(By Philip Gorham, CFA)
- Commodity cost inflation looks set to moderate as the global economy appears to be slowing once again. We expect the food CPI to peak in July or August.
- The same drivers that are causing a pullback in commodities markets are likely to mean that consumer spending will remain strained for the remainder of 2011.
- Given the continued challenging environment, we believe that economic moats are more important than ever. We recommend investors stick to the best-in-class names that have the most pricing power in their categories.
Fundamentals Are Weakening
We expect weakening fundamentals to limit commodity inflation over the next few months, and weak demand to result in softer revenue growth for consumer defensive manufacturers. Household incomes have begun improving on a nominal basis, but on a real basis, wage growth has been anemic, as rising gas prices (the average retail price of a gallon of gas is now $3.65 in the U.S.) and the higher cost of food have absorbed a sizable potion of the wage growth in recent months.
With commodity prices having eased in recent weeks, and with all else equal, the stage should be set for a period of real wage growth. However, we are concerned that the deterioration in the job market may prevent that from happening in the near term. Non-farm payroll employment increased by just 54,000 in May, down from an average monthly gain of 220,000 over the previous three months, and the unemployment rate ticked back up to 9.1%. While we are less concerned about the unemployment rate (people out of work but not seeking employment may look for a job when they gain confidence in the economy) the meager gain in the nonfarm payrolls number was disappointing.
Many consumer staples manufacturers--including Coca-Cola (KO), Hershey (HSY), Kraft (KFT), and PepsiCo (PEP)--have stated that they intend to raise prices in the second half of the year, but we think price hikes will be difficult to achieve. We think that there is a three-month time lag between the Producer Price Index (PPI) for food (the wholesale input prices of food) feeding through to the Consumer Price Index (CPI, the retail price of food). The spread between the CPI and the PPI turned positive in May 2011 for the first time since December 2009. The soft economic data could force consumers to once again become more laser-focused on price, which could, in turn, make the environment too difficult to raise prices at the retail level, forcing the CPI down. In short, consumer staples manufacturers and retailers could be forced to swallow some of the recent cost inflation if they are unable to raise prices in the back half of the year.
Looking into next year, as manufacturers' hedges roll off, the cost of goods sold should moderate slightly, and the pressure on margins should ease. That will be just as well if the pricing environment remains so challenging.
The Pause in Commodity Inflation Could Be Sustainable Through the End of 2011
Clearly, consumer confidence lies at the heart of manufacturers' and retailers' performance over the next few quarters, and the path of commodity prices will be critical to consumer spending in the second half of 2011 and early 2012.
The markets for energy and agricultural produce continued to be volatile in the second quarter of 2011, but we believe that the recent pullback in commodity prices could be sustained at least until the end of the year. Commodities have experienced a long bull market, driven by growing demand for raw materials in Asia and other emerging markets. At the end of May 2011, the Morningstar Long-Only Commodity Index was up 7.5% year-to-date, and up 45% on a trailing-12-month basis. However, the rally came to a shuddering halt in May, with the index falling 5.2%, and there have been further commodity declines to date in June. The 10-year annualized return on the index has been a solid 10.9%. The weak U.S. dollar and steady long-term demand are likely to prevent a steep decline in commodity prices, but with demand fundamentals appearing to soften, we think the period of speculation-driven hyperinflation in commodities could be over.
The global supply of agricultural commodities is recovering from geopolitical shocks. Russia has removed protectionist policies and has resumed exporting wheat, while prices of cocoa have softened following the cessation of civil unrest that followed the election in early 2011. In the longer term, improving technology, particularly in emerging markets, should improve yields, helping to offset growing demand from those regions. On the demand side, the global economy is slowing, leading to both the World Bank and the IMF cutting their forecasts of 2011 real U.S. GDP growth to 2.6% and 2.5%, respectively, down from almost 3.0% earlier in the year. China, long-heralded as the key driver of demand for commodities, is experiencing a slowdown in exports, and the government could soon take measures to dampen the inflationary effects of rapid economic growth. In the longer term, any increase in interest rates in the U.S. would both raise the opportunity cost to speculators of holding non-interest-bearing assets (such as commodities) and push the U.S. dollar higher. The dollar has historically held an inverse relationship with commodities.
We think the greatest risk to our thesis lies on the supply side. Inclement weather can dent supply, while some governments are unpredictable in their use of protectionist policies. Crop production is an energy-intensive business, both through the use of fertilizers and machinery, so the prices of agricultural produce could be forced higher if the oil price rebounds. On the demand side, growing populations and expanding middle classes should support demand in the longer term. Another risk lies in the financial factors that drive speculation in commodities. Slower economic activity overseas, combined with a rebound in Japan as manufacturing infrastructure comes back online following the earthquake, could pressure U.S. exports, leading to a widening of the current account deficit and further weakness in the U.S. dollar. As the dollar historically has an inverse relationship with commodity prices, commodity costs could rise once again.
