aranca views - consumer staples − losing steam?

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Consumer Staples − Losing Steam?

October 17, 2014

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Investment activity in consumer staples remains lackluster, yet selective stock strategy could turn tables

Since the beginning of 2013, consumer stocks, especially consumer staples, have underperformed due to the rising investment

opportunity across high-growth sectors such as industrials, materials, IT, and utilities. Despite subdued investor interest, consumer

stocks offer tremendous opportunity and a selective stock strategy may generate superior returns. Over the short to medium term, we

believe selection of consumer staple stocks for investment would be influenced by their ability to generate stable and growing cash

flow and to restrict losses during economic headwinds, wider exposure to high-growth emerging markets, focus on innovation, and

potential to enhance profitability through cost saving initiatives/restructuring.

Tanuja Chitre, Assistant Manager – Investment Research, Aranca

Good prospects in other sectors weigh down consumer stocks, yet opportunity exists

Consumer stocks, especially consumer staples, remain defensive during downturn…

Demand for non-discretionary consumer products (consumer staples) remains relatively steady through various stages of economic

cycles due to their fundamental nature. Thus, consumer staple companies can restrict revenue and profitability declines and generate

steady cash flow even during downturn. This defensive nature of business makes consumer stocks a preferred investment option

during tough economic conditions.

Given their defensive nature, consumer staples generated superior returns between 2008 and 2013 (global financial crisis until

recovery). On the contrary, other sectors whose performance is linked to economic prosperity or that are sensitive to interest rates (for

instance, auto, banking, real estate, and infrastructure) reported relatively poor performance during the same period.

The table below illustrates superior performance of consumer staples’ relative to other sectors in terms of five- and 10-year annualized

returns across various regions.

Heat chart – consumer vis-à-vis other sectors based on five- and 10-year annualized returns

Source: MSCI Barra; Note: The Investable Market Index (IMI), including large-, mid-, and small-caps across sectors, is considered as of October 16, 2014

…yet performance is limited during economic recovery and boom

The defensive nature of consumer staples attracts investors during tough economic conditions; however, during economic boom,

investors shift focus to high-growth sectors that offer greater upside potential. Over the past year, the global market recovery has

steered investors away from consumer staples to high-growth sectors such as utilities, healthcare, industrials, IT, and financials.

Period of returns

Sectors Europe EMU EM World ACWI Europe EMU EM World ACWI

Consumer staples 8.52% 7.68% 14.47% 7.96% 8.26% 7.24% 5.77% 8.20% 9.38% 9.22%

Energy Sector 0.58% 0.20% 5.19% 5.19% 5.01% -3.22% -4.13% -7.53% 1.53% 0.19%

Financials -2.33% -3.10% 8.40% -0.57% 0.08% -3.98% -8.55% -0.37% 2.61% 2.18%

Healthcare 6.98% 5.67% 12.56% 8.09% 8.21% 9.70% 7.90% 11.68% 13.39% 13.40%

IT 2.29% 1.30% 8.11% 6.66% 6.73% 3.87% 1.74% 7.16% 10.21% 9.78%

Industrials 6.26% 4.66% 7.17% 5.74% 5.71% 3.17% 0.32% -1.15% 8.13% 7.33%

Utilities 1.91% 0.19% 8.62% 3.46% 3.73% -4.38% -9.12% -1.78% 1.41% 1.03%

Telecom Services 0.59% -2.57% 7.78% 2.51% 3.30% -1.55% -9.04% 0.89% 4.50% 3.77%

Materials 5.93% 5.36% 5.19% 5.38% 5.27% -0.80% -0.80% -7.24% 0.35% -1.12%

All sector Average by region 2.32% 0.91% 8.26% 4.44% 4.68% 0.52% -2.98% 1.27% 5.97% 5.38%

10 Yr. Annualized return 5 Yr. Annualized return

Consumer sector - Above average returns Consumer sector - Above average returns

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Global markets recovering since 2013

Source: Bloomberg

Performance of consumer sector varies across phases of economic cycle

The chart below shows investment preference for consumer staples across different stages of the economic cycle.

Sector performance along business cycle (2000–14)

Positive Negative Nearly neutral

Source: Bloomberg

Where do we stand?

During tough economic conditions consumer staples attracted atttntion due to their ability to generate steady cash flow and limit

declines in revenue and profitability. However, with gradual recovery in global financial markets, investors are moving toward sectors

highly linked with economic expansion, such as materials, utilities, and technology. These sectors have been performing well, led by

recovery in transportation, infrastructure, and construction and greater focus on innovation. The charts below compare the performance

of the S&P consumer staple index with other sectoral indices for different periods between 2008 and 2014.

