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Industry Outlook

Stocks in the Consumer Staples sector have carried out their traditional defensive role despite concerns about the prolonged weak US economy and the debt crisis in Europe. Year to date (through June 22, 2012), shares of consumer staples companies, accounting for about 9% of the S&P 500 Index by market capitalization, were up 4.5%, compared with a 6.2% gain for the S&P 500. In 2011, the sector index grew 10.5% versus flat growth for the S&P 500 index.

The group’s defensive attributes stem from its ability to resist sluggish economic growth, as food, beverage, household products and cosmetics companies that manufacture and market non-durable consumables such as food, drink, toothpaste, deodorants, toilet paper, etc., are  essential parts of daily life.

Top-Lines Growing, Volumes Declining

Most of the consumer companies are enjoying an upside in their top lines, driven mainly by pricing gains, though volumes are still suffering. Volumes are suffering mainly due to constrained consumer spending, especially in the developed nations of North America and Europe. However, there are some exceptions like Kraft Foods Inc. ([url=http://www.zacks.com/stock/quote/kft]KFT[/url]) and H.J. Heinz Company ([url=http://www.zacks.com/stock/quote/hnz]HNZ[/url]), which have reported volume increases in Europe despite the severe economic challenges.

Moreover, significant price increases of products are also hurting volumes. However, companies like Kraft Foods, Starbucks Corporation ([url=http://www.zacks.com/stock/quote/sbux]SBUX[/url]) and The Hershey Company ([url=http://www.zacks.com/stock/quote/hsy]HSY[/url]) have successfully raised prices while maintaining positive volume growth.

Input Cost Inflation Hurting Margins

Continuously rising commodity and other input costs are pulling down the margins for most of these companies, despite top-line growth. Thus, these companies are resorting to price increases and cost-cutting measures to negate the inflated input costs.

Therefore, to survive in an environment where input costs are trending higher, many companies in the consumer staples sector have "right-sized" portions and packages of their products to pass the burden of higher prices to consumers. For example:  Heinz has introduced economical pouches, doy packs for most of its popular ketchup and sauces making it an affordable option for smaller households.

However, the companies are optimistic that commodity cost inflation will slowdown in the second half of 2012.

Cost Reduction Initiatives

In an effort to boost long-term growth and reduce the effects of inflating commodity costs, most consumer staples companies have undertaken several strategic initiatives like divesture of low-margin brands, improvement of supply chain and implementation of cost-reduction initiatives.

The Coca-Cola Company ([url=http://www.zacks.com/stock/quote/ko]KO[/url]) is undertaking various productivity initiatives to streamline its cost structure and boost profitability. In February 2012, it launched a four-year productivity and reinvestment program, which includes initiatives like optimization of global supply chain; improving effectiveness of global marketing and innovation; operating expense leverage; standardization of information systems and integration of Coca Cola Enterprises’ North America business that was acquired in 2010. The program is expected to generate incremental annualized savings of $550 to $600 million phased over a four-year period starting in 2012 through the end of 2015.

PepsiCo Inc.’s ([url=http://www.zacks.com/stock/quote/pep]PEP[/url]) restructuring program is expected to result in more than $1 billion in productivity in 2012 and a total of $3 billion over the next three years. 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. The program is expected to lower the company’s cost structure, thereby freeing up resources to invest in innovation and brand building.

Altria Group Inc. ([url=http://www.zacks.com/stock/quote/mo]MO[/url]) completed the cost reduction plan for the period of 2007 to 2011 very recently. It further initiated a new $1 billion cost reduction program in the third quarter of 2011, which 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 February 2012 as a part of its restructuring program to reduce cost.

Another tobacco seller, Reynolds American Inc. ([url=http://www.zacks.com/stock/quote/rai]RAI[/url]), recently completed its business analysis and in the process has identified resources to reinvest in the businesses to sustain their growth momentum. The business analysis was focused on the ways to reduce cost, and the company has decided that by eliminating surplus labor the company will be able to generate savings of about $25 million associated with the workforce restructuring by year-end 2012. Those savings will increase to about $70 million annually in 2015.

The world’s largest saucemaker, Heinz, invested in productivity initiatives in the just-completed fiscal year by increasing manufacturing efficiency, reducing overcapacity and streamlining its operations. In addition, the company is also investing in Project Keystone, a multi-year program aimed at increasing Heinz’s competitiveness by adding capabilities, improving processes and systems through SAP.

