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Industry Outlook

The operating backdrop for the consumer staples sector was more or less weak in 2013, as it was in 2012 due to a difficult consumer spending environment. Middle-class consumers have struggled to cope with rising gas prices, delayed income tax refunds and higher payroll taxes. In addition, difficult operating conditions in Europe and a slowdown in some Asian countries, like China, also weighed on the sector’s outlook. Consumer staple stocks have also underperformed the S&P 500 as a whole in the past one year.

Unlike discretionary items, demand for consumer staples remain relatively stable across the economic cycle. But consumer staple companies are witnessing sluggish growth in the developed markets, due to market saturation, which along with consumers’ stagnant disposable incomes and increased competitive activities have added to the companies’ woes.

Thus, many of the companies have been looking to the faster growing emerging markets. That’s a good strategy in the long run, but the near-term outlook for many of these markets remains uncertain. The ongoing emerging currency turmoil is particularly problematic, as a stronger dollar reduces the value of outside-U.S. sales and in turn limits growth.

This uncertain macro environment is a big reason why many companies in the sector have lowered guidance for 2014. With top-line growth hard to come by, many companies have been focused on cost controls, acquisitions and share buybacks.

Innovations

In a crowded and competitive space, consumer product companies need to regularly innovate and upgrade their brands to create differentiated value propositions for their customers and to remain successful.

For the consumer product giant Procter & Gamble (PG - Analyst Report), innovation has been a strong tradition and the company has introduced many new products in most of its categories. While global brewer Molson Coors Brewing Co (TAP - Analyst Report) plans to bring new variety in brands like Coors Light, Carling, Staropramen and Blue Moon to drive top line growth, cereal makers Kellogg Company (K) and General Mills Inc (GIS) plans to roll out more nutritious products in 2014. Consumer products giant Kimberly-Clark Corp's (KMB) innovation would include diaper and feminine care upgrades in Brazil, China and Russia. The company also has an innovative pipeline in North America that includes activity on Huggies diapers and baby wipes, the GoodNites youth pants, Depend briefs and Viva towels.

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

The companies are shifting focus to make healthier and nutritious products in view of increasing health consciousness and rising obesity concerns and growing regulatory pressures.

Beverage companies like Coca-Cola (KO) and PepsiCo (PEP - Analyst Report) are expanding their portfolio of non-carbonated drinks due to the increasing awareness about calorie intake and nutrition among consumers and declining demand for carbonated beverages. Though PepsiCo is not largely dependent on its underperforming and struggling carbonated beverages category, the company plans to introduce naturally sweetened, lower-calorie sodas like Pepsi Next to help revive sales in 2014. Beverage companies like Dr Pepper Snapple Group Inc. (DPS) and Coca-Cola are also working on the same lines to boost sales.

PepsiCo is increasing its focus on healthier snacks, lower calorie beverages and non-carbonated beverages, which include Gatorade and Aquafina. Its rival, Coca-Cola is also expanding its portfolio of non-carbonated drinks, which include Powerade sports drinks, Smartwater brand and Minute Maid fruit juices, whereas Coca-Cola’s bottler Coca-Cola Enterprises Inc. (CCE) is also slowly shifting its product mix from colas to energy drinks and other non-carbonated beverages.

Coffee giant Starbucks Corporation (SBUX - Analyst Report) is looking beyond its traditional coffee business and making an effort to bring more nutritional and healthy products to its menu. These include Evolution Fresh juices, Starbucks Refreshers energy drinks, wholesome Salad Bowls and Parfait Greek yogurt products.

Food and beverage companies are not the only ones trying to shift to healthier options. Tobacco companies are also adapting to the evolving needs of consumers and have resorted to less harmful alternatives like electronic cigarettes (e-cigarettes).

In the electronic cigarette industry, cigarette maker Lorillard Inc (LO) owned a leading position in the U.S. after it acquired e-cigarette brand blu e-Cigs in Apr 2012. Later with the acquisition of U.K.’s e-cigarette brand SKYCIG on Oct 3, the company strengthened its position in the wide electronic cigarette market. Nu Mark, the subsidiary of Altria Group Inc (MO) launched its e-cigarette brand -- MarkTen in Aug 2013, and now with the recent acquisition of e-vapor business of Green Smoke Inc, Altria has enhanced its competitive position in the market. Reynolds American Inc’s (RAI - Analyst Report) Vuse e-cigarette brand also offers potential for long-term commercial success. Philip Morris International Inc (PM - Analyst Report) has plans to foray into the e-cigarette business in late 2015.

Cost Reduction and Restructuring Initiatives

Most consumer staples companies are divesting low-margin brands, improving supply chains and implementing cost-reduction initiatives in order to boost profits. 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.

