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Industry Outlook

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Consumer Staples companies 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 enduring demand for these products irrespective of the economic cycle gives the sector a defensive posture.

Consumer staples stocks have outperformed the S&P 500 as a whole in the year-to-date period, generating gains of 16.8% in the year-to-date period compared with gains of 14.9% for S&P 500.

Though consumer staple companies, due to their defensive nature, are much less exposed to changes in income, they are still impacted when consumer confidence drops or income growth declines. In that case, consumers tend to buy staples but will prefer cheaper brands, which will hurt the profitability of the sector.

Innovations

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

A consumer product giant Procter & Gamble Co (PG - Analyst Report) has a strong tradition of not only introducing blockbuster products but also of creating new categories. The company has consistently increased market share in fast growing businesses over the years through innovation and new product launches. Through its game-changing new products like Daz automatic detergent and concentrated liquid detergent, P&G was able to capture a strong market share in U.K. in the laundry category in 2011.

Similarly, Head & Shoulders has transformed itself from merely being a North American brand to the largest shampoo brand in the world due to the company’s marketing efforts and product innovation. In 2012, P&G invested around $2 billion in innovation. It intends to expand its innovation and marketing strategies to more categories, geographies and channels, thus boosting top- and bottom-line growth.

Chocolate maker The Hershey Co. (HSY) regularly innovates in its core brands to meet consumer needs that are not addressed by its current portfolio. Some successful product innovations in recent years include Reese's Minis, Hershey's Drops and Rolo minis. Some new products lined up for 2013 include Kit Kat Minis (Jun 2013), Twizzlers Bites, Jolly Ranchers Bites, Kisses Deluxe, Hershey's Mais and many more. The company also has products planned for some international markets like China, Mexico and Brazil in 2013.

Beverage company PepsiCo Inc (PEP - Analyst Report) regularly creates new flavors of existing products alongside maintaining a robust pipeline of new products. The company also invests aggressively in new packaging to shift consumers to more profitable purchases. PepsiCo’s popular 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 products are expected to boost revenue growth and also enable increased price realization in the long run.

Global brewer Molson Coors Brewing Co (TAP - Analyst Report) introduced several beer brands in 2012 to ensure variety. New brands like Rickard's Cardigan and Oakhouse in the above-premium portfolio were launched in Canada. New varieties of beer brand Leinenkugel were rolled out in the U.S. under the Lemon Berry Shandy and Batch 19 brands.

Most recently, the company launched a non-beer drink, Molson Canadian Cider, made from apples. Cider will form a part of the popular Canadian beer brand Molson Canadian. Molson Coors has plans to roll out beer brands like Apple Ale and Third Shift brands under Redd's beer brand in 2013 in the U.S. These brands are strengthening the company’s portfolio and also adding to its market share.

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

Other than enhancing its products, the companies are also focusing on shifting consumer preferences, increasing health consciousness and rising obesity concerns. The companies are now inclined toward making healthier and nutritious products.

Beverage companies like The Coca-Cola Co (KO - Analyst Report) and PepsiCo 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 its carbonated beverages, the changing consumer preference toward health and wellness products pushes them to introduce a variety of non-carbonated beverages.

While Coca-Cola commands a leading position in the juices or still beverages category with its flagship brands such as Minute Maid, Simply and POWERade, PepsiCo is also increasing its focus on low calorie beverages, non-carbonated beverages and healthier snacks. The company’s low calorie cola, Pepsi Next and its 24-ounce can for regular and diet Dew have been well received.

The company also formed a joint venture with Theo Muller Group to open a new yogurt production facility to produce different varieties of yogurt, which is one of the fastest growing categories in the U.S. There is a huge demand for nutritious products and yogurts being rich in protein, calcium and vitamin D will prove to be a healthy snack. Further, the company’s nutrition brands like Quaker, Tropicana and Gatorade are expected to reap benefits from shifting consumer preference toward health and wellness products.

