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Consumer Staples Stock Outlook - Dec. 2011 - Zacks Analyst Interviews

Stocks in the Consumer Staples sector performed their traditional defensive role as the broader equity markets came under pressure over concerns about the prolonged weak U.S. economy and the debt crisis in Europe. Shares of consumer staples companies, accounting for a total of about 11.4% of the S&P 500 Index, were up 5.3%, compared with a 3.3% 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.

The consumer staples companies are typically able to buck sluggish economic growth as food, beverage, household products and cosmetics companies that manufacture and market non-durable consumables, are considered essential to daily life, such as food, drink, toothpaste, deodorants, toilet paper, etc.

Although, staples' earnings are expected to the continue the uptrend of the last quarters going forward, margins will remain under pressure due to elevated food prices.

Road Ahead

As referred to earlier, the macro-economic environment remains uncertain. However, we have seen that product demand has remained relatively stable for the companies that are more exposed to fast-growing emerging markets in comparison to the slow-growing developed markets. Moreover, favorable foreign exchange translation and lower production costs in developing markets led to higher operating margins than the U.S. Therefore, consumer staples companies have outperformed despite the challenges facing the U.S. and Europe.

Beverage companies, such as The Coca-Cola Company ( KO ) and PepsiCo Inc. ( PEP ) are showing keen interest in the emerging markets of India and China, as the developed markets are nearing saturation.

Coca-Cola has already invested over $1 billion in the last 18 years and remains very optimistic about its Indian operations. Last week, Coca-Cola, along with its bottling partners, announced an investment of $2 billion to build consumer marketing, infrastructure and brands in India. The investment will start in 2012 and will continue over the next five years.

PepsiCo had invested $500 million in India in 2008 and expects to triple its revenues over the next five years.

The largest packaged food maker, Kraft Foods Inc. ( KFT ), following its takeover of Britain based chocolates and confectionary company Cadbury Plc also expects to invest in the biscuits, candy and gum categories in India. Kraft also foresees sales growth for its own brands, like Oreo cookies and Tang powdered drink mix, which have already created its own space in India. Besides India, Kraft is also aggressively investing in Brazil, Russia, China and Indonesia.

However, the jobless recovery continues to remain in place, though there has been some modest improvement lately, primarily impacting beverages, tobacco, food, and hygiene items, sales of which have been hit hard by unemployment. Further, the unemployment scenario is expected to remain relatively high in 2012. We thus believe that the private label goods, which are comparatively cheaper than the branded items, will attract consumers, at the cost of growth of branded goods.

Further, the substantial rise in raw material prices remains a drag on margins of most of the companies in this sector.

Therefore, to survive in an environment of escalating prices, many companies in the consumer staples sector have "right-sized" portions and packages of their products to push higher prices to consumers. PepsiCo Inc. reduced the Lay's "Family Size" potato-chip bag from 16 ounces to 14 ounces in 2009, due to rising prices of raw materials. HJ Heinz Co. ( HNZ ) has also 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 tomatoes.

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. 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 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 currently plans to invest in 80 to 90 primary store remodels and open 80 to 90 Save-A-Lot stores by fiscal 2012. The company's '8 Plays to Win' strategy is gaining traction to improve Supervalu's price positioning. Increased discipline and analytical tools are helping to advance hyper local retailing initiatives, which appears to be having a positive impact on the company's customers' shopping experience.

Wal-Mart Stores, Inc. ( WMT ) announced earlier this year its 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, staples companies are generally flush with cash and have the wherewithal to withstand the current economic headwinds. Procter & Gamble Co. ( PG ) is one of the better-positioned companies in this space, with a strong track record of acquisitions, and despite a soft retail environment, recent volume growth has exceeded expectations. The company generated approximately $9.9 billion in free cash flow in fiscal 2011 - a free cash flow productivity of 84%. The company also 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.

The first quarter of 2012 also brought innovative premium-priced products in both mature and emerging markets such as Pantene treatments in Asia, Vicks Nature Fusion and Olay Pro-X Clear in North America, fragrances in Prestige such as Gucci Guilty; and market expansions, such as Pampers Super Dry Premium in China, Oral-B in Western Europe, and ProGlide in Asia, which fuelled more than 30% growth in the region.

Procter & Gamble also remains committed to improving the company's position in the faster growing developing markets, which currently represent only 30% of its total sales. The company also believes that the developing market could catch up with the combined value of North America and Europe by the next decade.

However, margins were impacted by higher commodity costs and unfavorable product mix, which resulted in an unanticipated earnings headwind of about 25 cents per share in fiscal 2011 or nearly a 7 percentage point drag on earnings per share growth versus our going-in expectations. 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 better-than-expected third-quarter 2011 results of $1.76 for Lorillard, Inc. ( LO ), as the company continues to outperform in terms of volume and retail shipments, despite difficult macro-economic environment.

