Can Consumer Staples Overcome Headwinds?

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Despite rising consumer spending and moderate improvement in U.S. economic growth, the consumer staples sector doesn’t seem to be the perfect choice for investors right now; it is viewed as more attractive when macro-economic environment remains sluggish. The bullish growth in 2017 will also invite another Fed rate hike. Higher U.S. interest rates will likely lead to a stronger dollar, which would hurt overseas profits and create an unfavorable environment for emerging economies.

Other headwinds like potential price wars, a competitive environment and slowdown in international markets may also hinder growth. Also, investors remain skeptical whether policies promised by the Trump administration will take shape.

We note that in spite of benefiting from lower fuel prices and higher wages, consumers are reluctant to spend more. The Consumers’ outlook for the labor market was also less favorable in April.

Hence, investors should carefully select stocks for their portfolio as certain headwinds are likely to prevail in the coming months.

WEAKNESSES

Pressurized Margins

The grocery/supermarket business has been grappling with food deflation, stiff competition, aggressive promotional environment, and waning store traffic over the past few quarters. These headwinds have severely impacted major food grocers like The Kroger Co. (KR), Whole Foods Market, Inc. (WFM), SuperValu, Inc. (SVU), Sprouts Farmers Market (SFM) and United Natural Foods, Inc. (UNFI). An oversupply in some types of food – particularly meat, poultry and dairy –dragged prices lower and compelled grocery stores to do more aggressive promotions.

Meanwhile, we note that the trend is finally beginning to shift toward inflation. Meat prices are abating and dairy prices have started to rise. This is expected to result in an increase in commodity prices, thereby putting pressure on margins. Also, price wars between companies may erode profits and margins in the near term.

Slowdown in Emerging Markets

The majority of the global population lives in emerging economies. Due to a slowdown in income and consumption growth, affordability is low. Though there remains a huge opportunity for sales growth in these markets, currently the state of affairs remains volatile.

Aside from China, which is struggling the past few quarters, developing countries like Brazil and Mexico are facing economic slowdowns. The Middle East, Russia and Ukraine are witnessing continued political and civil unrest, resulting in challenging operating conditions. Some developed markets are also facing weakness due to sluggish consumer demand.

For example, consumer product company Unilever plc (UL) still sees declining volumes in Brazil, while performance has improved in China and India. The company is also witnessing weakness in the developed markets with little sign of recovery in North America or Europe. Moreover, it remains cautious as consumer demand continues to be weak.

Beverage giant The Coca-Cola Company (KO) also remains apprehensive of broader economic challenges in future quarters. While the macro environment is improving in North America, Japan and India, Coca-Cola expects challenges in many key emerging/developing markets like Brazil, Russia and China.

Companies like Procter & Gamble Co. (PG) and Kellogg Co. (K) are also struggling with decelerating growth in the developing markets and currency headwinds. U.K.-based brewer Diageo Plc (DEO) also faces macroeconomic headwinds and tough retail conditions in emerging markets.

Higher Operating Expenses to Limit Profits

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. Companies like Kimberly-Clark Corp. (KMB), PepsiCo Inc. (PEP) and Procter & Gamble have significantly stepped up their investments in marketing, innovation, R&D, supply chain and capacity additions, which will weigh on profits in the short term. Pinnacle Foods, Inc. (PF) incurs higher expenses as a result of innovation and promotional activity.

Increased Competition

Consumer staples companies are also hit by stiff competition, which results in lower pricing power and a decline in market share. This in turn compresses margins and earnings. For example, Kimberly-Clark’s diaper segment is witnessing lower market share and higher competitive promotional activity, as its Huggies diapers are competing with Procter & Gamble’s cheaper Luvs and upscale Pampers offerings. The J.M. Smucker Co.’s (SJM) mainstream Pet Food business is also facing heightened competitive activity and challenges in dry dog food amid a deflationary macro environment, which is impacting the performance of its Kibbles ‘n Bits brand.

Unfavorable Foreign Currency Impact

Companies with a significant presence in emerging markets are being affected by currency headwinds, given the weakening of many emerging market currencies against the U.S. dollar.

Foreign exchange is a major headwind for companies like Estee Lauder Companies, Inc. (EL), Mondelez International, Inc. (MDLZ), Unilever and PepsiCo, which have significant business outside the U.S. Venezuelan currency issues are also hurting Nu Skin Enterprises, Inc.’s (NUS) earnings significantly.

Declining Volumes

Many consumer staples companies are struggling with declining volume or soft volume growth, which is hurting their top line.

For example, tobacco companies like Altria Group, Inc.(MO), Philip Morris International, Inc. (PM) and Reynolds American, Inc. (RAI) are facing declining shipment volumes, mainly due to anti-tobacco campaigns and general shifting from cigarettes and cigars to alternative tobacco products such chewable nicotine, e-cigarettes, etc. The government has imposed higher excise taxes on cigarettes, as a result of which tobacco companies are increasing prices. Further, rising competition from fake versions of branded cigarettes by local retailers is also hurting cigarette volumes.

Volumes of food company Mondelez International have been hurt by the elasticity impact from higher pricing and category weakness because of soft consumer demand.

Beverage companies like Dr. Pepper Snapple Group Inc. (DPS), Coca-Cola and PepsiCo have also been seeing declining volume trends in their carbonated soft drinks businesses due to category weakness. A muted volume trend will remain a concern going forward.

Bottom Line

As is evident, there are plenty of concerns in the consumer staples industry. However, as regards investing in the space right now, are there any opportunities for 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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May 17, 2017 at 01:02AM

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from Zacks Equity Research

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Muzaffaruddin Alvi | Corporate Governance Expert - Pakistan

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Can Consumer Staples Overcome Headwinds?

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