60

80

100

120

140

160

180

Jan-13 Aug-13 Mar-14 Oct-14

DJI FTSE NKY Sensex CRTX Bovespa SHCOMP

Investors prefer high-growth stocks over consumer staples

Investors prefer high-growth stocks over consumer staples

Toward the late phase, investors start moving back to consumer stocks

Investors primarily prefer defensive consumer staples over other sectors

2000-04 2005-07 2008-12 2013 to date

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S&P indices: Consumer staples vs.

others (2008–12) − Crisis


others (2013) − Stability


others (2014–YTD**) − Recovery

Source: Bloomberg; Note1: *Cons. Stapl. = Consumer staples, IT = Infornation Technology; **YTD refers to period between January 2014 and 22 September 2014

Between 2008 and 2012, the global economy continued to grapple with the aftermath of the financial crisis of 2008. Hence, returns from

the defensive consumer staples sector surpassed all other sectors (as reflected in LHS chart above).

In terms of P/E, consumers stocks have mostly traded at a higher multiple than that of the broader market across business cycles given

their defensive nature, except 2008 and 2009, as shown in the chart below:

Index P/E performance: S&P 500 index vs. S&P consumer staples index (2000–14)

Source: Bloomberg

During 2008–09, consumer staples witnessed lower P/E levels. This could be due to the delayed impact of the economic crisis on

emerging economies that enjoyed huge exposure to growth sectors other than consumer staples. However, as all markets tackled

the consequences of the crisis between 2010 and 2012, consumer staples’s P/E started inching higher than that of the

broader market, reflecting investor willingness to pay a higher price for consumer stocks during economic downturn.

With global economic recovery, S&P consumer staples index underperformed the broader S&P 500 index. For the twelve months

ended September, 2014, the S&P 500 index gained 17.3%, while the consumer staples index returned 13.4%. However, with

uncertainty in global economic recovery looming large, since the beginning of October 2014, the fall in consumer sector has

been limited relative to the broader index. Over the first fifteen days of October 2015, S&P 500 index contracted 4.3% while

consumer staples index contracted just about 0.9%.

-64.6%

-16.3%

-11.2%

-9.4%

-2.4%

-2.2%

3.4%

13.5%

18.4%

25.0%

-80% -40% 0% 40%

Financials

Telecom

S&P 500

Industrials

Utilities

Materials

Healthcare

IT**

Energy

Cons.stapl.*

26.3%

12.5%

13.3%

12.6%

-2.8%

12.3%

15.5%

16.9%

2.1%

7.7%

-40% 0% 40%

Financials

Telecom

S&P 500

Industrials

Utilities

Materials

Healthcare

IT**

Energy

Cons.stapl.*

8.6%

4.3%

9.0%

4.2%

12.2%

9.5%

16.8%

15.0%

6.0%

5.8%

0% 40%

Financials

Telecom

S&P 500

Industrials

Utilities

Materials

Healthcare

IT**

Energy

Cons.stapl.*

20.4

6

18.4

1

16.9

16.6

1

17.3

6

16.3

2

18.4

4

15.1

1

12.9

1

14.1 17.3

1

17.9

5

16.6

0

20.6

5

19.6

6

18.7

7

20.3

1

19.5

3

13.7

4

14.8

6

15.6

4

16.0

3

16.2

7

18.4

6

18.9

3

18.5

90

5

10

15

20

25

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Curr

ent

2014E

S&P 500 Consumer Staples

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S&P 500 index vs. S&P consumer staples index

Source: Bloomberg; Note: The index values are rebased to 100

We believe, during boom times consumer staples offer tremendous opportunity and a selective investment strategy may generate

higher returns than other growth sectors. For instance, tobacco players are focusing on product innovation. These companies generally

attract investor attention due to their ability to generate stable cash flow and provide consistent dividend payments and stock buybacks.

However, some tobacco players are seen foraying into e-cigarettes, which reflects additional upside potential through innovation. These

stocks could demonstrate superior performance and command premium over other incumbents. Apart from tobacco, consumer staple

companies with strong focus on product/services/supply chain innovation, cost savings, and restructuring would continue to trade at a

premium.

Consumer staples: Where is the opportunity?

With saturation in developed markets, emerging economies remain key driver…

Consumer staple companies in developed markets continue to face growth pressure due to overall saturation. Near-stagnant

disposable income, market maturity, and fierce competition adversely impacted performance. Additionally, depreciation of emerging

market currencies against the USD hampered sales growth for companies operating outside the US.

