CL Colgate Palmolive Co

Stocks in the Consumer Staples sector performed their traditional defensive role as the broader equity markets came under pressure in response to concerns over Europe’s sovereign debt crisis and a weak U.S. economy. The fundamental explanation is that food, beverage, household products and cosmetics companies that manufacture and market consumable products, most of which are considered essential to daily life, such as food, drink, toothpaste, deodorants, toilet paper, etc.

As of September 18, 2011 the consumer staples sector represented 11.8% of the S&P 500 Index, up 0.4%, compared with a 10.7% drop for the S&P 500. In 2010, the sector index grew 10.7% versus a 12.8% increase for the S&P 500 index. But with the market shifting gear and starting to move up again over the last few trading sessions, this defensive sector is expected to be unable to keep pace.

Road Ahead

As referred to earlier, the macro-economic environment remains uncertain. However, we have seen that product demands have remained relatively stable.

Going ahead, beverage companies, which make up 22.2% of the sector's market value, are expected to grow faster -- in the mid single-digit to high single-digit range -- displaying the benefits of volume growth and effective net pricing. On the other hand, cosmetics companies can grow their earnings from higher-margin product launches and effective advertising spending.

However, the essentially jobless recovery that defined 2010 has lingered through 2011. Further, worsening the situation is the high food inflation. In this environment, the less expensive private label goods are expected to attract consumers, thereby limiting the growth potential of branded food companies.

Further, the substantial rise in raw material prices remains a drag on margins of most of the companies in this sector. We have seen this trend with Colgate Palmolive Co. (CL), Kimberly-Clark Corporation (KMB) and Procter & Gamble Co. (PG) in recent days.

Therefore, to survive in the environment of escalating prices, many companies in the consumer staples sector have "right-sized" portions and packaging of their products to pass on the higher prices to consumers. PepsiCo Inc. (PEP) had reduced the Lay's "Family Size" potato-chip bag from 16 ounces to 14 ounces in 2009, due to rising grain prices. HJ Heinz Co. (HNZ) has reduced the portions of its several products, including its flagship Heinz 57 sauce, which now comes in a 4-ounce smaller package with no reduction in price. The reason behind this reduction remains the rising cost of wholesale tomatoes, which have more than tripled in 2010 from the previous year.

It is expected that higher wheat costs will begin to affect cereal and bakery product prices over the next few months, causing prices to rise 3.5% to 4.5% overall in 2011.

In spite of the price hike, these companies bring out new innovative products to cater to the ever-changing demands of customers.

Heinz Ketchup’s Dip & Squeeze product was a breakthrough dual-function ketchup package for the foodservice industry and the launch of Simply Heinz Tomato Ketchup for the retail market. From the first plastic ketchup bottle to Top-Down and Fridge Door Fit, Heinz continues to lead the industry in ketchup packaging innovation.

Health, beauty and other products also remain well positioned as they constantly introduce new products especially targeted at young women. Unilever plc (UL) has recently launched ‘Dove Ultimate Go Sleeveless’ which claims that its specialized moisturizers can give women better-looking underarms in five days.

Likewise, the top global beauty and direct selling brand, Avon Products Inc. (AVP) continues to revolutionize the beauty industry by launching innovative, first-to-market products using Avon-patented technology. The flagship Avon Color brand sells 4 tubes of lipcolor every second. Besides, its brands like Skin So Soft continue to evolve to meet today’s personal care needs.

Among discounters, Supervalu Inc. (SVU) has developed its retail operations primarily through new store development, adding merchandise to the existing stores and increasing the number of replacement food distribution centers. The company completed 11 traditional store remodels and opened 18 Save-A-Lot locations in the first quarter of 2012, and plans to complete 55 to 75 store remodels in fiscal 2012 and open 160 Save-A-Lot stores by fiscal 2012.

Wal-Mart Stores, Inc. (WMT) that runs chains of large discount department stores and warehouse stores also operated 803 discount stores, 2,747 supercenters, 158 neighborhood markets, and 596 Sam’s Clubs in the United States at the end of fiscal 2010. In April, 2011, the company announced a new "Walmart To Go" home delivery system where customers will be able to order specific items offered on their website such as groceries, toiletries and household supplies.

To generate employment and to protect the environment, Walmart also planned to install solar-power panels in more than 60 stores in California, which means that 75% of Walmart stores will have solar power. Through this solar program, Walmart has cut down its energy expenses by more than a million dollars, and created hundreds of new full-time jobs.

OPPORTUNITIES

Though temporarily impacted by inflation, there are companies, which are cash rich and can withstand the current economic headwinds. Procter & Gamble Co. (PG) is one of the well positioned companies in the consumer staples sector. The company generated approximately $9.9 billion in free cash flow in fiscal 2011, and repurchased $7 billion worth of shares in fiscal 2011 and increased its quarterly dividend by 9% in April, paying $5.8 billion in dividends to shareholders in fiscal 2011.