Management believes the project, which is focused primarily in Europe, will optimize the company’s sales mix, increase manufacturing efficiencies and improve costs. Cost-saving endeavors like these would help counter the impact of rising commodity costs and prepare the foundation for long-term growth.

Expansion Beyond U.S. Markets

With the economic environment being sluggish in the developed nations, demand has remained relatively stable for companies that are more exposed to developing countries, especially the fast-growing emerging markets. Developed nations are witnessing volume declines due to market saturation, low disposable incomes of consumers and competitive activity. However, their developing counterparts such as China, Brazil, India, Mexico, Russia and Southeast Asia boast positive consumer spending growth.

These developing countries are receiving greater support in terms of infrastructure investment and marketing outlays. Demand for convenient and branded packaged food is growing, as middle-class consumers in these countries shift to urban living. Thus, the rising pool of middle class consumers in emerging markets represents a huge opportunity for branded consumer companies.

Beverage companies such as Coca-Cola and PepsiCo 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 India over the last 18 years 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 Thums Up, Sprite and Maaza. Over the next five years, Coca-Cola, along with its bottling partners, is poised to make a further investment of $2 billion to build consumer marketing, infrastructure and brands in India.

The company also has plans to invest $4 billion in China over three years starting in 2012, thus raising Coca-Cola's total investment in China between 2009 and 2014 to $7 billion. Coca-Cola also plans to invest $3 billion in Russia between 2012 and 2016 and $8 billion in Brazil through 2016.

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 September 2011, Pepsi took control over 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.

Kraft Foods acquired Britain-based chocolates and confectionary company Cadbury in 2010. The acquisition opened new sales channels for the company through its vast distribution networks in developing markets such as India, Brazil and Mexico. Kraft’s brands like Oreo cookies and Tang powdered drink mix have also created its own space in India. Kraft’s developing market segment was the strongest performing segment for the company in 2011 and is expected to be the key growth driver in 2012.

Heinz 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 estimates that almost a quarter of the ketchup and sauces business is now in the emerging markets led by ABC, Master and Heinz Ketchup.

Coffee giant Starbucks Corporation’s business in China is rapidly growing, and the region is expected to become the company’s second-largest market by 2014. Starbucks is also looking to enter the Vietnam market in September and the lucrative Indian market with a store expected to be opened by the end of calendar 2012.

However, the companies find it difficult to maintain a favorable volume-price mix in the emerging markets where they cannot raise prices given the low standard of living compared to the developed countries.

Innovations

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

Pepsi’s low calorie cola, Pepsi Next, launched recently and is off to a good start. 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. Contribution from the new products to the total revenue is expected to double globally in 2012. Pepsi will increase its advertising and marketing spending from 5.2% to 5.7% of revenues in 2012. The brand investments are expected to boost revenue growth and also enable increased price realization in the long run.

In the last quarter, Coca-Cola also introduced a wide variety of brands like Coke-Zero in Uganda and Fanta Powder in India; and beverage products like Frugos Sabores Caseros juice in Latin America and Real Leaf green tea-based drink in Vietnam.

Starbucks has also been active to meet the needs of the increasingly health conscious Americans. In March 2012, Starbucks opened its first Evolution Fresh juice store in Bellevue, Washington, and also launched a new energy drink, Starbucks Refreshers, made from real fruit juice and green coffee extract, in select grocery stores.

In the same month, the company announced plans to launch the Verismo system by fall of 2012. Verismo is a premium machine which will allow customers to prepare Starbucks-quality espresso and coffee drinks at home. This machine is expected to help Starbucks capture a significant share of the fast growing premium single serve market. In January 2012, the company launched Blonde Roast coffee in US and Canada for consumers who prefer a light roasted coffee.

Coffee giant J.M. Smucker Company ([url=http://www.zacks.com/stock/quote/sjm]SJM[/url]) recently announced plans to branch out into specialty nut butters. It also plans to launch chocolate and mocha cappuccino varieties of Jif hazelnut spreads in early fiscal 2013.

The tobacco sector has also been active in upgrading their products. In the last quarter, Reynolds launched new mint flavors for the Camel brand of smokeless tobacco like Camel SNUS to adapt to changing tobacco usage patterns, offering adult tobacco consumers with innovative, smoke-free tobacco products. Its subsidiary American Snuff launched natural premium-style cigarettes under its flagship brand.