That said, long-term opportunities across emerging markets are attractive. Rising population, increasing disposable income due to

growing ranks of the middle-class population, and rapid urbanization across emerging economies (including India, China, Latin

America, and Africa) are expected to support growth in consumer staples. Despite higher growth opportunities relative to developed

economies, emerging markets remain a high volume, low margin proposition. Although margins underperform those in developed

market (due to infrastructure bottlenecks and higher cost of distribution networks), significantly higher volume growth would ensure

profitability. Moreover, as economic expansion in emerging countries continues, gradual improvement in margins would boost

profitability.

…yet risk and reward evaluation is essential to determine performance

Given the tremendous opportunity, all emerging markets would register substantial growth. A country’s ability to scale up infrastructure

(with expansion in consumer base) and address geopolitical and regulatory concerns would determine the degree of success. For

instance, despite attractive growth opportunities in the consumer sector in India, multinationals continue to face headwinds from FDI

regulations. Likewise, in Latin America, high inflationary pressures and inadequate infrastructure limit entry (and growth) of consumer

staple multinationals. Accordingly, global consumer stocks with greater exposure to the right set of emerging markets are likely to be

preferred by investors. The key growth regions for the consumer sector and main drivers thereof are shown in the table below:

95

100

105

110

115

120

125

Aug-13 Jan-14 May-14 Oct-14

S&P 500 Index− Rebased Consumer Staples Index− Rebased

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Consumer staples – key growth regions

Region Key drivers of consumer staples

Asia-Pacific

Higher urbanization rate, changing consumption trends, and expanding middle class

Changing government policy and rising proportion of earning population to support demand in key markets China

and India, respectively

91 million urban households in India likely to fall under middle class category by 2030 compared with 22 million in

2010; urbanization rate1 in India estimated to increase to 40% by 2030 from 30% in 2008 (source: 2010 Mckinsey

Report – India’s Urban Awakening)

Latin America

Growing population, urbanization and per capita income

86% of population is likely to be urbanized by 2050 compared with 80% expected in 2014 (source: UN World

Urbanization Prospects – 2014 edition); level of urbanization comparable with developed areas such as Europe and

the US

Africa

Rising proportion of young and earning population with growing disposable incomes and higher levels of

urbanization

Proportion of urban population is likely to increase to 56% by 2050 from 40% expected in 2014 (source: United

Nations report on World Urbanization Prospects – 2014 edition)

Source: News articles

Overall, demand for consumer staples from emerging economies is expected to increase due to an expanding population base and

rising per capita income. The chart below highlights the rapid growth markets for consumer staples:

Consumer staples − other rapid growth markets across the globe

Source: International Monetary Fund (IMF); Note1: GDP growth at constant prices is considered above; Note 2: Size of the bubble indicates population in millions

1 Proportion of urban population to total population

China

India

US

Indonesia

Brazil

Pakistan

NigeriaBangladesh

Mexico

Philippines

Ethiopia

Vietnam

Egypt

Iran

Germany

Turkey

Myanmar

Thailand

UKFrance

Italy

South Africa

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0%

GD

P g

row

th

Population growth

Highlighted section represent markets with

Population growth close to 1% or above 1%

GDP growth above 3%

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Other drivers of consumer staples

Health and wellness at the fore

The global population is becoming increasingly health conscious due to the rising incidence of lifestyle-related cardiovascular diseases

and obesity. Hence, more companies are focusing on expanding portfolio to include nutritious products. The table below illustrates

consumer staple companies’s shifting focus toward health-based products:

Consumer staple companies shifting focus to health conscious products

Staple segment Companies Efforts

Beverages Pepsi Co, Coca-Cola Focus on including non-carbonated drinks such as sports drinks and fruit juices

Snacks Pepsi Focus on baked chips over fried chips

Tobacco

Lorillard, British American

Tobacco, Altria Group Introduction of e-cigarettes that are supposed to be less risky than traditional cigarettes


Cost reduction remains key to profitability

With limited scope for margin expansion through price increases, consumer staple companies across the globe are focusing on cost

reduction. Cost-cutting measures such as divestiture of low-margin brands, factory rationalization, centralized distribution, and vertical

integration mitigate the adverse impact of inflation in commodity and other input costs. High commodity and input costs remain the

primary cause of margin dilution in the consumer staples sector. Some recent examples of cost reduction and restructuring initiatives by

consumer staple companies are tabulated below:

Consumer staple companies focus on cost reduction to improve performance

Staple segment Companies Initiatives and their impact

Essentials Unilever

Between 2012 and 2013, Unilever sold its slow growing North American frozen

meal, Wish-Bone salad dressing and Skippy peanut butter businesses to to

ConAgra Foods Inc. This step falls in line with Unilevers’ strategy to reduce the

size of its brand portfolio from 1,600 (as of 2013) to 400 by 2015 to be able to

focus available resources on core categories like personal care and home care.

