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All Rosy for Consumer Staples Stocks? Not Really

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Even though the picture appears rosy for the U.S. economy, this favorable economic landscape can divert investors’ focus from the defensive consumer staples zone to other seemingly attractive spaces.

This is likely one of the explanations for the sector’s recent underperformance, a trend that can remain in place for quite some time. Stocks in the Zacks Consumer Staples sector are down -4% over the last 12 months, lagging the S&P 500 index’s +14.2% gain over the same time period.

Continued Fed tightening and higher interest rates also remain an issue for these stocks. This is so for two reasons. First, Consumer Staples stocks, like Utility stocks, are typically dividend payers which tend to struggle during periods of rising interest rates.

Second, Consumer Staples companies have global operations and remain vulnerable to strength in the exchange value of the U.S. dollar. The dollar has started gaining ground lately on account of the Fed and interest rate backdrop.

Also, possibility of a trade war with China continues to raise fears for companies whose business operations are likely to be hit by tariffs.

Other than this, the consumer staples space is grappling with rising input costs as well as intense competition, with the latter stemming from consumers’ changing preferences and Amazon’s AMZN ever-growing dominance. This, in turn has created significant pricing pressure, alongside compelling companies to undertake aggressive promotional activities. These factors pose major threats to margins, which have been plateaued for quite some time now.

That said, we believe that investors must take stock of the possible obstacles in the consumer staples sector before making any investment decision within it.

Input Cost Volatility, Escalated Freight Costs

Input costs play a major role in determining the performance of a company. An increase in input cost directly hits the company’s margins and profits. Moreover, any price increase to offset the same may drive consumers away. We note that many Consumer Staples companies are bearing the brunt of high input costs, which remains a concern for the future. Also, the food industry in general is battling a tough transportation landscape due to lower driver availability.

This, in turn, has raised freight costs for many players like Smucker’s (SJM - Free Report) , Pinnacle Foods PF, United Natural UNPI and Sysco SYS, among others. In fact, most of these companies expect higher freight costs to remain a threat to their margins.

Moving to higher commodity costs, consumer goods behemoth Colgate has been bearing the brunt of increased commodity and packaging costs, which have been hurting its gross margin. Input cost inflation also remains a cause of concern for players like Campbell Soup CPB, Dean Foods DF, Molson Coors (TAP - Free Report) , Pinnacle Foods, Church & Dwight CHD and Kimberly-Clark (KMB - Free Report) . In fact, Kimberly expects commodity costs to shoot up mainly due to higher prices for several raw materials, including pulp. As for Church & Dwight, it expects both higher commodity and transportation expenses to weigh on gross margin in 2018. Sysco and Pinnacle Foods are other examples that remain troubled by both these headwinds.

Intense Competition

Consumer staples companies face stiff competition with respect to innovation, pricing, brand strength, promotions and responsiveness to evolving consumer trends. This results in lower pricing power and a decline in market share, which in turn compresses margins and earnings. For example, Kimberly-Clark’s diaper segment faces significant competitive activity, which puts the company’s market share at risk.

Dean Foods also battles stiff competition, not only with various dairy processors for shelf space, but also with various beverages and nutritional products. Further, the beauty and beauty-related products industry is highly competitive, which remains a challenge for players like Avon Products AVP and Coty COTY. Results of alcohol giants like Constellation Brands (STZ - Free Report) and Brown-Forman BF.B may also be somewhat stifled in a cut-throat competitive environment.

Strained Margins

Many companies in the consumer staples sector have been plagued by strained margins, stemming from various factors. These include tough grocery market conditions, rising input costs, costs associated with meeting consumers’ changing demands and stiff competition that leads to aggressive promotions and price wars. From grocery chains like SUPERVALU SVU, food companies like Campbell Soup, cosmetic biggies like Estee Lauder to consumer products companies like Church & Dwight, Colgate CL, Newell Brands (NWL - Free Report) and Kimberly-Clark, all remain troubled by squeezed margins.

