Consumer Staples Stock Outlook - October 2013

The consumer staples sector has been generally weak in the recent past due to a difficult consumer spending environment resulting from slow job growth, rising interest rates and tightened credit availability. In addition, difficult operating conditions in Europe and a slowdown in some Asian countries, like China, also weigh on the sector’s outlook.

As a result, consumer staple stocks have underperformed the S&P 500 as a whole in the year-to-date period. We see that in the stocks of most staples stocks, particularly the leaders like The Coca-Cola Company (KO), The Procter & Gamble Company (PG) and Kellogg Company (K). Most of the large consumer staples companies are able to increase their earnings solely with the help of cost controls, innovations, acquisitions and share buybacks, but only a few have been able to deliver impressive top-line growth – thus signaling a lack of real growth.

Innovations

In a crowded and competitive space, consumer product companies are forced to innovate and upgrade their brands to create differentiated value propositions for their customers to remain successful.

Kellogg’s efforts on that count include introductions of several breakfast options like Special K Nourish hot cereal and bars, Pop-Tarts Gone Nutty toaster pastries, Raisin Bran Healthy Heart Omega 3 cereal, Special K Multigrain cereal, Kashi Golean Vanilla Graham Clusters cereal and Kashi Heart-to-Heart cereal.

Consumer product giant Procter & Gamble has a strong tradition of introducing blockbuster products and new categories. The company has launched new products in most of its categories. In fact, P&G invested around $2 billion in innovation in 2012, which shows the importance of innovation in the company.

Global brewer Molson Coors Brewing Co (TAP) introduced several beer brands in 2012 to ensure variety and it continues to focus on the above premium category in beer in 2013. Other than beer, the company expects to launch the world’s first low-alcohol cider beer mix in the Czech Republic. It will also introduce a new non-alcohol category with the launch of Brewers Lemonade in 2013.

Shifting Focus on Health and Wellness and ‘Good-for-You’ Products

The companies are shifting focus to make healthier and nutritious products according to consumer preferences, increasing health consciousness and rising obesity concerns.

Beverage companies like Coca-Cola and PepsiCo Inc (PEP) are slowly expanding their portfolio of non-carbonated drinks due to the increasing awareness about calorie intake and nutrition among consumers.

Though these companies are still largely dependent on carbonated beverages, changing consumer preference toward health and wellness products has led them to introduce a variety of non-carbonated beverages.

Coca-Cola is expanding its portfolio of non-carbonated drinks, which include Powerade sports drinks and Minute Maid fruit juices, whereas Coca-Cola’s bottler Coca-Cola Enterprises Inc. (CCE) is also slowly shifting its product mix from colas to energy drinks and other non-carbonated beverages. PepsiCo is also increasing its focus on low calorie beverages, non-carbonated beverages and healthier snacks.

Coffee giant Starbucks Corporation (SBUX), is looking beyond its traditional coffee business and making an effort to bring more nutritional and healthy products to its menu. These include Evolution Fresh juices, Starbucks Refreshers energy drinks and new wholesome Salad Bowls.

Food and beverage companies are not the only ones trying to shift to healthier options. Tobacco companies are also adapting to the evolving needs of consumers and have resorted to less harmful alternatives like electronic cigarettes (e-cigarettes).

In the electronic cigarette industry, cigarette maker Lorillard Inc (LO) captures a leading position in the U.S. after it acquired e-cigarette brand blu e-Cigs in Apr 2012. Later with the acquisition of U.K.’s e-cigarette brand SKYCIG on Oct 3, the company has strengthened its position in the wide electronic cigarette market. Nu Mark, the subsidiary of Altria Group Inc (MO) also launched its first e-cigarette brand MarkTen in Aug 2013, whereas Reynolds American Inc’s (RAI) Vuse e-cigarette brand also offers potential for long-term commercial success.

Cost Reduction and Restructuring Initiatives

In order to boost profits, most consumer staples companies are divesting low-margin brands, improving the supply chain and implementing cost-reduction initiatives. These initiatives help companies to reduce the effects of inflating commodity costs and other input costs, which have remained a drag on margins of most companies in this sector, despite top-line growth.