Further, the new Newport Non-Menthol launch and the flagship Newport Menthol business continued to improve in the quarter. Despite such launches, Lorillard managed to control its promotional spending.

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 return capital to shareholders through share repurchases and dividends. In August 2011, the company's Board approved a new share repurchase program to repurchase up to $750 million of its outstanding common stock. Previously, Lorillard completed repurchases under its $1.4 billion share repurchase program announced on August 20, 2010.

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 third quarter 2011, the company's adjusted earnings came in at $1.26 per share, in line with the Zacks Consensus Estimate. However, the adjusted earnings increased 11% from the prior-year earnings on the back of all time high sales growth, cost savings, a lower share count and a reduced tax rate.

However, operating profit declined, as cost inflation more than offset efficiency initiatives. Increasing cost inflation has resulted from the tight supply for raw materials used in the production and strong global demand, particularly in China, though cost inflation has decreased for the full year 2011 to a range of $575 million to $625 million, compared with the previous expectation of $650 million to $750 million, resulting from lower pulp costs. The company has also reduced its 2011 volume estimates for the developed markets due to the current market turmoil.

Nevertheless, Kimberly-Clark's plans to direct its surplus cash flow toward increasing dividends and repurchasing shares. Moreover, Kimberly-Clark is also focusing on reducing cost and improving margin.

These initiatives have led to cost savings of about $240 million in 2009 and about $370 million in 2010. It also led to sales growth and $90 million in cost savings in the third-quarter 2011. Our outlook for the stock remains neutral, supported by the Zacks recommendation as well as the short-term Zacks Rank.

WEAKNESSES

The packaged and processed food-maker Kellogg, Inc. ( K ) posted weak third-quarter 2011 earnings of 80 cents per share, which lagged the Zacks Consensus Estimate by 10.1% and the prior-year earnings by 11%, on the back of economic slowdown, increased cost of goods sold, increased supply-chain costs and reinstatement of incentive compensation costs.

The cost of commodities, energy and fuel soared and peaked in the quarter, exceeding expectations. Gross margins and operating margins also plummeted by 270 and 310 basis points, respectively, in the third quarter of 2011 due to mounting costs. Besides, the investments in the supply chain infrastructure across the U.S. network added to gross margin pressure, resulting in increased logistic costs, and reduced operating leverage.

Kellogg also expects gross margin to remain under pressure in fiscal 2011 and be down approximately 100 basis points compared to 2010. Kellogg has also narrowed its internal operating profit guidance to a range of down 2% to 4% for the year 2011 due to the impact of third quarter results and expected continued investments in the supply chain during the remainder of the year.

Though the company has shown compelling signs of improvement in the third quarter, particularly in the top-line growth, the weak margin outlook is expected to continue weighing on its earnings prospects.

In addition, Kellogg has a highly leveraged balance sheet. Though the company generates substantial amounts of cash, it has significant uses for that cash in dividend payouts and interest on its heavy debt load. The company's debt load, though by all means very manageable, has increased by 4-year CAGR (2006-2010) of 13%. The recent downtrend in the company's earnings estimates, a reflection of its weak earnings outlook, is showing up in our long-term Underperform recommendation on the shares. We also have a Zacks #5 Rank on the stock, indicating its weak near-term earnings picture.

Sara Lee Corporation ( SLE ) also faces tremendous inflationary pressure and severe competition from several branded and private label products, being a global manufacturer and marketer of high-quality brand 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 registered decent first quarter 2012 earnings of 18 cents per share, exceeding the Zacks Consensus Estimate by a penny, we do not see any compelling reason that will 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, though the spin-off is subject to clearance under several regulations.

For fiscal 2012, Sara Lee affirmed its earnings guidance to be in the range of 89 cents to 95 cents per share, amidst unfavorable foreign currency exchange rates and the reclassification of North American Foodservice Beverage as a discontinued operation. Thus, Sara Lee holds a Zacks #3 Rank implying a short-term Hold rating. On a long-term basis, we maintain a Neutral rating on the stock.

HEINZ (HJ) CO ( HNZ ): Free Stock Analysis Report

KELLOGG CO ( K ): Free Stock Analysis Report

KRAFT FOODS INC ( KFT ): Free Stock Analysis Report

KIMBERLY CLARK ( KMB ): Free Stock Analysis Report

COCA COLA CO ( KO ): Free Stock Analysis Report

LORILLARD CO (LO): Free Stock Analysis Report

PEPSICO INC (PEP): Free Stock Analysis Report

PROCTER & GAMBL (PG): Free Stock Analysis Report

SARA LEE (SLE): Free Stock Analysis Report

SUPERVALU INC (SVU): Free Stock Analysis Report

UNILEVER PLC (UL): Free Stock Analysis Report

WAL-MART STORES (WMT): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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