OPPORTUNITIES

We do not have an Outperform recommendation on any consumer staples companies. However, companies like Hershey, Starbucks, Coca Cola and Walmart Stores ([url=http://www.zacks.com/stock/quote/wmt]WMT[/url]) are showing impressive improvement despite industry headwinds.

The Hershey Company reported impressive first quarter with solid sales and profit growth. The company also upped its guidance for fiscal 2012. Moreover, the company’s strong brand positioning, strategic marketing investments in core brands, disciplined innovation, and consumer capabilities make it attractive. However, higher ingredient costs and lack of significant presence outside U.S. keep us on the sidelines. The stock carries a Zacks #3 Rank (short-term Hold rating).

Starbucks Corporation also delivered better-than-expected second quarter of fiscal 2012 earnings and raised its fiscal 2012 outlook backed by improving business trends and strong first half results. Overall, we are encouraged by Starbucks’ strong market standing, new product launches, rapid growth in China and the flourishing Channel Distribution segment as well as solid turnaround in its U.S. business. The stock also carries a Zacks #3 Rank.

Coca-Cola’s delivered solid revenue and volume growth in the first quarter of 2012, which made up for margin declines. We are encouraged by the company’s global reach, strong brand power, expanding presence outside the U.S. and its solid cash position. Moreover, the company’s acquisition of Coca-Cola Enterprises’ bottling business and its productivity initiatives are expected to result in significant cost savings.

Share buybacks continue to be significant and the company aims to buyback substantial amount of shares in 2012. The company has also increased its dividend rate for 50 consecutive years. The stock carries a Zacks #3 Rank.

Walmart Stores’ first quarter 2013 earnings beat both the Zacks Consensus Estimate and the prior-year earnings. The first quarter 2013 results also surpassed the company's guidance on the back of top-line growth. Improved traffic and product offerings resulted in strong comp sales during the quarter.

Moreover, Walmart is the sixth-largest Internet retailer. The company is focusing to expand its presence in online business, which is already strong in the US, UK, Canada and Brazil. The stock carries a Zacks #2 Rank (short-term Buy rating).

WEAKNESSES

We advise investors to avoid names that have reported earnings declines in the latest quarter. These consumer goods companies also show signs of slackening profitability.

Kellogg Company’s ([url=http://www.zacks.com/stock/quote/k]K[/url]) first quarter 2012 earnings missed the Zacks Consensus Estimate and the prior-year quarter earnings due to decline in top line, high commodity costs and investments in supply-chain initiatives. Revenues declined due to the sluggish European business and weakness in the U.S. cereal category. The company slashed its 2012 financial outlook following the weak start to the year. The stock carries a Zacks #3 Rank.

The consumer goods giant Procter & Gamble Company ([url=http://www.zacks.com/stock/quote/pg]PG[/url]) also reported dismal third quarter fiscal 2012 results. The adjusted earnings were flat with prior-year levels as benefits from top-line growth and cost savings were offset by rising commodity costs. Moreover, the company cut its earnings outlook for fiscal 2012 due to Venezuela price regulations, rising input costs and economic uncertainty in Western Europe and U.S. The stock carries a Zacks #5 Rank (short-term Strong Sell rating).

Smithfield Foods Inc.’s ([url=http://www.zacks.com/stock/quote/sfd]SFD[/url]) operating margins also suffered on the back of increased prices in the hog market. Though the management has undertaken cost saving initiatives, the rising prices of raw materials are offsetting the benefits from these initiatives in the near term. Feed grains, including corn, soybean meal and wheat prices, which are the company’s primary raw materials, have fluctuated and escalated in recent years due to increased worldwide demand.

We expect the rising costs of raw materials to pull down the company’s margins significantly in the future. Moreover, widespread anti-obesity campaigns in U.S. have resulted in a general shift of consumer’s preference away from meat products. The stock carries a Zacks #3 Rank (short-term Hold rating).

Iconix Brand Group ([url=http://www.zacks.com/stock/quote/icon]ICON[/url]) continued to witness weak demand for men’s apparels. This compelled the company to chop its revenue and earnings guidance for fiscal 2012. The company projects lower revenue from these brands in 2012 versus 2011 levels. The transfer of the Royal Velvet brand to J.C. Penney ([url=http://www.zacks.com/stock/quote/jcp]JCP[/url]) is also expected to negatively impact fiscal 2012 revenues. The stock carries a Zacks #3 Rank (short-term Hold rating).

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