(By Philip Gorham, CFA)
- With the economic picture slowly brightening in the United States, we expect food inflation to return in 2011 as consumers bear more of the brunt of rising commodity costs.
- Equity valuations appear to have run slightly ahead of the economic recovery, as risks remain on the horizon.
- As manufacturers struggle to generate organic growth in mature markets, M&A activity is heating up in the consumer defensive sector.
The economy appears to be over the worst of the recession, and the stage looks set for a gradual rebound in consumer sentiment in 2011. While challenges remain in the shape of high unemployment in both the U.S. and Western Europe, European austerity measures (the impact of which is yet to be fully felt), and the threat of further volatility in housing prices, consumer confidence is trickling back in some consumer staples categories.
In the immediate term, however, the environment is likely to remain challenging for manufacturers and retailers, as value-conscious consumers are still sensitive to price. Deflation is still a threat, largely due to sustained promotional activity by national brand manufacturers, although grocers have had recent success pushing through price increases to consumers in perishable categories such as meat and produce. However, if U.S. GDP growth accelerates and the employment picture brightens as the year progresses, consumers may increase impulse purchases, which should drive revenue growth in the grocery and convenience store channels and make price hikes easier. However, we expect the recovery will be more drawn out than previous rebounds, and that inflation will remain benign at least in the first quarter.
The ability to raise prices will assume greater importance as commodity costs rise. Wholesale prices for sugar, coffee, and cocoa are all at or near multiyear highs, as concerns over supply shortages have driven prices higher. Russia has banned exports of wheat, barley, rye, and corn until next year's harvest following a drought. A similar hoarding of coffee stocks is occurring in Vietnam, a key exporter, and bad weather in South America is causing concern over coffee supply from Brazil and Colombia.
While supply shocks are supporting prices in the near term, we anticipate prices to trend higher in the longer term due to increasing demand for commodities driven by expanding middle classes, growing populations, and urbanization in emerging markets. For some protection against this headwind, we recommend investors focus on those firms with the widest moats in the consumer staples space--such as Coca-Cola (KO), McCormick (MKC), PepsiCo (PEP), and Procter & Gamble (PG)--as these are the firms with the most pricing power in their respective categories.
With an equally-weighted mean price/fair value ratio of around 1.06 times, we think the consumer defensive sector is currently slightly overvalued. The rebound in equity valuations appears to have outpaced that of the economic recovery and companies' earnings, in our opinion, and the market is underestimating the risks that remain on the horizon.
Having said that, pockets of value still exist, and the market is providing an attractive entry point into some wide-moat names. Despite a small rebound in its market value in the last quarter, Procter & Gamble still appears undervalued to us, at a price/fair value multiple of 0.84 times. P&G fell out of favor with the market as a result of fairly soft performance during the recession, but management is focusing on regaining lost market share, and the company possesses several of the investment criteria we look for: structural competitive advantages, pricing power, ample resources to extend its brand reach, and exposure to growing emerging markets.
As consumer staples firms struggle to ignite any meaningful growth in mature markets such as the United States and Western Europe, many are exploiting a favorable interest rate environment to make acquisitions, and we expect the mergers-and-acquisitions landscape to remain active in 2011. In 2010, both Coke and Pepsi completed transformational deals to acquire North American bottlers, Kraft (KFT) closed its deal for Cadbury, and Unilever (UN)(UL) (UNA) (ULVR) lodged a successful bid for Alberto Culver (ACV). We expect further activity ahead, particularly in the packaged food and alcoholic beverage industries, where we expect the larger players to make a series of bolt-on acquisitions in order to achieve production and distribution synergies. Armed with pools of undeployed capital, private equity firms are also likely to target food and beverage companies that generate strong free cash flow and limited financial leverage.
Industry-Level InsightsAlcoholic Beverages
Emerging markets are likely to continue to be the growth drivers for alcoholic beverage companies well into 2011. Beer is often the entry point for alcohol consumption, so international brewers with a strong foothold in fast-growing developing markets, such as SABMiller (SBMRY)(SAB) and Anheuser-Bush InBev (BUD) (ABI), should continue to benefit from growth in Asia, Latin America, and Africa.