Coca-Cola started a four-year productivity and reinvestment program early last year, under which it plans to optimize its global supply chain, improve global marketing and innovation, achieve operating expense leverage, standardize information systems and integrate North American bottling and distribution operations acquired from Coca-Cola Enterprises.

The program is expected to generate incremental annualized savings of $550 to $600 million through 2015. As the company’s tepid volume growth in the just released third quarter earnings season shows, these measures are key to the company’s bottom-line. PepsiCo also announced a restructuring program last year, which is expected to generate productivity savings of up to $3 billion through 2015.

Through its cost savings program FORCE (Focused on Reducing Costs Everywhere), consumer products giant Kimberly-Clark Corp (KMB) is expected to save $300–$350 million by the end of 2013. Kimberly-Clark’s pulp and tissue restructuring program is expected to increase operating profit by at least $75 million in 2013 and at least $100 million in 2014.

The company has also dissolved the diaper segment in Western and Central Europe, except the Italian market, in order to streamline its manufacturing facilities in Europe. This has reduced its European workforce by approximately 1,300 to 1,500 positions.

Coffee maker Green Mountain Coffee Roasters Inc (GMCR) is also taking several steps to optimize its efficiency and reduce operational costs. It aims to deliver annual productivity and cost savings benefits in the range of $70 million to $100 million by 2015.

Cigarette company Altria made significant progress with its $1 billion cost reduction program in 2012 by reducing headcount, consolidating certain facilities, improving business processes, and pursuing other savings. The cost reduction program is expected to deliver $400 million in annualized cost savings by the end of 2013. Reynolds American is also expected to save about $70 million annually by 2015 through workforce restructuring.

Consumer giant Unilever PLC (UL) also has been divesting businesses to concentrate on its core foods portfolio. Recently, it has sold its Wish-Bone salad dressing business to Pinnacle Foods Inc (PF). Besides, it has sold its Skippy peanut butter business in Jan 2013 to Austin, MN-based producer of branded food and meat, Hormel Foods Corp. (HRL), while in Aug 2012, ConAgra Foods Inc. (CAG) bought its Bertolli and P.F. Chang's frozen meals brands.

Expansion in Emerging Markets

Besides costs saving initiatives, many consumer staples companies are shifting their focus to emerging markets to boost sales. With market saturation, low disposable income of consumers, uncertain macroeconomic conditions and increased competitive activity in developed markets, these companies are diverting their resources to explore emerging markets.

Relative to the mature North American and European markets, emerging markets such as Brazil, India, China, Mexico, Russia and Southeast Asia are to a large untapped opportunities where consumer spending is still growing. Additionally, demand for convenient and branded packaged food tends to grow as middle-class consumers shift to urban living. Thus the rising pool of middle class consumers in emerging markets represents a huge opportunity for the companies.

However, increased exposure to emerging markets also brings along the negative impact of currency fluctuations for many consumer staples companies. A stronger dollar reduces the value of outside-U.S. sales and in turn limits growth. But with improving standards of living in developing countries, the companies are now focusing on increasing pricing to derive profits, which was difficult earlier.

PepsiCo is expanding in nations like Russia, Mexico, Canada and the United Kingdom and also in the emerging markets of China, India, Brazil and Africa by offering locally relevant innovation and value-added products. The company has tripled its revenues from the emerging and developing markets in the past five years. Going forward, management expects two-third of its revenues to come from the emerging markets.

Cereal maker General Mills, Inc (GIS) is also focusing on expansion in China, Brazil, India and Russia, where consumer spending is on the rise.

Tobacco company Philip Morris International Inc (PM) has a significant presence in a large number of markets. Asia remains a growth engine for the company. It also enjoys robust growth in Indonesia, Pakistan, China, Philippines, Mexico and Korea.

