume declines of this magnitude to persist indefinitely, but they could continue to affect results over the next couple of quarters and make positive volume growth difficult for companies to achieve in these regions. As a result, we remain cautious about the growth prospects for this region. Passing an austerity package is difficult enough for lawmakers to achieve, but generating meaningful growth in the face of austerity's effects may be still harder for many companies.

Despite these challenges, fears about disorderly sovereign defaults in Europe have dissipated for the time being, and several commentators have now pegged higher oil prices as the next big headwind to the global economy. Iran's recent threat to close off the Strait of Hormuz, which carries around 20% of the world's global oil supply (according to the U.S. Energy Information Administration), could restrict global oil supplies and drive crude prices upward.

While many consumers have yet to fully adjust to the higher retail prices implemented to cover elevated raw material costs, higher fuel prices could reduce spending capacity on both discretionary and nondiscretionary items. This additional pressure on consumer incomes would not only translate to weaker revenues for household staples as shoppers cut back spending even more, but profitability could also be challenged as higher oil prices drive up other manufacturing input and distribution costs. In such a scenario, any tailwind from moderating cost inflation from other raw material inputs would quickly fall by the wayside. Still, at this point, we don't believe there is enough visibility to place a probability on the occurrence of an oil shock or to accurately predict its effect on the household staples we cover. 

Success With Pricing Has Been All Over the Map
We've heard from some firms that have been successful at pushing through price increases and have maintained decent volume growth, but at the same time other firms have seen dramatic volume declines and face price rollbacks.

 J.M. Smucker (SJM), for example, reported one of the most surprising volume declines (down 10%) in its third quarter, as consumers' response to Smucker's decision to maintain significantly higher coffee prices (amidst stiff price competition from private-label and other branded players) was greater than anticipated.

These challenges were not limited to Smucker. Across the packaged foods industry, many of the major branded players reported volume declines in the most recent quarter.  General Mills (GIS) (pricing/mix up 8%),  Kraft (KFT) (7%), and  Campbell's Soup (CPB) (3%) all reported respective volume declines of 3%, 1%, and 3%, while  Heinz's North American consumer products segment posted volume declines of 2% amidst 3% higher prices. Most of these volume declines were anticipated in some form, but the price elasticity for numerous product categories appears to be greater than we (and many management teams) had originally anticipated.

Achieving solid volume performance in the coming quarters will be paramount, however. Most companies believe that commodity cost inflation is moderating, if only temporarily, and expect volume performance to improve as consumers adjust to new price points. However, so long as income growth remains subdued in mature markets, consumers with roughly the same number of dollars in their pockets will not be able to buy the same as they could at lower price points. Stable retail prices may slow the downward pressure on volumes, but positive volume growth in developed markets could still be hard to come by without strong innovation. As a result, we plan to watch volume performance in the U.S. and other mature economies closely, as this could foreshadow whether consumers are currently trading (back) up to branded products or to what degree they might do so in the future.

Given this backdrop, we expect emerging markets will continue to be an important source of volume growth for consumer firms in the next several periods. In our last quarterly update, we expressed our view that the wealth and spending power of consumers in emerging economies will continue to grow, which should lead to increased per capita consumption. We think recent results and comments made at this year's Consumer Analyst Group of New York (CAGNY) conference in February support this view. Heinz's management, for example, recently expressed that consumer packaged food companies that are not expanding in emerging markets will struggle to grow. We concur with this outlook, primarily because emerging markets with young, growing populations and increased disposable income are likely to offset sluggish developed market growth. As a result, we believe that the market may reward firms that have strong brand portfolios and increasing exposure to faster-growing markets.

Industry Overviews
Non-Alcoholic Beverages
For both  Pepsi (PEP) and Coke, the focus has been on bottler acquisitions as a way to maintain some negotiating strength with retailers, but the strategy leaves  Dr. Pepper Snapple (DPS) out in the cold. Longer term, we question how interested the beverage giants will be in holding their bottler assets, should declines in cola consumption continue. With increased consumer attention directed at health and wellness and sugar content, we're also not sure that energy drinks are the best equipped innovative offerings to drive growth in the industry. Growth in Asia and Latin America is likely to remain strong, while North America could be more challenging. We expect per capita consumption to rise along with disposable income in developing markets, and Coke's established infrastructure in international markets will leave the firm well placed to exploit that trend. In fiscal 2012, we anticipate revenue growth in the high-single-digit range for the nonalcoholic beverage firms we cover but limited margin expansion over the near term, as rising commodity costs continue to pressure margins.

