Consumer Staples

The stock market has begun to discount a recovery from the global recession. Prior rallies after major declines of similar magnitude (such as after the recession in the mid-1970’s and the Great Depression in the 1930’s) were sharp and unrelenting.

It is expected that stocks in the Consumer Staples sector will underperform as cyclical stocks begin to discount the recovery out of the current global economic recession.

OPPORTUNITIES

Stocks in the Consumer Staples sector have traditionally performed better than the stock market, and especially cyclical companies, during market declines. The fundamental explanation is that food, beverage, household products and cosmetics companies manufacture and market brand name consumable products, most of which are considered essential to daily life, such as food, drink, toothpaste, deodorants, toilet paper, etc.

Since product demand is relatively stable, the companies should report earnings in line with expectations and, hence, the stocks have outperformed. Generally speaking, food companies generate earnings growth at a mid-to-high single-digit rate.

Beverage companies, however, are structurally able to grow faster at the high single-digit to low double-digit rate. But, cosmetics companies can grow earnings a percentage point or two above beverage companies.

At year-end of 2008, Consumer Staples sector has outperformed the market on a total return basis for five consecutive years; therefore, the positive performance disparity is long-in-the-tooth. In addition, the relative performance has seasonal attributes with almost all the relative gain coming in the fourth quarter as investors flee more cyclical investments, which tend to disappoint near the end of the year.

In 2009, it is highly probable that Consumer Staples will underperform as stocks begin to discount the recovery out of the current economic abyss. During the second quarter of 2009, Consumer Staples stocks were only up 11.7% versus the 15% gain for the S&P 500.

WEAKNESSES

The outlook for the tobacco industry is negative due to the impact of a 150%+ increase in the federal excise tax, the high probability of additional federal regulation, and the recent losses in product liability lawsuits. In February, President Obama signed the congressional SCHIP (State Children's Health Insurance Program) bill that included a $0.6166 per pack increase in the federal tobacco tax. Hence, the federal excise tax per pack of 20 cigarettes was increased from $0.39 to $1.01 per pack.

When federal excise taxes are increased, it is estimated that industry volume will decline by at least 8%, but the magnitude of the decline could be much greater, especially considering the backdrop of the weak economy. During the first quarter, industry cigarette volume declined 10.4% due to wholesale inventory reductions associated with the federal tax increase. A tobacco tax increase of this magnitude is unprecedented.

Additional regulation of tobacco products by the U.S. Federal Government is now expected. On June 8, 2009, the U.S. Senate again passed legislation, empowering the U.S. Food and Drug Administration (FDA) to regulate cigarettes and other tobacco products. Over the last several years, the House had not passed a similar bill, but in April, the House finally passed a comparable measure, indicating a more stringent regulatory framework for all domestic tobacco companies in the future.

The tobacco companies are losing product liability law suits. In late March 2006, the U.S. Supreme Court refused to hear an appeal in the Boeken case; therefore, Altria (MO - Analyst Report) paid the $50 million judgment, despite claiming the judgment was excessive. Altria also lost the Bullock case; however, a new trial is scheduled to revise the amount of initial punitive damages of $28 million.

Lastly, in March 2009, Altria lost the Williams case when the U.S Supreme Court dismissed the Altria’s appeal of a 1999 punitive damages award of $79.5 million. However, the company is delaying payment by disputing an Oregon state law that requires 60% of any punitive damages should be paid to the state.

As a result of these negative developments, the ratings on both domestic tobacco companies, Altria and Reynolds American (RAI - Analyst Report), are rated Sells.