In the U.S., the migration to better-quality beer continues, with Boston Beer (SAM), maker of Sam Adams, likely to be the main beneficiary of growing demand for craft brands. However, we would not be surprised to see mainstream brands launch craft brews of their own and to attempt to maintain share by being more promotional on price, a strategy that is likely to be appealing to the still-cautious consumer.
For spirits manufacturers Pernod Ricard (RI) and Diageo (DEO) (DGE), Asia and Latin America are likely to continue their double-digit growth rates as the trend toward premium beverages continues, but mature markets tell a very different story. Demand in North America is likely to remain anemic, and the pricing environment difficult, in the first quarter. And in Western Europe, bar traffic is down significantly in the key market of Spain, which is proving a drag on results.
Restaurant traffic--and subsequently sales at foodservice distributors--began to show some signs of life in the most recent quarter. However, we caution that until unemployment levels retreat further, consumer spending and restaurant traffic could remain lumpy. Particularly notable in the quarter was the significant rate of inflation in the meat, dairy, and seafood categories, which, according to estimates by Sysco (SYY), increased 10%. While food distributors are typically able to pass through modest levels of price inflation, it is more challenging in the short term to pass through double-digit price increases to customers without negatively impacting their business. Given the capital-intensive nature of the food distribution business, this puts additional strain on already-thin margins. As a result, we recommend investors look to the industry leader Sysco for exposure to food distributors, due to the expansive scale that enables it to generate superior margins and returns on capital versus its smaller competitors.
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. We believe this is due to a continued focus on price to drive traffic, particularly among consumer packaged goods firms. Kroger's (KR) management noted that this was the main cause of the 50 basis points of deflation in the center of the store (excluding milk) in its third quarter.
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. Many CPG firms are now increasing prices to offset rising input costs: General Mills (GIS) rolled out price increases on about 25% of its ready-to-eat cereal portfolio in mid-November and also intends to raise the price on some of its baking offerings in January. Kroger has passed these through to the consumer and will continue to do so, which may alleviate some deflationary pressures. Additionally, grocers have been able to pass through increases in certain perishable categories like meat and produce. Nonetheless, we expect a focus on price to remain prevalent in the near term as unemployment levels remain elevated.
We continue to see value in supermarket names like Kroger, Safeway (SWY), and Supervalu (SVU), as we believe the tepid near-term outlook is weighing disproportionately on shares. We do expect food price inflation to take hold, albeit at a slower rate than we originally expected. We view these larger players as better able to withstand competitive pressures compared with smaller peers.
Household and Personal Care
Commodity, currency, and competitive pressures hindered firms throughout the household and personal care space in the fourth quarter, and we doubt that these headwinds will subside over the near term. With growth rates in developed markets hovering close to zero, these firms are even more dependent on growing sales in developing markets, where negative currency translation is pressuring sales and profits.
In the most recent quarter, Kimberly-Clark (KMB) lowered guidance for fiscal 2010, and Colgate-Palmolive (CL) dialed back sales and EPS growth for fiscal 2011. Even Procter & Gamble, with the healthiest performance in the space so far, remained cautious, and rightly so, in our opinion. Furthermore, we do not see a catalyst on the horizon to reignite growth in either North America or Western Europe, and comparisons become tougher over the next several quarters.
Within the beauty-care space, we do not believe that recent performance is indicative of future trends. For instance, Estee Lauder (EL) reported double-digit (i.e., unsustainable) growth in the Americas region, which was in stark contrast to recent results from other beauty-care firms, such as Avon (AVP), which reported declining sales in the domestic market. Consumer spending remains fragile, and we believe this could continue as long as unemployment levels remain elevated. Despite the results from this quarter, we contend that Avon is appropriately investing in marketing its products and supporting its representatives--which should lead to improving results over the long term--while Estee Lauder will need to continue spending behind marketing (investments that it throttled back earlier this year) as the competitive environment remains intense. In addition, Estee Lauder is highly exposed to the traditional department store channel, which we expect will weigh on its growth going forward, as this channel is losing share to alternative outlets.
A similar dichotomy between developed and developing markets is occurring in the soft drinks industry. Coca-Cola and PepsiCo are investing a combined $35 million into just four of the largest developing markets: Russia, Africa, Mexico, and China. We expect double-digit revenue growth in Asia and Latin America over the next several quarters. In North America, however, the firms face a more challenging environment. Both companies have now closed their deals for their bottlers in an attempt to become more flexible in their route-to-market amid changing consumer tastes. Consumers are switching from sodas to healthier alternatives, and the emergence of new categories and brands is creating complexity.