Zacks Industry Rank

Consumer Staples is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The consumer staples sector is further sub-divided into the following industries at the expanded level (260 industry groups): Beverages – Alcohol, Beverages – Soft, Consumer Products – Miscellaneous Staples, Cosmetics & Toiletries, Food – Meat Products, Food – Miscellaneous/Diversified, Publishing – Newspapers, Soaps & Cleaning Preparations, Textile – Apparel and Tobacco.

The ‘Consumer Products – Miscellaneous Staples’ is the best placed among them with its Zacks Industry Rank #33, comfortably placing it into the top 1/3rd of the 260+ industry groups. It is joined by the 'Cosmetics & Toiletries' with a Zacks Industry Rank #53. The Tobacco, Food – Meat Products and Beverages – Alcohol also lies in the top 1/3rd with Zacks Industry Ranks of #63, #67 and #70, respectively.

The Textile – Apparel lies in the middle 1/3rd with Zacks Industry Rank #157. The Food – Miscellaneous/Diversified barely makes into the middle 1/3rd with a Zacks Industry Rank #168.

However, all the other sub-sectors –- Beverages – Soft, Publishing – Newspapers and Soaps & Cleaning Preparations -- are featured in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #241, #214, and #232.

Looking at the exact location of these industries, one could say that the general outlook for the consumer staples space as a whole is positive.

Earnings Trends

The Consumer staples sector depicts mixed earnings trends. The third quarter 2013 results for the sector have been average in terms of earnings beat ratios (percentage of companies coming out with positive surprises) and weak for revenue.

Of the 20.6% companies reported under the consumer staples industry, the earnings "beat ratio" was 42.9%, while the revenue "beat ratio" was only 14.3%. Total earnings for this sector increased only 0.3% until now, compared with a decline of 0.6% registered in the second quarter. Total revenue declined 1.5% in the quarter, worse than the decline of 0.6% in the previous quarter. We note that the companies are facing weak results due to difficult consumer spending environment.

The consensus earnings expectations for the rest of the year remain muted with earnings projected to grow 2.1% in the fourth quarter of 2013, thereby pegging the full-year 2013 growth outlook at 5.5%. Revenues will decline 7.1% in the fourth quarter, with full-year revenue to decline 7.5%.

Moreover, the consumer staples sector is expected to account for only 6.8% share of the S&P 500 index earnings in 2013, while it accounts for 7.8% of the total market capitalization.

However, we believe the consumer staple environment will improve in 2014 with the expected recovery in economy and job environment. Earnings for 2014 are expected to grow 9.3%, while revenue is expected to improve 4.1%.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

OPPORTUNITIES

Despite macroeconomic headwinds, some of these companies have been able to deliver impressive results and have the potential to grow in the upcoming quarters. The J. M. Smucker Co. (SJM) and Green Mountain have been delivering strong performances consistently and have gained from lower green coffee costs. Both companies have raised their guidance for the fiscal year. The positive earnings momentum of these stocks resulted in a Zacks Rank #2 (Buy).

Companies like PepsiCo, Kraft Foods Group Inc (KRFT), Tyson Foods Inc. (TSN) and Hershey Co. (HSY) also have solid growth potential, despite carrying a Zacks Rank #3 (Hold). While Kraft and PepsiCo boasts solid organic growth and productivity gains, Tyson and Hershey have solid innovation programs and international presence which helps them to maintain top line growth despite macroeconomic headwinds faced by the developed nations.

WEAKNESSES

There were some companies which were hit hard by the challenging macro-economic environment, owing to lower consumer spending. U.S. consumers are burdened with higher gasoline prices, payroll tax increases and delayed tax refund checks. These external forces might restrict consumer discretionary spending. The persistently sluggish European economic conditions also remain an overhang.

While Zacks Rank #3 companies like Molson Coors, Procter & Gamble and Kellogg are facing the brunt of sluggish sales, currency headwinds, weakness in Europe and poor volumes; beverage company Dr Pepper Snapple Group (DPS) has been suffering due to weakness in overall carbonated soft drinks (CSD) volumes in North America and increasing regulatory pressure besides weak volume growth, higher cost pressure and macro-economic headwinds. Dr Pepper holds a Zacks Rank #4 (Sell).

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