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Industry Outlook

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Stocks in the Consumer Staples sector carried out their traditional defensive role as the broader equity markets came under pressure over concerns about the prolonged weak US economy and the debt crisis in Europe. But the group has been a laggard as momentum returned to the market over the last three months. In 2011, the sector index grew 10.5% versus a flat finish for the S&P 500 index.

The group’s defensive attributes stem from its ability 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’ top-line is expected to continue the uptrend of the last few quarters going forward, margins will remain under pressure due to elevated food prices.

Road Ahead

The macro-economic environment remains uncertain. However, we have seen that product demand has remained relatively stable for 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 resulted in higher operating margins than in the US. Therefore, consumer staples companies have performed decently despite the challenges in the US and Europe.

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

Coca-Cola has already invested over $2 billion in the last 18 years in India and remains very optimistic about its Indian operations. Further, Coca-Cola has seen a double-digit growth rate in India aided by its top-brands, which includes Thumbs Up, Sprite and Maaza. Over the next five years, Coca-Cola, along with its bottling partners, will make a further investment of $2 billion to build consumer marketing, infrastructure and brands in India.

PepsiCo had invested $500 million in India in 2008. In 2009, PepsiCo poured in $200 million in India and also plans another $500 million investment over the next three years. PepsiCo expects emerging markets like India, China, Russia and Brazil to drive its growth in future.

As part of an ongoing push into emerging markets, Coca-Cola also plans to invest $3 billion in Russia from 2012 to 2016. Coca-Cola plans to invest $4 billion in China over three years starting in 2012, thus raising its total investment in China between 2009 and 2014 to $7 billion.

The largest packaged food maker, Kraft Foods Inc. (KFT), following its takeover of Britain-based chocolates and confectionary company Cadbury Plc in 2010, expects to invest in the biscuits, candy and gum categories in India. Kraft’s brands like Oreo cookies and Tang powdered drink mix have also created its own space in India. Kraft is also aggressively investing in Brazil, Russia, China and Indonesia.

H.J. Heinz Company (HNZ) also remains well positioned in the key emerging markets of Russia, India, China and Indonesia. With the acquisition of Quero brand from the Brazilian food manufacturer Coniexpress S.A. Industrias Alimenticias in April 2011, Heinz expects its sales in the Latin American market to double. In addition, Heinz expects investments in emerging markets to generate more than 20% of its total sales in fiscal 2012.

Tough Job Markets

Overall, the job environment remains tough, though there has been some modest improvement lately in the sectors of beverages, tobacco, food and hygiene items. Still, 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.

Rise in Raw Material Costs

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 had reduced the Lay's "Family Size" potato-chip bag from 16 ounces to 14 ounces in 2009, due to rising prices of raw materials, while Heinz has also reduced the portions of its several products in the third quarter of 2012.

Companies have also been focusing on managing costs through cost reduction initiatives. Coca-Cola is undertaking various productivity initiatives to streamline its cost structure and boost profitability. In 2011, the company successfully completed its four-year productivity program, with annualized savings over $500 million, and has made plans to launch a new global productivity initiative in 2012 that will target $350 to $400 million in annualized savings by the end of 2015.

Unilever PLC (UL - Analyst Report) is also raising its prices and carrying out cost reduction initiatives to combat the input cost headwinds, but still expects the commodity prices to rise in 2012.

In spite of the price hike, these companies bring out new innovative products to cater to the ever-changing demands of customers. Unilever launched 10 new brands in its Home care segment in 2011, including the Domestos Toilet System in the UK and Sunlight hand dishwash in Indonesia and Vietnam. In the Hair section, Unilever experienced success with Dove Damage Therapy, the introduction of Suave Pro-Styling range, the re-launch of Clear and the launch of TRESemmé in Brazil.

Heinz’s Dip & Squeeze Ketchup, launched in September 2011, was a breakthrough dual-function ketchup package for the foodservice industry and it continues to expand across Continental Europe, Mexico and Canada. From the first plastic ketchup bottle to Top-Down and Fridge Door Fit, Heinz continues to lead the industry in ketchup packaging innovation.

Likewise, the top global beauty and direct selling Avon Products (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. Its brands like Skin So Soft continue to evolve to meet today’s personal care needs.

