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Industry Outlook

Stocks in the Consumer Staples sector have carried out their defensive role despite concerns about the prolonged weak U.S. economy, the debt crisis in Europe and the slowdown in Chinese economy. The companies under the 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. Year to date (through September 21, 2012), shares of consumer staples companies, accounting for about 11.1% of the S&P 500 Index by market capitalization, were up 10.9%, compared with a 16.1% gain for the S&P 500.

In 2011, the sector index grew 10.5% versus flattish growth for the S&P 500 index. It should surprise no one that the group will get back into the limelight should market conditions grow challenging in the coming days.

Expansion in Emerging Markets

The macro-economic environment in the U.S. has remained challenging and uncertain for quite some time now. Therefore, many consumer companies are expanding focus to emerging markets as developed markets are witnessing volume declines due to market saturation, low disposable income of consumers and competitive activity.

However, their developing counterparts such as Brazil, India, Mexico, Russia and Southeast Asia boast positive consumer spending growth. Moreover, we have seen that product demand has remained relatively stable for companies that are more exposed to fast-growing emerging markets in comparison to the slow-growing developed markets like the U.S.

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.

Beverage companies such as The Coca-Cola Company ([url=http://www.zacks.com/stock/quote/ko]KO[/url]) and PepsiCo, Inc. ([url=http://www.zacks.com/stock/quote/pep]PEP[/url]) have invested heavily in the emerging markets of India, Russia and China.

Coca-Cola has already invested over $2 billion in India over the last 18 years and has seen a double-digit growth rate in India aided by its top-brands, which includes Thumbs 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, $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, PepsiCo 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.

H.J. Heinz Company ([url=http://www.zacks.com/stock/quote/hnz]HNZ[/url]) 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.

Coffee giant Starbucks Corporation ([url=http://www.zacks.com/stock/quote/sbux]SBUX[/url]) has expanded in China, and the region is expected to become the company’s second-largest market by 2014. Starbucks is also looking to enter the lucrative Indian market with a store to be opened by the end of October 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. In addition, companies have seen lower growth in emerging markets in the past quarter than prior quarters. Emerging market growth 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. Moreover, the slowdown in Chinese economy will significantly impact the investments.

Input Cost Inflation

Continuously rising commodity and other input costs remain a drag on margins of most of the companies in this sector, despite top-line growth. Thus, these companies are resorting to price increases and cost-cutting measures to negate the inflated input costs. However, the companies are optimistic that commodity cost inflation will slowdown in the second half of 2012.

Cost Reduction Initiatives

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

Coca-Cola 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 North American bottling and distribution operations acquired from Coca-Cola Enterprises Inc. ([url=http://www.zacks.com/stock/quote/cce]CCE[/url]). 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.

Tobacco company Altria Group Inc.’s ([url=http://www.zacks.com/stock/quote/mo]MO[/url]) cost reduction program of $1 billion, which started in October 2011, 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 its growth momentum. The business analysis focused on ways to reduce cost and the company has decided to eliminate surplus labor to generate savings of about $25 million associated with workforce restructuring by year-end 2012. Those savings will increase to about $70 million annually in 2015.

The manufacturer of health and hygiene products, Kimberly-Clark Corporation ([url=http://www.zacks.com/stock/quote/kmb]KMB[/url]) 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 and about $265 million in 2011. Kimberly-Clark expects $150–$200 million of cost savings in 2012.

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 necessarily 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, was launched in July 2012 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. The brand investments are expected to boost revenue growth and also enable increased price realization in the long run.

Coffee makers have also been introducing new products to excite customers. Most recently, Starbucks launched the premium single cup at-home coffee machine, Verismo that is now available at company stores and select high-end specialty retailers, mainly in the U.S. and Canada. This will allow customers to prepare Starbucks-quality espresso and coffee drinks at home and help Starbucks capture a significant share of the fast growing premium single serve market. In January 2012, the company launched Blonde Roast coffee in the U.S. and Canada for consumers who prefer a light roasted coffee.

Green Mountain Coffee Roasters, Inc. ([url=http://www.zacks.com/stock/quote/gmcr]GMCR[/url]) also has launched low-priced Keurig Vue coffee brewer models like Keurig Vue V600 and Vue V700, an addition to the Keurig Vue Brewing System, in order to reach out to more consumers. The models include some of the most popular features such as auto on/off, strength, temperature control, energy saver mode and size selection.

J.M. Smucker Company ([url=http://www.zacks.com/stock/quote/sjm]SJM[/url]) has 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.

Another tobacco company Philip Morris International, Inc. ([url=http://www.zacks.com/stock/quote/pm]PM[/url]) has also strengthen its brand portfolio through innovation based on enhanced consumer understanding. Among the recent launches, Marlboro Black Menthol Edge 8 and Marlboro Menthol Edge 1 were introduced during the second quarter of 2012 in Japan.

