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Industry Outlook

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The companies under the Consumer Staples sector sell relatively low-priced products that consumers use frequently in their daily lives, including food, beverages and products for personal hygiene or household cleaning. The purchase of these necessities is generally stable over time, irrespective of the spending patterns or whether the economy is expanding or contracting.

This is a defensive sector, as the outlook for its companies would not change much with the economic cycle. We have seen that lately, as these companies have been playing their role despite concerns about the prolonged weak U.S. economy, the debt crisis in Europe and the slowdown in China.

Consumer staples stocks have outperformed the S&P 500 as a whole in the year-to-date and trailing 52-week periods, up +9% and +18.4% in the YTD and trailing 52-week periods, compared to gains of +6.4% and +10.8% for the S&P 500, respectively.

Many consumer companies are expanding focus to emerging markets, while many are resorting to cost saving initiatives to survive input cost pressures. The companies are also expanding their portfolios through product innovations and acquisitions.

Expansion in Emerging Markets

With market saturation, low disposable income of consumers and increased competitive activity in developed markets, many companies are diverting their resources to explore emerging markets. Though companies like Coca-Cola (KO - Analyst Report) and PepsiCo (PEP - Analyst Report) are witnessing improving volume trends in North America, driven by increased marketing and advertising spending, we believe that the markets of North America are relatively mature compared to their untapped developing counterparts such as Brazil, India, China, Mexico, Russia and Southeast Asia, which exhibit positive consumer spending growth.

Moreover, we have seen that product demand has remained stable for companies that are more exposed to fast-growing emerging markets in comparison to the slow-growing and saturated developed markets. Demand for convenient and branded packaged food is growing in the developing countries, as middle-class consumers shift to urban living. Thus, the rising pool of middle class consumers in emerging markets represents a huge opportunity for branded consumer companies.

However, growth in the emerging markets has been largely hurt by currency headwinds for many consumer staples companies due to a stronger dollar, which reduces the value of outside-U.S. sales. But with improving standard of living in developing countries, the companies are now focusing on increasing pricing to derive profits, which was earlier difficult.

Beverage companies such as Coca-Cola and PepsiCo have invested heavily in the emerging markets of India, Russia and China, encouraged by the high-growth nature of these countries. However, the slowdown in Chinese economy has hurt the return on investments for companies.

Coca-Cola has already invested over $2 billion in India in the last 18 years and has been witnessing double-digit business growth in India aided by its top brands like Thumbs Up, Sprite and Maaza. Over the next eight years, Coca-Cola, along with its bottling partners, will make a further investment of $3 billion to build consumer marketing, infrastructure and brands in India.

Coca-Cola also has plans to invest $4 billion in China over three years starting 2012, invest $3 billion in Russia between 2012 and 2016, $8 billion in Brazil through 2016 and $300 million in Vietnam between 2012 and 2015.

PepsiCo has invested $700 million in India since 2008. It also plans another $500 million investment over the next three years. Further, with the acquisition of Wimm-Bill-Dann in Sep 2011, PepsiCo took control of the largest food-and-beverage business in Russia, bringing the company closer to its strategic goal of building a $30 billion nutrition business by 2020.

PepsiCo’s strategic alliance with leading Chinese food and beverage maker Tingyi Holding Corp. has created the number one liquid refreshment beverage (LRB) manufacturing network in China, and is expected to help PepsiCo to revamp its Chinese business.

H.J. Heinz Company (HNZ) has a significant presence in India, China and Indonesia. Heinz products, especially ketchup, sauces and infant nutrition goods, are showing healthy growth in all of these markets due to brisk demand. Management expects its businesses in China, Indonesia, Brazil and Eastern Europe to each generate around $1 billion in sales over the next 3-5 years, with emerging markets as a whole to double its sales to around $5 billion.

Recently, Heinz agreed to be acquired by an investment group led by Warren Buffett’s Berkshire Hathaway (BRK.B) and private Brazilian investment firm 3G Capital for $28 billion, including debt.

Coffee giant Starbucks Corporation (SBUX - Analyst Report) is also gaining popularity with consumers across China and the Asia-Pacific region, which has grown 33% (in terms of revenue) since 2010 and is expected to achieve meaningful business growth over the next five years.

Starbucks has already entered the lucrative Indian market with its first three store openings in Mumbai in Oct 2012 and a fourth store in Delhi early this month. The company has also entered the Vietnam market with its first store in Ho Chi Minh City on Feb 1.

Cost Reduction Initiatives

Most consumer staples companies are also undertaking several strategic initiatives like the divestiture of low-margin brands, improvement of the supply chain and implementation of cost-reduction initiatives, in an effort to reduce the effects of inflating commodity costs. Though cost inflation has subdued, rising commodity and other input costs remain a drag on margins of most of the companies in this sector, despite top-line growth.