Tobacco companies are also adapting to the evolving needs of consumers and have developed less harmful tobacco products. Increasing health consciousness among youth has reduced the demand for tobacco over time, thus forcing the companies to look for other alternatives like e-cigarettes. E-cigarettes are very popular among youngsters as they have the same simulating effect as cigarettes but are less harmful.

Altria Group Inc (MO - Analyst Report) has developed innovative, less harmful and non-combustible nicotine- products for adult tobacco consumers in collaboration with Okono A/S. This is expected to help the company gain market share in the industry. Moreover, existing smokeless tobacco brands like Copenhagen and Skoal are also gaining retail share, having grown from 47.5% in 2008 to 50.6% in 2012.

In addition, in Jun 2012, Altria's subsidiary Nu Mark introduced Verve Discs, a mint-flavored, chewable tobacco product that contains tobacco-derived nicotine, which has been widely accepted by consumers as a substitute to harmful tobacco derivatives. Nu Mark also plans to launch its first e-cigarette brand MarkTen in Aug 2013.

Another cigarette maker Lorillard Inc (LO - Analyst Report) acquired the e-cigarette brand blu e-Cigs in Apr 2012. blu e-Cigs look like traditional cigarettes but do not produce smoke, ash or smell. The company’s sales significantly increased post-acquisition and we believe the rising popularity of e-cigarettes will boost blu e-Cigs popularity in the upcoming quarters amid overall slowdown in the cigarette industry.

Another tobacco seller, Reynolds American Inc (RAI - Analyst Report) also remains committed to stimulating demand through new and innovative products in the smokeless category, owing to growing health concerns. New mint flavors for the Camel brand of smokeless tobacco like Camel SNUS are intended to meet changing demand.

Moreover, American Snuff’s Grizzly natural premium style cigarettes introduced in 2012 occupy a major portion of America’s smokeless tobacco market. Reynolds American’s Zonnic nicotine replacement therapy gum and the Vuse e-cigarette brand offer potential for long-term commercial success.

Cost Reduction and Restructuring Initiatives

In order to boost profits and top-line growth, 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 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 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 a four-year period ending 2015.

PepsiCo also announced a restructuring program in Feb 2012. It is expected to result in productivity savings of $900 million in 2013, which will go up to $3 billion through 2015. The program will include leveraging new technologies and processes across operations, consolidating facilities, simplifying organization structures, lowering layers of management and workforce.

Consumer products giant, Kimberly-Clark Corp (KMB - Analyst Report) is streamlining its manufacturing facilities in Europe. As a part of this initiative, the company dissolved the diaper segment in Western and Central Europe, except the Italian market. This reduced the European workforce by approximately 1,300 to 1,500 positions. The company has stopped selling Huggies diapers in 13 countries so far and expects to exit the remaining five markets by the end of Jun 2013.

Its cost savings program FORCE (Focused on Reducing Costs Everywhere) is expected to generate cost savings of $250–$300 million in 2013 and benefit the company through the continued rollout of lean manufacturing and supply chain practices and the formation of a global procurement organization.

Kimberly-Clark’s pulp and tissue restructuring program helped improve underlying profitability and return on invested capital of its consumer tissue and K-C Professional businesses. Kimberly-Clark anticipates operating profit to increase by at least $75 million in 2013 and at least $100 million in 2014 through the restructuring plan.

The J. M. Smucker Co. (SJM - Analyst Report) has also been involved in restructuring its coffee, fruit spreads and Canadian pickle and condiments operations since 2010. The initiative involves capital investments in a food manufacturing facility in Ohio; consolidation of coffee production in Louisiana; and transfer of the company’s pickle and condiments production to third-party manufacturers.

These initiatives will lead to workforce reduction, closure of six facilities and reduction in the overall cost structure in 2013. In Feb 2013, Smucker announced a capacity expansion initiative, scheduled to be completed in 2014, to support the company’s growing peanut and other nut butter businesses.

Global brewer Molson Coors began a number of new initiatives in the third quarter of 2012 for the next two years. The initiatives involved combining its UK and Ireland businesses with its newly-acquired StarBev breweries (later named as Molson Coors Central Europe) to create a single unit called Molson Coors Europe.