Alcoholic Beverages
Thanks to more stable and relatively low levels of price elasticity of demand, alcoholic beverage firms tend to have more pricing power in challenging economic times than peers in other categories. To a large degree, we've considered our alcohol manufacturers a shelter from the twin pressures of rising costs and slowing growth. Firms are still grappling to garner additional scale, however, particularly given the critical importance that volume plays in the beer industry, so we expect M&A will remain an area of focus, especially since there are plenty of assets in emerging markets up for grabs. Otherwise in terms of the beer industry, the shift to spirits consumption in the U.S. continues, as both  SABMiller and  Diageo (DGE) have addressed, and weakness in bar traffic in Europe and beer consumption in the United Kingdom persists. Additionally we are still cautious about how much more capacity developed market consumers have to trade up and pay premium prices given that high unemployment translates to greater mainstream beer consumption, in our view. We believe emerging markets are likely to continue to be the growth drivers for alcoholic beverage companies through 2012 because of increases in personal disposable income, which translate into per capita consumption increases and consumers shifting to premium brands.

Household Product and Personal Care  
This has been a challenging year for some of the largest firms as a step up in competitive pressure alongside increased commodity pressures hurt margins almost across the board. After several years of sluggish developed-market growth, neither  Procter & Gamble (PG),  Kimberly-Clark (KMB),  Clorox (CLX),  nor Colgate (CL) seem to be any closer to growing categories that are stagnant. Their weak results in the U.S. and Europe point decidedly to a middle-class squeeze, as offerings at the higher end from  Estee Lauder (EL) and in the value tier from  Church & Dwight (CHD) gained market share.

Consumer spending remains constrained, and the balance of power has shifted away from brands in categories with strong private-label penetration. We've heard less discussion about consumer trade-up over the past few years, and we expect companies will continue touting their new product pipelines and plans to keep categories growing. This is all well and good, but the innovation stream from household product firms hasn't exactly been overwhelming. Too many brand and product extensions aren't going to be enough to drive growth at home or in Europe, and given the incredible focus on emerging-market expansion, we anticipate added pressure on profitability. With the dollar strengthening and foreign exchange headwinds increasing, the manufacturers with less non-U.S. exposure will stand to benefit in coming quarters.

Packaged Foods  
An unenviable dilemma has challenged packaged foods firms in virtually all categories over the past year. Elevated raw material prices have pressured the cost structures of many consumer packaged goods firms, leaving limited options (namely cost-cutting initiatives, increased prices, and product innovation) to preserve margins.

In order to increase profits without disgruntling consumers, most companies strive to reduce operating redundancies on an ongoing basis. Given that consumers have remained very price sensitive, it comes as no surprise that companies have opted to double-down on cost-cutting efforts before pushing through higher prices. Still, cost-cutting is inherently limited, and the magnitude of cost inflation has forced almost all companies in the industry to utilize additional levers to preserve profit margins.

As a result, many firms, such as General Mills, Kraft, Kellogg, and J.M. Smucker opted to increase prices in order to cover higher costs. Yet even this has proved difficult, as consumers remain price conscious and volumes have subsequently declined. As volumes have declined in response to higher prices, competition (between both branded and private-label players alike) has been fierce. Most companies haven't even been able to completely cover higher costs through to begin with, making the pricing dynamic all the more difficult.

As a final source of profit enhancement, product innovation has become increasingly important for firms in the industry because introducing new products can help to improve mix and alleviate some margin pressures. Still, innovation isn't just a way in which CPG firms can expand margins; retailers continue to demand more innovation from packaged food companies. If packaged food firms are not developing innovative new products to drive traffic or boost the margins of their biggest customers, retailers will justifiably view private-label brands as cheaper, yet adequate alternatives for shelf space.