Coca-Cola is undertaking various productivity initiatives to streamline its cost structure and boost profitability. With the launch of a four-year productivity and reinvestment program in Feb 2012, the company plans to optimize its global supply chain, improve effectiveness of global marketing and innovation, achieve operating expense leverage, standardize information systems and integrate North American bottling and distribution operations acquired from Coca-Cola Enterprises (CCE). The program is expected to generate incremental annualized savings of $550 to $600 million over the four-year period ending in 2015.

PepsiCo also announced a restructuring program in Feb 2012, which is expected to result in $3 billion productivity savings by 2015. The program will include leveraging new technologies and processes across operations, consolidating facilities, simplifying organization structures, lowering layers of management, workforce reduction of 3% and many more efforts.

Tobacco company Altria Group's (MO - Analyst Report) cost reduction program of $1 billion is expected to deliver $400 million in annualized cost savings by the end of 2013. The company also reduced its workforce by 700 employees in Feb 2012 as a part of its restructuring program to reduce cost.

Another tobacco seller, Reynolds American (RAI - Analyst Report), also remains focused to reduce cost. The company is expected to save about $70 million annually by 2015 associated with workforce restructuring done in the year 2012.

Philip Morris International (PM - Analyst Report) has also announced a one-year gross productivity and cost savings target for 2013 of approximately $300 million. Last year, the company managed to exceed its one-year gross productivity and cost savings target of $300 million primarily through the rationalization of tobacco blends and product specifications and other manufacturing and procurement initiatives.

Consumer products giant, Kimberly-Clark (KMB - Analyst Report) is undertaking a cost savings program, FORCE (Focused on Reducing Costs Everywhere), which is benefiting the company through the continued rollout of lean manufacturing and supply chain practices and the formation of a global procurement organization. These initiatives generated cost savings of about $240 million in 2009, about $370 million in 2010, about $265 million in 2011 and $295 million in 2012. Kimberly-Clark expects $250–$300 million of cost savings in 2013.

Kimberly-Clark’s pulp and tissue restructuring program focuses on improving underlying profitability and return on invested capital of its consumer tissue and K-C Professional businesses, which have been facing declining profits for many years. Through this program, Kimberly-Clark anticipates operating profit to increase by at least $75 million in 2013 and at least $100 million in 2014.

Innovations

Consumer product companies need to innovate and upgrade their brands to create differentiated value propositions for their customers in order to remain successful.

PepsiCo’s low calorie cola -- Pepsi Next, launched in July 2012 -- was successful. The company also utilizes new packaging to shift consumers to more profitable purchases. Its 24-ounce can for regular and diet Dew is generating good customer response. The company’s recent innovations at the premium end include Quaker Real Medleys hot cereals, Stacy's Gingerbread and Stacy's Cocoa and Lay's Stax potato chips. The new innovations are expected to boost revenue growth and also enable increased price realization in the long run.

Starbucks has also introduced new products to excite customers. With the launch of its premium single cup domestic coffee machine Verismo in Sept 2012, the company expects to significantly expand Starbucks’ presence in the fast growing premium single cup coffee segment. Apart from coffee, the company opened four Evolution Fresh juice stores across the U.S., in order to meet the needs of the increasingly health conscious Americans. In March 2012, the company launched a new energy drink, Starbucks Refreshers, thus marking its entry into the $8 billion energy drink market.

Starbucks is also diversifying with the La Boulange bakery acquisition to popularize the French bakery experience in the U.S. markets. In addition, with the acquisition of Teavana in late Dec 2012, the company aims to capture further share of the $40 billion tea category. The company has also enhanced its core food offering, which has jumped double digits in each of the last two fiscal years.

The tobacco sector has also been active in innovation with the development of new products which reduce the harm caused by tobacco. Reynolds American’s Zonnic nicotine replacement therapy gum and the Vuse e-cigarette offer potential for long-term commercial success. Zonnic gum saves smokers from the harmful effects of tobacco, while Vuse e-cigarette delivers vapor and taste and has potential for long-term growth.

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 improved business backdrop is showing up in positive earnings momentum for consumer staples stocks, resulting in a Zacks Rank #1 (Strong Buy) for Green Mountain Coffee Roasters (GMCR), Tyson Foods (TSN - Analyst Report) and Smithfield Foods (SFD).

Some attractive Zacks Rank #2 (Buy) stocks worth considering are Smucker's (SJM - Analyst Report), Kellogg's (K), Procter & Gamble (PG - Analyst Report) and Hershey's (HSY).

Coffee maker Green Mountain’s performance turned around in the fourth quarter of 2012 (ending September) from past few weak quarterly results, driven by the success of Keurig Single Cup Brewers, single serve packs (K-cups), and Keurig-related products. The company’s margins are improving with favorable green coffee costs.

The company is focusing on its products through innovations and upgrading its Keurig brewing system to attract more customers. Green Mountain has raised its earnings guidance twice for fiscal 2013 in the last two quarters. Green Mountain appears to be well positioned for growth in the future quarters.