Other than this, the company liquidated its under-performing China joint venture, restructured its Coors Light beer business in the rest of China, improved performance in Japan, and integrated the Central Europe license and export business. These initiatives are expected to improve the efficiency of the organization and generate additional resources to invest in brands and innovation.

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.

Though companies like Coca-Cola and PepsiCo are witnessing improving volume trends in North America, driven by increased marketing and advertising spending, we believe that the North American markets are relatively mature compared to their untapped counterparts such as Brazil, India, China, Mexico, Russia and Southeast Asia, which exhibit consumer spending growth.

Moreover, we have seen that the 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, the increasing presence in the emerging markets also brings along the negative impact from currencies for many consumer staples companies. A stronger dollar reduces the value of outside-U.S. sales and in turn limits growth in the emerging markets. However, with improving standard 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. Bottling consolidation in Mexico and the strategic partnership with leading Chinese food and beverage maker Tingyi have strengthened PepsiCo’s business in those countries.

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. 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.

Tobacco company Philip Morris International Inc (PM - Analyst Report) also commands a footprint in a large number of markets. Asia remains a growth engine for the company. It witnessed robust growth in Indonesia, China, Philippines and Korea.

Further, through strategic acquisitions like Sampoerna in Indonesia and Larkson in Pakistan in 2012, the company has gained a strong foothold in the non OECD (Organisation for Economic Co-operation and Development) markets. In addition, Philip Morris’ acquisition (which is expected to close by Sep 2013) of 100% interest in its Mexican subsidiary will boost its presence in Mexico.

Cereal maker General Mills, Inc (GIS) also focuses on expansion in China, Brazil, India and Russia where consumer spending is on the rise. The company is especially focusing on China, which has one of the largest numbers of consumers given its growing number of middle-class and affluent households.

The company plans to achieve $600 million in sales from its wholly-owned businesses in China in fiscal 2013 and $900 million by 2015. In Brazil, the company’s growth prospects have improved largely following the acquisition of Yoki. In India, though the company’s business is small, it is growing quickly. Sales in India are expected to exceed $70 million in fiscal 2013.

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 positive earnings momentum of consumer staples stocks, which resulted in a Zacks Rank #2 (Buy) for Kraft Foods Group Inc (KRFT - Analyst Report), PepsiCo and Lorillard, reflects the improved business backdrop.

Food maker Kraft Foods Group has outperformed the Zacks Consensus Estimate since it was spun off from Kraft Foods, Inc into an independent company last year in Oct 2012. In first quarter 2013, Kraft Foods beat the Zacks Consensus Estimate for both revenues and earnings on the back of solid innovation and stepped up advertising spending for its biggest brands.

The company also reaffirmed its full year 2013 outlook. We are encouraged by Kraft’s aggressive cost reduction and efficiency-improvement initiatives, which will provide more cash for innovation, brand building and marketing initiatives. Kraft also aims to maximize cash flow, which will be used to pay robust dividends.

PepsiCo has delivered positive surprises in the last four quarters on the back of improved performance of its snacks business and encouraging growth in the international markets. The company’s strong brand portfolio, its product and geographic diversity, productivity gains, solid organic revenue growth and strong margins also contributed to growth. Year 2012 was a turning point for PepsiCo with increased investments in brand building, market execution and innovation and improved productivity expected to set the foundation for further growth and competitive advantage.

PepsiCo is positive for 2013 too. The company expects to achieve its top-line target through its strong portfolio of beverages, snacks and healthy & wellness brands. Moreover, the company noticed that many international markets are relatively untapped by other companies, especially for products like salty snacks. Hence, PepsiCo enjoys a competitive advantage over other players.

We are also impressed with cigarette manufacturer Lorillard, which has a dominant share in the tobacco market owing to the popularity of its premium brand Newport and value brand Maverick. Newport continues to gain popularity despite higher pricing and amid overall slowdown in the cigarette industry. Moreover, it is adapting to changing consumer demands by investing in less-hazardous alternatives for tobacco with the acquisition of blu eCigs and developing electronic cigarettes. The rising demand for electronic cigarettes is expected to boost blu e-Cigs sales, going ahead.