However, even with input cost headwinds flowing through results for the next couple of quarters, there may be cause for optimism. Some companies believe their primary input costs have peaked, while other firms have expressed confidence that they have taken enough pricing to cover commodity costs in 2012. The inflation rate could again trend higher, but a deceleration in input cost inflation could be a tailwind for CPG margins in the back half of the year.

We still believe consolidation in the packaged foods industry will continue, as evidenced by General Mills' recent acquisition Food Should Taste Good and Kellogg's recent purchase of the Pringles brand from Procter & Gamble. We expect other industry players may follow suit in the future.

In addition to mergers and acquisitions, however, we have noted that several firms have moved away from a "bigger-is-better" mentality and embraced spin-offs and divestitures in favor of more focused operations.  Ralcorp's spin-off of Post and Kraft's decision to split its business in two are such examples. These opportunities not only give firms more focused operations, but they also present opportunities for consolidation to resume once again. For example,  Sara Lee's decision to separate its business presented an opportunity for Smucker to scoop up the firm's North American Foodservice Coffee assets. We believe that Sara Lee's meats business could be of interest to  Hormel (HRL) and/or  Tyson Foods (TSN) in the future. Whether acquisitions or spin-offs, most companies have pursued such strategies in order to foster growth. Going forward, we expect international expansion, acquisitions, and divestitures will be of focus in the CPG industry.

 

Tobacco Industry Overview
Tobacco is one of the widest-moat industries in our consumer coverage universe, reflected by the consistent double-digit returns on invested capital generated by the largest manufacturers in the tobacco category. For the most, part we see rational pricing and stable market shares with a low degree of rivalry globally. U.S. cigarette manufacturers continue to hold the upper hand with suppliers due to fragmentation and the abolition of price support, but government regulation is the ongoing wild card.

Despite headwinds from higher taxes, smoking bans, and tightening regulation, however, tobacco industry fundamentals have improved over the last 18 months. But while a more rational pricing environment seems to have eased competitive pressures, 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. We anticipate a low- to mid-single-digit decline in volumes, though price increases put in place this year will still push industry revenue growth to the low-single-digit range in 2012. We also continue to monitor the comments by  Altria (MO) and  Philip Morris (PM) about the growing market for smokeless tobacco and other potential substitutes that are emerging.

There are still headwinds in international markets including excise tax increases in late 2010 and trading down to lower-priced cigarettes, but rebounding markets in Asia are likely to provide a boost to the larger international players.

Top Consumer Defensive Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Campbell Soup Co.		$36.00	Wide	Low	$28.80
PepsiCo Inc		$72.00	Wide	Low	$57.60
Procter & Gamble Co.		$72.00	Wide	Low	$57.60
Reckitt Benckiser Group PLC		GBX 4046	Narrow	Medium	GBX 2832
Sysco Corporation		$36.00	Wide	Medium	$25.20
Data as of 03-23-2012.

 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. We don't forecast material gross margin expansion at the firm, but operating margin expansion is achievable. 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.                    

 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 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 story. However, the catalyst for the stock is likely to come from improvement in unemployment or share gains from rebranding and incremental advertising and marketing investments. Management has recommitted to its "Power of One" strategy, so plans for splitting up the beverage and snacks business are off the table for the time being. 

 Procter & Gamble (PG) 
In February at CAGNY, P&G announced plans to reduce costs by $10 billion by 2016 with $3.5 billion of the reduction coming from overhead costs and reduced, non-manufacturing head count. We expect that much of the savings the firm generates from these efforts will be reinvested back into the business and directed to building the firm's brands and reach in emerging markets, as this is where P&G is generating the lion's share of its growth. While the plan is a significant undertaking, if the firm can successfully execute, there could be further upside than our current fair value estimate. In the meantime investors can be paid to wait by holding this fairly stable blue chip with a healthy dividend and cash yield. 

 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. Newly announced strategies for growing in developing markets are also sound, and the firm has a history of strong execution. 

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. Moreover, as consumer fortunes improve, we see eating out occasions ticking back up.

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