Coca-Cola started a four-year productivity and reinvestment program in Feb 2012, under which it 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. The program is expected to generate incremental annualized savings of $550 to $600 million through 2015.

PepsiCo recorded $2 billion as productivity savings through 2013 under its current productivity plan and intends to generate another $1 billion in 2014. The company also announced a new 5-year restructuring plan in its fourth quarter fiscal 2013 that will aims to generate annual productivity savings of $1 billion from 2015 to 2019. The savings are expected to come from improved efficiency through manufacturing automation and factory closures.

Through its cost savings program FORCE (Focused on Reducing Costs Everywhere), Kimberly-Clark generated cost savings of $310 million in 2013, and expects to continue the momentum going forward and targets delivering at least $300 million of cost savings in 2014. Kimberly-Clark’s pulp and tissue restructuring program is expected to increase operating profit by at least $100 million in 2014.

Coffee maker Green Mountain Coffee Roasters Inc (GMCR) is also taking several steps to optimize its efficiency and reduce operational costs. It aims to deliver annual productivity and cost savings benefits in the range of $70 million to $100 million by 2015.

Consumer giant Unilever NV (UN - Analyst Report), has also been divesting businesses to concentrate on its core businesses such as detergents, foods, toiletries, and specialty chemicals. On Jan 6, 2014, Unilever agreed to sell its Royal pasta brand to RFM Corporation, one of the biggest diversified food and beverage companies in the Philippines.

Earlier in Nov, it has sold its Wish-Bone salad dressing business to Pinnacle Foods Inc (PF - Snapshot Report). Besides, it has sold its Skippy peanut butter business in Jan 2013 to Austin, MN-based producer of branded food and meat, Hormel Foods Corp. (HRL), while in Aug 2012, ConAgra Foods Inc. (CAG) bought its Bertolli and P.F. Chang's frozen meals brands.

Expansion in Emerging Markets

Besides costs saving initiatives, many consumer staples companies are shifting their focus to emerging markets to boost sales. Relative to the mature North American and European markets, emerging markets such as Brazil, India, China, Mexico, Russia and Southeast Asia are still untapped. Moreover, consumer spending in these markets is also increasing. 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, increased exposure to emerging markets also brings along currency headwinds, which adversely impacted several consumer staples companies like Procter & Gamble, Unilever and Kimberly-Clark in the recently reported quarter. Though these companies expect currency headwinds to persist in 2014, they still forecast strong sales gains in the emerging markets.

PepsiCo has been performing well in the high-growth developing and emerging markets and about 35% of the total net revenue comes from these markets. Going forward, the company expects emerging markets revenues to increase in high single to low double-digits and also expects two-third of its revenues to come from the emerging markets. Tobacco company Philip Morris also has a significant presence in a large number of markets. Asia remains a growth engine for the company as it enjoys robust growth in Indonesia, Pakistan, China, Philippines and Korea.

Acquisitions and Strategic Partnerships

Many consumer staple companies are also carrying out acquisitions both domestically and internationally to expand their existing customer base and product lines into new markets. On the other hand, many companies are forming partnership to take a lead in this challenging environment.

For example in Dec 2013, food distributor Sysco (SYY - Analyst Report) agreed to buy US Foods to create one of the largest food companies in the country and improve efficiency of both the companies. After the completion of the deal (expected in the third quarter of fiscal 2014), Sysco will receive annual synergies of at least $600 million per annum over the next three or four years. Apart from this acquisition, the company acquired other 14 companies during fiscal 2013, which represents annualized sales in excess of $1 billion.

Most recently, Green Mountain tied up with Coca-Cola Company on the development and introduction of Coca-Cola’s global brand portfolio for use in GMCR’s forthcoming Keurig Cold at-home beverage system. The deal will allow consumers to make the sodas and other drinks at home through GMCR’s Keurig Cold beverage system.

Also, Coca-Cola is taking a 10% stake in Green Mountain for about $1.25 billion. This partnership will help GMCR to expand its cold beverage lineup, and it will also allow Coca-Cola to get into this growing segment too. However, it could pose a serious competition to the at-home carbonated beverage company SodaStream International Ltd (SODA - Snapshot Report) in the near future.

Altria has partnered with Philip Morris whereby the two cigarettes have combined their marketing powers to ramp up the distribution of their unconventional cigarettes. Under the deal, Philip Morris will market Altria’s MarkTen e-cigarettes internationally and the latter will distribute two of Philip Morris’ heated tobacco products in the United States, as Philip Morris sells cigarettes outside U.S. Altria and Philip Morris have also decided to partner to work on gaining market share as well as improving existing versions for the products.