There are some other attractive stocks which are worth considering though they carry a Zacks Rank #3 (Hold). They are Kellogg Co (K), Tyson Foods Inc (TSN - Analyst Report), Hershey and Smucker.

Smucker’s performance remained strong in all the four quarters of fiscal 2013 (ending April), driven by a 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.

Stabilizing coffee costs also improved margins at Smucker's. The company has increased its fiscal 2013 earnings guidance twice, reflecting the company’s potential to drive profits in the coming quarters.

Kellogg has strong earnings potential as it delivered solid growth in earnings in all the four quarters of 2012, driven by robust organic sales growth performance. Though Kellogg’s performance was weak in the first quarter of 2013 due to decline in the snacks category, higher costs and headwinds from the Venezuela currency devaluation, the company remains positive for 2013 and has re-affirmed its 2013 guidance.

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.

Even with a Zacks Rank #3 (Hold), chocolate maker 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 four out of the last five quarters. The company has raised its guidance thrice in 2012, highlighting its attractive earnings potential.

Meat products processor Tyson Foods has been delivering strong earnings in the past several quarters. Though the first-quarter fiscal 2013 (ending Sept) results were sluggish, we remain encouraged with the company’s strong product portfolio and its presence in the international markets, particularly in China, Mexico and India. Tyson is also focusing on strengthening its presence in Mexican cuisine, as Mexican food is becoming increasingly popular in the U.S. processed food industry.

To enhance its portfolio with Mexican cuisine brands, Tyson acquired the assets of Circle Foods in early-June, which owns popular brands like Nuevo Grille and Tortillaland handheld Mexican products, Tortillaland uncooked tortillas and ROTILAND Indian flat breads. Tyson’s focus on Mexican food is also evident from its strategic acquisition of the Mexican snacks and tortilla producer, Don Julio Foods of Clearfield, Utah in Apr 2013. Tyson also has acquisitions and new product launches in the pipeline for 2013.

WEAKNESSES

The macro-economic environment in the U.S. has remained challenging and uncertain for quite some time. U.S. consumers are burdened with higher gasoline prices, payroll tax increases and a labor market that is improving at a glacial pace. These external forces might restrict consumer discretionary spending in addition to slow job growth, high interest rates and tightened credit availability. The persistently sluggish European economic conditions also create an overhang. We expect these global economic pressures to continue in 2013.

While the acquisition of StarBev Breweries in Jun 2012 opened doors of opportunities for Molson Coors in the attractive beer market in Central Europe, the unfavorable economic conditions in Europe are expected to offset the gains from this acquisition. Moreover, the acquisition has increased the debt burden of the company.

In addition, 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. Lack of brand marketing and unfavorable weather conditions are also hurting volumes. Though Molson Coors has been spending on marketing and advertising for its Miller Lite and the Molson beer brands, it has not led to consistent growth in volumes.

The increasing raw material costs of the company and the currency headwinds are also denting top-line growth. 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).

The consumer products giant Procter & Gamble had a tough fiscal 2012 (ending June) as it performed below its own expectations due to an uncertain economic environment, currency headwinds and rising input costs. The company implemented some meaningful changes to re-accelerate top and bottom-line growth to keep pace with its peers.

These initiatives also improved its performance in the first two quarters of fiscal 2013. However, the effect was short lived as the company posted mixed third-quarter results in late April. Though earnings exceeded management’s expectations on strong cost savings, organic revenue growth was quite weak and below expectation.

Its fourth-quarter outlook was also quite subdued with earnings expected to decline from the year-ago results. P&G is also facing rapid and significant increases in commodity costs, which are hurting margins despite revenue growth. P&G holds a Zacks Rank #3.

Beverage company Dr Pepper Snapple Group (DPS) has been suffering due to weak volume growth, higher cost pressure and macro-economic headwinds in the U.S. The company has had a dismal 2012 and also posted weak sales in the first quarter of 2013.

The company has been facing persistent weakness in 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. The stock carries a Zacks Rank #3 (Hold).

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