As consumer confidence rebounds going into 2011, any recovery in revenue growth in the U.S. for Coke and Pepsi, as well as energy-drinks leader Hansen (HANS), could come at the expense of Dr Pepper Snapple (DPS), whose portfolio is skewed to carbonated drinks and is likely to suffer when consumers become more willing to pay up for premium beverages.
Thanks to recent promotional spending by packaged-food firms, consumers are accustomed to reduced prices and may maintain their focus on value until unemployment levels recede further. However, according to several packaged-food firms, these lower prices aren't driving the incremental volumes necessary to support them. For instance, H.J. Heinz (HNZ) CEO Bill Johnson recently noted that "aggressive promotions are even less effective today than in previous years in driving profitable growth or producing acceptable returns." As a result, we expect increased investments behind product innovation that resonates with consumers, but in our view, this spending is unlikely to yield measurable improvements overnight.
Input cost inflation is adding to the challenges facing packaged-food firms. In order to offset these higher costs, various firms throughout the industry (including General Mills, Kraft, and Sara Lee (SLE)) have announced their intentions to raise prices. We intend to monitor the impact these higher prices have on the volume and profitability of competitors in the space. We contend that firms that possess inherent brand equity in their portfolios (like wide-moat packaged-food manufacturers Hershey (HSY), Campbell Soup (CPB), and McCormick) will manage through this difficult operating environment relatively unscathed. Conversely, we believe that those firms that operate with a portfolio of second- and third-tier brands that lack brand equity and pricing power, like ConAgra Foods (CAG), are likely to incur further margin pressure.
Despite headwinds from higher taxes, smoking bans, and tightening regulation, tobacco industry fundamentals have improved significantly over the last six months, and we expect that to continue going into 2011. In the U.S., Reynolds American (RAI) 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 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 Eastern European markets 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 bigger international players Philip Morris International (PM) and British American Tobacco (BTI) (BATS) in the first quarter.
Consumer Defensive Stocks for Your Radar
| Consumer Defensive Stocks for Your Radar|
| ||Star Rating||Fair Value|
Price/ Fair Value
|Supervalu || 5|| $20.00|| None||High||0.44|
|Delhaize Group ||4|| $98.00|| None||Medium||0.73|
|Procter & Gamble|| 4|| $77.00|| Wide||Low||0.84|
|Colgate-Palmolive|| 4|| $92.00|| Wide||Low||0.87|
|Estee Lauder|| 1|| $46.00|| Narrow||Medium||1.72|
|Data as of 12-20-10. |
Weaker-than-expected results from the quarter ended Sept. 11 led us to trim our fair value estimate, but we continue to believe shares are undervalued. Supervalu started on less advantageous footing compared with peers, evident in its results, which lag its competitors'. However, we see areas for improvement, notably through private label growth and SKU rationalization, which should benefit margins longer term.
Delhaize Group (DEG) (DELB)
Competitive pressures in the Southeast United States drove weaker results at the company's Food Lion banner. Although the near-term should remain challenging, longer term we expect the banner's low-price positioning to appeal to a price-conscious consumer. Also, Delhaize's Northeast U.S. stores have been more resilient, as well as its operations in its home market of Belgium.
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.
Competitors have stepped up in Colgate's core oral care category aiming to take market share from the firm. This, and Colgate's fumbles in containing problems in Venezuela, have raised questions about how much investment Colgate will need in order to retain its leading position in regions like Latin America. We certainly expect the firm to face top-line and margin pressure in the coming quarters, but Colgate has a deeper category understanding than its competitors, and a best-in-class cost structure.
Estee Lauder (EL)
With unemployment at stubbornly high levels, we doubt that Estee Lauder's increasing sales momentum in the U.S. market has legs over the next several quarters. In addition, we contend that Estee Lauder's long-term prospects will be constrained by its exposure to traditional department stores, which have been losing share as shoppers venture to alternative outlets for beauty-care offerings. As a result, the substantial premium the market is affording to Estee Lauder is unjustified, in our view.