Marlboro Ice Blast, 5 milligram and 1 milligram variants were launched during July, 2012, following successful market share gain by the 8 milligram variant during the second quarter. Similarly in Russia, Marlboro Clear Taste was launched during June 2012, and it received positive feedback from customers.

OPPORTUNITIES

We do not have an Outperform recommendation on any of the consumer staples companies. However, companies like Starbucks, Coca-Cola, Heinz, Hershey, Walmart and Molson Coors are showing impressive growth despite industry headwinds.

Coca-Cola ([url=http://www.zacks.com/stock/quote/ko]KO[/url]) has beaten estimates and delivered solid growth in all the quarters of 2012. 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 has also increased its dividend rate for 50 consecutive years. The stock carries a Zacks #3 Rank.

The Hershey Company ([url=http://www.zacks.com/stock/quote/hsy]HSY[/url]) raised its 2012 earnings guidance after a solid first-half performance. Earnings in the second quarter increased 17.9% year over year, driven by revenue growth and improved gross margins. Moreover, the company’s strong brand positioning, strategic marketing investments in core brands, disciplined innovation, and consumer capabilities make it attractive.

The company’s pricing and productivity benefits and improved efficiencies from the company’s supply-chain initiatives overshadowed the headwinds from rising input costs. The company pays a regular quarterly dividend that yields 2.7%, which makes this chocolate maker attractive to income seeking investors. Hershey’s has also raised its long-term targets following its continued earnings upside. The company aims to achieve $10 billion in net sales by 2017. The stock carries a Zacks #2 Rank (short-term Buy rating).

Wal-Mart Stores, Inc.’s ([url=http://www.zacks.com/stock/quote/wmt]WMT[/url]) second quarter 2013 earnings were impressive, driven by top-line and positive same store sales. Though currency headwinds and continued economic pressures remained a hurdle, the company upped its full year forecast versus its prior earnings forecast.

We are encouraged by the scale, product and geographic diversity of Walmart. Moreover, Walmart is the sixth-largest Internet retailer. The company is focusing on expanding its presence in the online business, which is already strong in the US, UK, Canada and Brazil. The stock carries a Zacks #2 Rank (short-term Buy rating).

Heinz’s first quarter 2013 results exceeded the prior-year earnings due to a lower-than-expected tax rate, organic sales growth and productivity improvements. Though reported revenues declined due to currency headwinds, organic revenues grew 4.8%. Overall, Heinz’s robust brand portfolio, continued strong growth in emerging markets, strong marketing investments and ongoing cost saving efforts will boost long-term growth. The stock carries a Zacks #3 Rank (short-term Hold rating).

Despite challenging market conditions, global brewer Molson Coors Brewing Company ([url=http://www.zacks.com/stock/quote/tap]TAP[/url]) posted impressive results in the last three quarters. The company’s acquisition of StarBev is highly encouraging as the addition of StarBev’s flagship brand Staropramen to the company’s portfolio will help it to expand in untapped markets. The stock carries a Zacks #3 Rank (short-term Hold rating).

WEAKNESSES

Some of the companies have been, however, suffering from continued input cost pressure and economic slowdown.

Kellogg Company’s ([url=http://www.zacks.com/stock/quote/k]K[/url]) second quarter 2012 earnings were significantly impacted by weak revenues in Europe and high commodity costs. The acquisition of Pringles benefited the top-line, but was largely offset by currency headwinds. Gross margin and operating margin also suffered due to commodity cost inflation, sluggish European results and investments in supply-chain initiatives. The stock carries a Zacks #3 Rank (short term Hold rating).

Smithfield Foods Inc.’s ([url=http://www.zacks.com/stock/quote/sfd]SFD[/url]) earnings lagged on the back of rising raw material costs and weak margins in the fresh pork business. Sales were hurt by softness in the hog production and international business. Operating margins have remained sluggish on the back of increased prices in the hog market.

Despite management’s cost saving initiatives, the rising prices of raw materials are offsetting the benefits from these initiatives in the near term. 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 the 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).

Coffee maker Green Mountain ([url=http://www.zacks.com/stock/quote/gmcr]GMCR[/url]) posted lower-than-expected sales and margin performance in fiscal third quarter 2012. Gross margin also contracted due to lower-than-expected production of K-Cup portion packs which led to under-utilization of current manufacturing base.

The company also lowered its earnings and sales guidance both for the fiscal 2012 and 2013. Though coffee prices are showing signs of stabilization, over dependence on Keurig brewers, increasing competition from Starbucks’ Verismo also concerns us. The stock carries a Zacks #3 Rank (short-term Hold rating).

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