Zacks Industry Rank

Consumer Staples is one the 16 broad Zacks sectors within the Zacks Industry classification. We rank all the 260 plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries in the top 1/3rd of all Industry Ranks or a Zacks Industry Rank of #88 and lower is 'Positive,' the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is 'Neutral' and the bottom 1/3rd or Zacks Industry Rank of #177 and higher is 'Negative.'

The consumer staples sector is further sub-divided into the following industries at the expanded level (260 industry groups): Beverages – Alcohol, Beverages – Soft, Consumer Products – Miscellaneous Staples, Cosmetics & Toiletries, Food – Meat Products, Food – Miscellaneous/Diversified, Publishing – Newspapers, Soaps & Cleaning Preparations, Textile – Apparel and Tobacco.

The ‘Publishing – Newspapers’ is the best placed among them with its Zacks Industry Rank #7, placing it into the top 1/3rd of the 260+ industry groups. It is joined by 'Food – Meat Products and Textile – Apparel' with Zacks Industry Ranks of #55 and #78, respectively.

Only ‘Beverages – Soft’ lies in the middle 1/3rd with a Zacks Industry Rank #106. However, all the other sub-sectors –- Consumer Products – Miscellaneous Staples, Food – Miscellaneous/Diversified, Beverages – Alcohol, Soaps & Cleaning Preparations, Tobacco and Cosmetics & Toiletries -- are featured in the bottom one-third of all Zacks industries with respective Zacks Industry Ranks of #198, #214, #217, #217, #228 and #249.

Looking at the exact location of these industries, one could say that the general outlook for the consumer staples space as a whole is negative, as many of the companies do not expect macroeconomic environment to improve drastically in 2014.

Earnings Trends

The consumer staples sector depicts weak earnings trends, with lackluster top-line growth and continued negative guidance. The fourth quarter 2013 results for the sector have been average in terms of earnings beat ratios (percentage of companies coming out with positive surprises) and weak for revenue.

Of the 78.8% companies reported under the consumer staples industry, the earnings "beat ratio" was 69.2%, while the revenue "beat ratio" was only 30.8%. Total earnings for this sector increased 2.4% until now, compared with a growth of 2.3% registered in the third quarter.

Total revenue increased 1.7% in the quarter, better than the growth of 0.2% in the previous quarter. Though revenues have improved marginally, but the companies are expecting difficult consumer spending environment to persist in 2014, which has also reflected in companies’ weak guidance.

The consensus earnings expectations for 2014 are projected to grow 5.8%, lower than 9.3% growth expected earlier. Revenues are expected to decline 6.0% in 2014, as against 4.1% growth in revenues expected earlier.

The consumer staples sector is expected to account for only 6.5% share of the S&P 500 index earnings in 2013, while it accounts for 7.2% of the total market capitalization.

For more details about earnings for this sector and others, please read our ‘Earnings Trends’ report.

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. Beverage company Constellation Brands Inc. (STZ - Analyst Report), holding a Zacks Rank #1 (Strong Buy) has a solid brand portfolio enhanced by regular acquisitions, impressive wine volume growth and effective cost management. Tyson Foods Inc. (TSN - Analyst Report) enjoys strong demand for its products, and benefits from operational improvements and positive pricing and thus holds a Zacks Rank #1 (Strong Buy).

Companies like Starbucks Corporation and The Hershey Co. (HSYTM) have solid growth potential. While Starbucks boasts solid organic growth, innovation program and productivity gains, Hershey, with a Zacks Rank #2 (Buy) have solid innovation programs and international presence which helps them to maintain top line growth despite macroeconomic headwinds faced by the developed nations. Despite holding a Zacks Rank #3 (Hold), Starbucks raised its earnings expectations for 2014 on the back of first quarter earnings beat.

WEAKNESSES

There were some companies which were hit hard by the challenging macro-economic environment, owing to lower consumer spending. The persistently sluggish European economic conditions also remain an overhang.

Zacks Rank #3 companies like Procter & Gamble, Mondelez International Inc (MDLZ) and Kellogg are facing the brunt of sluggish sales, currency headwinds, lower pricing and poor volumes. Beverage company Molson Coors, holding a Zacks Rank #4 (Strong Sell) is also a victim of weak consumer demand across many regions and declining sales volume.

Though these companies are fundamentally strong and regularly innovates products, invest in the emerging markets, adopts measures like cost savings and restructuring to revive sales, we are uncertain about the economic environment in 2014, due to our budget-constrained consumers. However, we do believe that the scenario will improve soon.

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