Among discounters, Supervalu Inc.'s (SVU - Analyst Report) Save-A-Lot stores offer savings of up to 40% on groceries, compared to traditional grocery stores. The company currently plans to invest in 80 to 90 primary store remodels and increase its store count by approximately 50 to 60 stores in 2012.

Wal-Mart Stores, Inc. (WMT - Analyst Report) has recently taken initiatives to open better and cleaner stores, merchandising and provide a different shopping experience to its customers. The stores feature enhanced service and improved layout that is designed to make the shopping experience more convenient for customers.

Wal-Mart has also aligned the departments that are favorites of customers. Most recently, Wal-Mart has opened such stores in Chantilly, Covington and Crowley with the same concept, providing job opportunities and savings.

OPPORTUNITIES

Tobacco company Philip Morris International Inc. (PM - Analyst Report) 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.

Philip Morris’ earnings grew 13.4% year over year $1.10 per share in the fourth quarter and increased 26.1% in fiscal 2011 to $4.88 per share. Excluding the currency headwind, the company projects its adjusted earnings to increase by approximately 10% to 12% versus $4.88 per share in 2011.

Its sales also increased 9.7% in the quarter, excluding the favorable currency translation, mainly driven by favorable pricing of $1.9 billion, primarily in Asia, and favorable volume of $472 million.

However, the company was negatively impacted by the weakening euro, mainly due to the sovereign debt issues in Europe and several emerging market currencies which have depreciated against the US dollar. In addition, 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 deliver strong business results with substantial amounts of cash to enhance shareholder value through share repurchases and dividends. During the year, Philip Morris spent $5.4 billion to repurchase 80.5 million shares of its common stock, and spent $1.0 billion to repurchase 14.5 million shares in the quarter. The company also plans to buyback approximately $6.0 billion in fiscal 2012.

In addition, Philip Morris hiked its dividend by 20.3% to 77 cents per share in 2011, representing an annualized rate of $3.08 per common share. The company has been constantly increasing its dividend after the company spun out from Altria Group, Inc. (MO - Analyst Report) in 2008. The previous three dividend increases were 17.4%, 7.4% and 10.4% in 2008, 2009 and 2010, respectively.

The company had also completed the acquisition of a cigarette business in Jordan, consisting primarily of cigarette manufacturing assets and inventories, for $42 million in June 2011, while it acquired a cigar business, consisting primarily of trademarks in the Australian and New Zealand markets, for $20 million in January. We thus give a Zacks #2 Rank which implies a short-term Buy rating and provide a Neutral rating on the stock on a long term basis.

The global manufacturer and marketer of high-quality brand products Sara Lee Corporation (SLE) also registered decent second quarter 2012 earnings of 27 cents per share, exceeding the Zacks Consensus Estimate by 8% and the prior-year quarter by 29%. Strong yearly growth in the Coffee & Tea business led to the rise in sales.

The company is also undertaking strategic disinvestments to cope with higher expenses. During the quarter, Sara Lee closed the divestiture of its North American foodservice coffee and shot beverage business to J.M. Smucker Company (SJM - Analyst Report). It is also planning to split itself into two businesses and maintain the company’s policy of streamlining the portfolios for a strong and focused business.

Sara Lee however faces tremendous inflationary pressure and severe competition from several branded and private label products. However, the company is able to combat its rising commodity costs by higher prices. Thus, Sara Lee holds a Zacks #2 Rank implying a short-term Buy rating. On a long-term basis, we maintain a Neutral rating on the stock.

The packaged and processed food-maker Kellogg, Inc. (K - Analyst Report) has generated strong revenue growth and increased its focus on investment in brand building and stronger innovation. The company has posted fourth-quarter 2011 earnings of 64 cents which exceeded the prior-year earnings by 25%. Kellogg also expects its full-year 2012 guidance of currency-neutral earnings per share to grow 2% to 4%.

Though Kellogg’s cost of commodities, energy and fuel peaked in the quarter, which led to a decline in the operating profits by 0.7%, the top-line jumped 5.4% to $3.02 billion in the quarter.

Recently, after winning the Pringles deal, Kellogg has become a strong player in the savory salty snacks business, second only to PepsiCo. The Pringles deal will shore up Kellogg’s overseas business and increase returns from its snacks by almost three times.