Hot beverage: Coffee Green Mountain Coffee

Roasters Inc.

Green Mountain Coffee Roasters Inc. is focusing on improving efficiency through

cost reduction. By 2015, the company targets to save USD70–100 million by

improving operational productivity.

Snacks & Beverages Pepsi Co.

Pepsi Co. announced a five-year annual productivity plan for 2013–19. In 2013,

the company achieved productivity-related cost savings of USD 2billion. By 2019,

Pepsi aims to save USD1 billion each year through improved productivity.

Beverages Coca-Cola

In 2012, Coca-Cola launched a four-year productivity improvement program.

Under this, Coca-Cola aims to improve supply chain, marketing and innovation

efforts; standardize information systems; and integrate its bottling and distribution

operations acquired from Coca-Cola Enterprises, North America. These activities

are expected to generate incremental earnings of USD550–600 million by 2015.


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Changing consumption trends across emerging markets present new opportunity

Rising disposable income and changing lifestyles (urbanization) have boosted demand for packed foods in emerging economies. Unlike

mature markets, emerging economies remain relatively untapped, thus offering significant potential in the packaged food and ready-to-

eat (RTE) segment. While emerging markets primarily offer volume proposition, demand for packaged/RTE food is steadily giving way

to an evolving high-margin trend. In this category, emerging countries could soon present margin-enhancing opportunity for

multinational consumer staple companies.

Americas and Asia-Pacific remain preferred destinations for M&A deals

With limited scope for profitability improvement, consumer staple companies are increasingly focusing on strategic partnerships and

mergers/acquisitions to generate additional revenues by:

Leveraging scale of operations

Improving distribution/marketing efficiency

Reducing cost through vertical integration across value chain

Capturing additional customer base by expanding in unexplored markets

Introducing new products

Broadly, M&A activity in consumer staples is subject to the quality of the target company. The selection depends on the target’s ability

to add value in terms of products, geographic dispersion or productivity enhancement. According to the M&A Transaction Tracker by

American Appraisal, the consumer staples sector recorded 502 transactions in the twelve months ended June 30, 2014. In terms of

value, the transactions accounted for 6% (or USD149.3) of the M&A deals during the same period. Geographically, 90% of the deals (in

value terms) were carried out in North America & Canada (35%), Europe (32%), and Asia-Pacific (23%).

Consumer staples – deal value by geography Region-wise EBITDA multiples for consumer staples

Source: American Appraisal M&A Transaction Tracker, released in Q2-2014; Note: The

deal value is for 12 months ended June 30, 2014 Source: American Appraisal M&A Transaction Tracker, released in Q2-2014; Note:

The revenue and EBITDA multiples by region are for 12 months ended June 30,

2014; Median EBITDA multiples are provided above

Product innovation may sustain market position/profitability

Apart from M&A and strategic partnerships, consumer staple companies are focusing on product innovation to bolster revenue and

profitability. Through innovation, companies aim to offer differentiated products, thereby maintaining (and improving) their competitive

market positioning. For instance, Pepsi Co’s new soda dispenser, ‘Spire’, allows customers to create up to 1000 different soda drinks.

This dispenser was primarily launched to improve competitive positioning vis-à-vis Coca-Cola that has been operating ‘Freestyle’

Africa/Middle East Asia-Pacific

Europe Latin America and Caribbean

US and Canada

11.210

8.9

10.7 10.910.2

0

2

4

6

8

10

12

US

& C

anada

LatA

m &

Caribbea

n

Eu

rope

Asia

-Pacific

Afr

ica/M

iddle

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fountain machines since 2009. Similarly, Kimberly Clark plans to offer various innovative products across the baby diapers and wipes

categories in North America.

The way forward

Since 2012, the consumer staples segment has been facing macroeconomic headwinds and the situation is unlikely to change over the

short term. In 2014, the trading environment is expected to remain tough due to continued cautious spending in both developed and

emerging markets consumer. Additionally, political unrest in certain countries has adversely impacted operations of multinational

consumer companies. Despite the tough environment, consumer staple companies that focus on value addition through strategic

partnerships/tie-ups, product innovation, and cost-savings initiatives stand a better chance to bolster profitability over the short to

medium term.

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