The grocery industry has been grappling with challenges like stiff competition and aggressive promotions, which became more pronounced after Amazon’s takeover of Whole Foods Market. Traditional grocery companies are facing competition from rivals, which are strengthening their franchises and offering alternative outlets for food and other staples. Also, customers are more inclined toward private label products, which are low-cost alternatives to national brands. This, in turn, is hurting food companies.

Higher Operating Expenses to Limit Profits

As demand for staples is usually consistent, companies strive to increase sales and market share through innovations, promotions and efficient marketing and advertising. Thus, consumer staple companies tend to spend heavily on marketing and advertising.

Though advertising strengthens brand appeal and helps to counter competition, it severely hits the profit margins of these companies. Also, efforts to keep up with consumers’ changing needs entail significant costs. In this regard, costs related to e-commerce development and marketing are likely to impact profitability.

Companies like Kimberly-Clark, PepsiCo (PEP - Free Report) and Procter & Gamble (PG - Free Report) have significantly stepped up their investments in marketing, innovation, R&D, supply chain and capacity additions, which may hinder profits. Pinnacle Foods has also been witnessing escalated marketing costs, and expects these barriers to linger.

Emerging Market Volatility

The majority of the global population is clustered in emerging economies. Thus, food/beverage companies are increasingly investing in developing and emerging markets like India, China and Brazil which boast significant growth potential due to relatively low per-capita consumption. Another reason is the burgeoning middle-class population with rising income levels, which in turn is increasing the demand for convenience food and beverages.

Though emerging markets offer strong growth prospects, they are generally volatile due to fluctuating currencies and other structural and political issues. Moreover, any unprecedented event that may impact economic conditions in countries like China, Brazil and Russia remains a threat.

Soft Volumes

Many consumer staples companies are struggling with declining volumes or soft volume growth, which is hurting their top line. Mondelez’s (MDLZ - Free Report) volumes have been weak since 2014 due to volume erosion from higher pricing and category weakness because of lower demand. Another company that has long been battling soft volumes is dairy products player, Dean Foods.

Apart from this, growing health and wellness consciousness has resulted in volume declines of carbonated drinks of Coca-Cola (KO - Free Report) , PepsiCo (PEP - Free Report) and Dr. Pepper DPS, while it has also been hurting cigarette volumes of bigwigs like Altria (MO - Free Report) and Phillip Morris (PM - Free Report) . Molson Coors has also been posting soft beer volumes in the United States for quite some time now, on account of difficult industry conditions.

Government Restrictions

Tobacco companies like Altria Group, Philip Morris and British American Tobacco are facing constant government regulations to make consumers aware of the health hazards associated with tobacco products. Well, government authorities have been brandishing the whip on tobacco players as smoking has become one of the primary causes of heart diseases and cancer. Apart from seeking authorization for any new tobacco product, the FDA has made it mandatory for tobacco companies to use precautionary labels on cigarette packets.

Additionally, these companies have been directed to put self-critical advertisements on television and newspapers, particularly emphasizing the addictive nature of cigarettes. To add to the woes, the FDA is bent on drastically reducing nicotine in cigarettes to minimally addictive levels. The initiative was proposed in 2017 but was delayed due to ongoing research. If enacted, low nicotine levels will prove to be disastrous for cigarette manufacturing companies.

Moreover, increasing regulatory moves have raised awareness amongst consumers regarding the detrimental effects of tobacco consumption, motivating them to quit smoking. These restrictions have lowered cigarette consumption and significantly dented volumes.

While this was for tobacco companies, alcohol stocks also remain vulnerable to government regulations. Distilled spirits are subject to excise tax in various countries. Thus, rising fiscal pressure in the United States, European and emerging markets may lead to increasing risk of a potential excise tax on spirits by governments of the respective countries.

Bottom Line

Though the consumer staples industry is faced with a number of problems, does the sector have anything to offer to short-term investors?

Check out our latest Consumer Staples Outlook for more on the current state of affairs in this market from an earnings perspective and the trend in this important sector of the economy.

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