Stabilizing coffee costs also improved the margins at Smucker's. The company has witnessed year-over-year earnings growth in all the three quarters of fiscal 2013 (ending April), driven by company’s strong portfolio of brands, focus on innovations and promotional offerings. Moreover, strategic acquisitions have broadened Smucker’s presence across emerging markets and added popular brands to its portfolio. The company has increased its fiscal 2013 earnings guidance in the last two quarters, reflecting the company’s potential to drive profits in the coming quarters.

Like Green Mountain, the consumer products giant P&G also had a tough fiscal 2012 (ending June). However, the company has implemented some meaningful changes to re-accelerate its top and bottom-line growth to keep pace with its peers, which is reflected in its two back-to-back solid quarterly results in fiscal 2013. In addition, the company’s cost savings and productivity improvement initiatives have improved margins.

The world’s largest cereal maker, Kellogg, has delivered solid growth in earnings in all the four quarters of 2012, driven by robust organic sales growth performance. Despite its sluggish cereal business, challenges in Europe and rising input costs, we are optimistic about Kellogg’s solid brand positioning, its geographic diversity and cost-saving efforts, especially its supply-chain initiatives. Moreover, we are encouraged by the growth potential of the Pringles snack business, which was acquired in June last year from P&G.

Meat products processor Tyson has been witnessing strong momentum in the last several quarters backed by its bright prospect in beef and chicken business and consistent innovation towards low fat meat production. Rising demand for chicken coupled with positive pricing is helping the company reap wider margins. In addition, Tyson is working on growing its prepared foods, international poultry and value-added poultry businesses by producing high quality foods by using innovative and cost-effective processes.

Tyson’s close peer Smithfield also has bright prospects ahead as the company expects hog prices and the impact of grain costs to ease in the upcoming quarters. Smithfield’s results have been suffering since last two or three years as a result of higher grain costs and oversupply of hogs. However the company recovered nicely in fiscal 2011 (ending April) and posted record revenues in fiscal 2012, backed by the company’s brand building investments and innovation, restructuring initiatives, improved packaging and production of healthier choices for consumers using lean protein and natural ingredients.

Smithfield is also increasing its focus on consumer convenience by introducing more ready-to-eat foods. Increased export volume of fresh pork is also encouraging and we expect strong demand of fresh pork in the upcoming quarters.

Hershey has solid growth potential driven by strong brand positioning, strategic marketing investments in core brands, disciplined innovation, lower cost inflation, improved pricing and volumes and strong productivity. In fact, Hershey has outperformed and delivered positive surprises in three out of the four quarters of 2012 and has raised its guidance thrice in 2012, highlighting its attractive earnings potential. The outlook for 2013 is also encouraging, especially the expectation of no cost inflation this year.

WEAKNESSES

The macro-economic environment in the U.S. has remained challenging and uncertain for quite some time now. The European economy has also remained unfavorable. The pace of economic recovery is relatively slow in U.S., whereas the consumer environment in U.S. is recovering at a mild pace. In Europe, the economic conditions are uncertain and China is also seeing some slowdown. These global economic pressures are expected to continue in 2013 and severely impact the companies in the coming quarters.

For the global brewer Molson Coors (TAP - Analyst Report), the acquisition of StarBev in Jun 2012 opened opportunities in the attractive beer market in Central Europe. However, unfavorable economic conditions in Europe will offset the gains from the acquisition. Moreover, the company has been facing continued decline in volumes in three major markets of U.S., U.K. and Canada in the last three years.

Molson Coors has also spent on marketing and advertising for its Miller Lite and the Molson Brands but this has not led to consistent growth in volumes. The increasing raw material costs of the company and the currency headwinds hurting the top line also remains a concern.

We believe that tough global macroeconomic conditions and declining volume trends will continue to drag the company’s performance in the upcoming quarters. Currently, the stock carries a Zacks Rank #3 (Hold).

Mondelez International (MDLZ - Analyst Report), which focuses on the global food and snacks business of the old Kraft Foods, missed on both the top and bottom lines in fourth quarter 2012 mainly due to currency headwinds. In addition, the gum and candy business has been suffering for the last few quarters. Management does not expect the gum business to stabilize in the coming quarters. The stock carries a Zacks Rank #3 (Hold).

Beverage company Dr Pepper Snapple Group (DPS) has had a dismal 2012, posting a negative surprise in two of the four quarters of 2012. The company missed the Zacks Consensus Estimates for both revenue and earnings while just managing to meet company expectations for the year.

Moreover, the company’s weak volume growth, higher cost pressure and lack of exposure outside the U.S. is concerning. The company has been facing persistent weakness in the overall carbonated soft drinks’ (CSD) volumes in North America since the past few months, which also remains a significant overhang.

Changing consumer preferences, increasing health consciousness and growing regulatory pressures are affecting beverage sales. We therefore prefer to avoid the stock for the next few quarters. The stock carries a Zacks Rank #4 (Sell).

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