Procter & Gamble also continues to see healthy growth rates in developing markets. In fiscal year 2011, the company experienced unit volume increases in all reportable segments due to investments in innovation and market expansions, such as Olay and Head & Shoulders in Brazil, Gillette Guard in India. The results thus led to inflated guidance for net sales and organic sales (based on solid volume momentum, partially offset by product mix and pricing) in the range of 5%–9% and 3%–6%, respectively, for fiscal year 2012.

However, margins were impacted by higher commodity costs and unfavorable product mix, which resulted in a 120-bp gross margin contraction in the fourth quarter and 140 basis points in fiscal year 2011. Nevertheless, the company’s expansion of its portfolio of brands, both through internal development and acquisition remains encouraging. On a long-term basis we are Neutral on the stock, and on a short-term basis the stock has a Zacks #3 Rank which implies a Hold rating.

We can also see the global net sales of Philip Morris International Inc. (PM) growing 17.2% year over year to $8.3 billion in the second quarter of 2011, including favorable currency of $494 million. Philip Morris’ earnings also surpassed the Zacks Consensus Estimate to $1.34, attributable to price increases and strong volume growth in Asia.

Concurrently, the company has raised its outlook for fiscal 2011. Phillip Morris expects earnings in the range of $4.70 to $4.80 for fiscal 2011, reflecting a growth of approximately 20.0% to 22.5% from $3.92 earned in 2010.

Philip Morris is well positioned to capitalize on its strong brand in emerging economies, while enjoying the benefit of reduced liability risk in developed countries, since its operations are globally diversified.

However, there have been significant increases in cigarette-related taxes which might impact the company’s cigarette volume and sales due to lower consumption levels, a shift in sales from manufactured cigarettes to other tobacco products and a shift from the premium price to the mid-price or low-price cigarettes.

In spite of the above difficulties, management continued to enhance shareholder value through share repurchases and dividends. During the second quarter of 2011, the company repurchased as many as 22.7 million shares worth $1.5 billion; while recently, the company raised its quarterly dividend by 20.3% to 77 cents per share, which will be paid on October 11, 2011 to shareholders of record as of September 27, 2011.

This was the biggest and the fourth consecutive annual dividend increment after the company spun out from Altria in 2008. The previous three dividend increases were 17.4%, 7.4% and 10.4% in 2008, 2009 and 2010, respectively. On a long term basis we are Neutral on the stock, and on a short term basis the stock has a Zacks #3 Rank which implies a Hold rating.

WEAKNESSES

Kimberly-Clark Corporation (KMB) is one of the world’s leading manufacturers of health and hygiene products, and commands a strong portfolio of well-established brands. In the most recent quarter, the company’s earnings and margins were hit by significant input cost inflation and a higher effective tax rate.

Further, the company assumes input cost inflation to be in the range of $650 million–$750 million compared to the previous assumption of $450 million–$550 million, primarily due to higher costs for polymer resin, superabsorbent, adhesives and other packaging materials. On a long-term basis we are Neutral on the stock, and on a short-term basis the stock has a Zacks #3 Rank which implies a Hold rating.

Altria Group (MO), the manufacturer and seller of cigarettes, wine and other tobacco products, is also seeing volume declines in its cigarette segment due to growing health consciousness among consumers, a ban on public smoking as well as high excise duties on tobacco products and other legislative controls. On a long-term basis we are Neutral on the stock, and on a short-term basis the stock has a Zacks #3 Rank which implies a Hold rating.

Fred's Inc. (FRED), which operates discount general merchandise stores across 15 states in the southeastern US, has experienced tough retail conditions across the markets in 2011. With rising account receivables and declining cash assets, the company is finding it difficult to maximize its revenue in this state of the economy.

Moreover, the company operates in a highly fragmented industry and faces intense competition from national, regional and local retailing establishments. On a long-term basis we believe that the stock will Underperform, and on a short-term basis the stock has a Zacks #5 Rank, which implies a Strong Sell rating.

Being a global manufacturer and marketer of high-quality brand products, Sara Lee Corporation (SLE) also faces tremendous inflationary pressure and severe competition from several branded and private label products. While combating the high price of coffee and meat by raising prices, the company is sacrificing volume. Moreover, strict regulations imposed by several authorities as well as inherent risks associated with the food industry like contamination, wastage and recall of products affect sales and the confidence of customers.

Although Sara Lee’s fourth quarter 2011 earnings of 20 cents were decently ahead of the year-ago period and in line with the Zacks Consensus Estimate, we do not see any solid ground which can hold the top line at decent levels. The company is undertaking strategic disinvestments to cope with higher expenses. It is also planning to split itself into two businesses.

However, the spin-off is subject to clearance under several regulations. On a long-term basis we are Underperform on the stock, and on a short-term basis the stock has a Zacks #5 Rank, which implies a Strong Sell rating.
 
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