Economic Moats Are More Important Than Ever
With such major challenges ahead, we recommend that investors look to wide-moat names for shelter from the coming storm. At a time when margins for retailers and manufacturers are being squeezed by both costs and weak consumer spending, we believe the best-in-class operators with the widest moats are the safest way to play the space. Those firms with the widest gross margins will be forced to raise prices by a lower amount in percentage terms, but we are wary of those companies that have escaped significant cost inflation this year, because they could be forced to roll their commodities hedges at exactly the time that costs are peaking.
Those categories in which private-label penetration is weak (such as soft drinks) are likely to hold the most pricing power in this environment, while companies that own products in niche categories are not likely to face new entrants if competitors believe the category is too small. Examples of this include Colgate (CL) with its Murphy's Oil products and Dean Foods (DF) with almond milk. Retailers are apt to push back on price increases in most categories, because the control over shelf space is a very powerful lever. Only the strongest brands, such as Coca-Cola, Lay's, and Doritos, give manufacturers the power to pass through price hikes in difficult environments without losing shelf space.
Some manufacturers with strong pricing power currently offer quite attractive valuations. PepsiCo in snacks, Lorillard (LO) in tobacco, and Avon (AVP) and Procter & Gamble (PG) in the household and personal-care categories offer the safest havens from the weak economy. Among the retailers, we believe Costco (COST) has the strongest ability to push back on price increases from retailers, while Kroger (KR) has the ability to retain traffic in difficult economic times as a result of using gas as a loss leader.
'Sin' Stocks May Shelter Investors from the Twin Pressures of Rising Costs and Slowing Growth
Sin stocks tend to have more pricing power in challenging economic times than peers in other categories. For example, inelastic demand and limited input cost inflation could make tobacco a safe haven in the troubled times ahead. We estimate that demand elasticity in the U.S. has been negative 0.35 since cigarette consumption peaked in 1978. Manufacturers are able to pass through price increases at a rate of between 2.5 times and 3.0 times the rate of volume declines, and that relationship has held firm even through the perfect storm of the large excise tax increase, the recession, and the spread of smoking bans in 2009. In fact, as excise taxes become a larger piece of the retail price of a pack of cigarettes, it takes a smaller percentage increase in the price at retail to grow manufacturers' revenues at any given rate, and we think this should allow cigarette makers to grow revenue for several years to come, even as industry volumes decline.
The multi-year maturing process means that today's commodity inflation will not hit spirits makers' income statements for several years. Our top pick in the alcoholic beverage space is Diageo (DEO), the best-in-class spirits maker with a vast global presence and very strong brand portfolio. Commodities such as wheat and barley represent just 4% of sales, with packaging and distribution accounting for much of the rest of Diageo's 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 maturing process can take many years. For example, 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. Due to the matching principle, which is similar under IFRS as to U.S. GAAP, cost of goods sold are not recognized until revenue is recognized when product is shipped, and Diageo accounts for its cost of goods sold for maturing products on an actual usage basis. Costs for the remaining two-thirds of its portfolio, which are not maturing products, are accounted for using FIFO. This all means that it will be at least another decade before some of today's commodity cost inflation feeds through to Diageo's income statement, and we expect the recent rise in commodities to impact Diageo much less than staples firms in other categories.
| Consumer Defensive Stocks for Your Radar|
Price/ Fair Value
|Molson Coors |
|Procter & Gamble|
Data as of 6-24-11.
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. For patient investors, job growth could provide an upside catalyst.
A management restructuring, some execution issues, and a bribery probe have all weighed on Avon's stock recently. Operational challenges in Brazil and Russia have also led to some disappointing sales growth figures. However, we think the direct sales business model remains the most effective way to penetrate emerging markets, and we believe that patient investors will be rewarded if a turnaround in key developing markets leads to a higher valuation multiple in the medium term.
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.
Boston Beer (SAM)
A significant pullback has presented a buying opportunity in Boston Beer. The firm's core market segment of 21-35-year-old males looks set to grow by around 4% over the next five years. Given the firm's ability to take prices higher, even in difficult macroeconomic environments, and the continued share gains from wine and other beers, we think the market is underestimating Boston Beer's growth potential over a two- to three-year time period, and we think revenue growth above consensus could be a catalyst for a higher valuation next year.
Lorillard's stock has been volatile in recent months, and we believe a pullback on jitters relating to the FDA present a buying opportunity. The FDA is expected soon to announce whether it will impose restrictions on the use of menthol in cigarettes. Menthol could be banned, which would be disastrous for Lorillard, which generates around 90% of its revenue from menthol products. However, we think a ban is highly unlikely given that it would lead to a significant loss in tax revenue for governments and the emergence of a black market would take regulatory control out of the hands of the FDA.