The buyout is expected to strengthen sales in Europe and mark a forceful entry for the retail giant to Asia and Latin America. Moreover, the Pringles buyout is likely to reduce Kellogg’s dependence on its mainstay cereal business apart from adding an important brand to its already popular offerings of snacks like Keebler and Cheez-It.

Analysts, however, have mixed opinions about the deal. While some felt that Pringles will add to the already dominant position of Kellogg in the snacks category, some are of the opinion that the brand is not very useful as it had not been faring well in its domestic market for quite some time. We thus hold a Zacks #3 Rank implying a short-term Hold rating. On a long-term basis, we maintain a Neutral rating on the stock.

WEAKNESSES

Pressured by inflation and current economic headwinds, Procter & Gamble Co. (PG - Analyst Report) has not been able to please its investors lately because of delivering a disappointing second quarter 2012, with net earnings from continuing operations sliding 49.0% year over year to 57 cents per share. The results were also 47.22% below the analyst estimates. Profits were restricted on account of charges associated with the Appliances and Salon Professional businesses.

Though its net sales increased 4% year over year to $22.1 billion in the quarter, based on volumes which were fuelled by initiatives and continued market expansions, the estimates marginally missed the Zacks Consensus Estimate of $22.2 billion. Gross margins also declined 210 basis points, due to higher commodity costs, and operating margins slipped 160 basis points due to lower gross margin and higher selling, general and administrative expenses (SG&A) as a percentage of net sales.

In order to combat with the rising commodity prices, P&G has decided to slash 1,600 jobs during the current fiscal year and another 4,100 jobs during fiscal year ending in July 2013, to save up to $10 billion of cost, including $1 billion in marketing costs and $3 billion in overhead costs, by the end of the fiscal year ending in June 2016.

In mid-Feb, P&G also shed off its Pringles potato chip business by striking a $2.7 billion deal with Kellogg. The pending Pringles deal also lowered its forecasts for the third-quarter 2012 net earnings from continuing operations and core earnings to be in the range of 89-95 cents per share compared to 91-97 cents per share, announced previously.

P&G is still one of the largest consumer products makers, but has been thrashed by uncertain economy and higher materials costs. Moreover, the delay in the launch of its new Tide Pods detergent caused losses because it could not match demand with its supplies. In addition, it had to rescind price increases on items such as Cascade dishwasher detergent after competitors decided not to raise their prices.

We therefore provide a Zacks #4 Rank to P&G, which implies a short-term Sell rating. However, on a long-term basis, we remain Neutral on the stock, as the company continuously expands its portfolio of brands, both through internal development and acquisitions.

The world’s leading manufacturers of health and hygiene products Kimberly-Clark Corporation (KMB - Analyst Report) reported fourth quarter and fiscal year earnings of $1.28 and $4.80 per share, which missed the Zacks Consensus Estimate of $1.29 and $4.82 per share, respectively. The adjusted earnings, though, increased 7% from the prior-year fourth quarter 2010 earnings and 2.6% from fiscal year 2010.

Net sales also showed growth of 2.0% to $5.2 billion in the quarter, while it increased 5.6% to $20.8 billion in the year. However, Kimberly-Clark was negatively impacted by rising input cost inflation, higher effective tax rate and lower net income from equity companies in the quarter. Thus it expects sales to decrease by 2% in 2012.

Gross profits and operating profits also contracted in the quarter, as cost inflation more than offset efficiency initiatives. Inflation in key cost inputs was approximately $55 million overall in the fourth quarter 2011 versus 2010, which included increases of $75 million for raw materials other than fiber, primarily polymer resin and other oil-based materials, $15 million in distribution costs and $5 million for energy, partially offset by $40 million of lower fiber costs.

Kimberly-Clark’s cash flow from operations declined in the quarter, driven by increased working capital, along with higher defined benefit pension plan contributions, partially offset by improved cash earnings. Cash provided by operations in fiscal 2011 was also lower than 2010 at $2.29 billion, driven by higher pension contributions in 2011.

Nevertheless, Kimberly-Clark directed its cash flows toward increasing dividends by 6% to 74 cents per share. Our outlook remains Neutral, we currently have a Zacks #4 Rank on the stock, which implies a short-term Sell rating.

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