By Lauren DeSanto
After reaching a five-year low in November of 2008, the University of Michigan's Consumer Sentiment Index has slowly climbed from the mid-fifties to the mid-seventies, suggesting improving consumer optimism about present and future economic conditions. As anyone who has studied psychology knows, however, thoughts aren't always reflected in behaviors, so although consumers may be increasingly optimistic, it's not a foregone conclusion that they will act on this optimism.
To a large degree, we expect the behaviors that we've seen over the past two years to continue, with consumers in the lead role of cautious capital allocators, and persistently high unemployment playing the primary villain. In such a setting we doubt consumers will be opening their wallets too wide. The household products category, with both staple and discretionary products in the mix, should provide a useful backdrop from which to view this consumer spending story over the next year. In that context, there are several themes for investors to watch:
Do Private Label Market Shares Hold, Increase or Reverse?
To save money, consumers traded out of branded goods into private label or store-branded products during the downturn. By the second half of 2010, however, consumer packaged goods manufacturers (CPG) had regained some of the lost market share. It is not clear, however, to what degree promotional efforts by packaged good (CPG) firms are warding off store brand market share encroachment, and to what degree consumers feel less financially constrained. If it’s promotional efforts alone, then Procter & Gamble (PG) and Unilever (UL) may have a tougher time defending their turf now that the heightened promotional spending of the last several quarters seems to be tapering off (since it was hurting profitability without driving sufficient volume leverage). If consumers are feeling more financially flush, though, it bodes well for branded manufacturers, particularly those with differentiated, value-added products. Discriminating consumers traded out of branded products for private label in categories like toilet paper and paper towels, and in these categories some of the consumers may not return to branded goods. In other categories, such as shampoo or laundry detergent we wouldn't be surprised to see consumers trade back up from store brands or lower priced offerings to their favorite branded products.
When and Where Does Mature Market Sales Growth Return?
For household products geographic diversity has been a very good thing, particularly for those with exposure to developing markets where sales growth of 8% to 12% handily outpaces low single digit growth in markets like the U.S. and Europe. Whether it's Avon (AVP) exposure to China, Unilever’s presence in India, or Kimberly Clark's (KMB) investment in Kimberly-Clark de Mexico, strong sales growth in overseas markets has allowed household product firms to cope with flattish or declining category sales growth rates in North America. The firms can enter new markets, introduce new products and, over time, trade low income consumers up to higher gross margin products as their fortunes improve. Certainly, the devaluation of the Venezuelan bolivar in late 2009 and early 2010 proved problematic for firms with significant exposure to the country, such as Colgate-Palmolive (CL) and Clorox (CLX), but the promise of growing consumer spending in emerging markets has been an undeniable boon to household product manufacturers.
What is certainly more problematic, however, is the possibility that category growth rates in mature markets will remain rangebound to 1% to 2% annual increases for the foreseeable future. We think this is quite likely, and there is little on the new product front that has us excited about any particular category. Sluggish response to P&G's Pantene product restage and Clorox's goodwill write down of its Burt's Bees acquisition are good examples of this. The former is P&G's effort to reinvigorate one of its billion-dollar brands with new product formulations and packaging designs. While Pantene continues to do well outside of the U.S., the restage hasn't given the brand much market share traction here at home. This isn't terribly surprising. We rarely see product restages deliver the needed volume lift to justify their investment, but as brands age, these type of "make-overs" to refresh products as "new" and "improved" have become standard practice. We believe there are diminishing returns to these investments, however, as by now mature market consumers are more than familiar with these tactics and are saturated with information. Breaking through the media clutter with a meaningful new product message is extremely hard to do.
The case of Burt's Bees offers an even more insightful view of mature market growth prospects. In 2007, Clorox paid $925 million for the acquisition in an effort to break into more personal care categories with a well-regarded, faster-growing organics brand. While the acquisition has been fruitful as the firm expanded distribution, it hasn't lived up to expectations. The company is taking a $250 to $255 million impairment on its purchase after paying 5.4x sales for Burt's and an estimated 18.1x EBITDA. A slowing economy and cash strapped consumer hampered expectations for growth of Burt's product offerings, but we don't believe a longer time horizon to realize Burt's new, lowered value is the only problem. In our view, there are genuinely fewer strong category growth opportunities in the U.S. and Europe. Burt's is just one example, but as an organics brand, it's a significant one.
With these factors in mind, and with Morningstar's household products coverage trading at a median price to fair value ratio of .91, we see only modest upside to the sector at this point. Any accelerated growth in emerging markets will be tempered by slow growth in developed markets and we're mindful of input cost inflation that could curb profits, and rising gas prices that could squash any nascent uptick in consumer spending. Currently, the four stocks trading at the greatest discount to our fair value estimates in our household products coverage include the following high quality names:
Henkel AG & Co. KGAa | Narrow Moat | Low Uncertainty | P/FV .77
Henkel operates as a leading global player in adhesive technologies, with 15% share of the market, and as the number-two player in the worldwide laundry-care market. Rising input costs and promotional spending could weigh on the firm's ability to continue generating outsize profitability improvements but Henkel's favorable results aren't fully reflected in the shares, which are trading at just 11 times our fiscal 2011 earnings per share estimate. Additionally, nearly 40% of Henkel's sales result from faster-growing emerging and developing markets, up from 26% in 2004. So while the company faces significant foreign exchange exposure, it also stands to benefit as we expect growth in emerging markets to remain healthy for the foreseeable future.
Avon | Wide Moat | Low Uncertainty | P/FV .82
The market appears to be underestimating the benefit of Avon Products' long history of operating through global economic disruptions and its intense focus on managing costs. Increased investments in advertising, representatives, and supply chain have hindered operating margins in recent quarters, but we believe these investments should drive improved profitability over an extended horizon. Avon is currently trading at about 16 times our 2011 earnings per share estimate.
Procter & Gamble | Wide Moat | Low Uncertainty | P/FV .84
Through much of last year, P&G significantly increased its promotional and advertising spending to reclaim lost market share. The firm has an aggressive plan to expand its brands and products into "white spaces" overseas by 2016, where its offerings are underpenetrated. Obviously, these efforts won't come cheap, but P&G has tremendous scale and roughly $3 billion in cost savings opportunities over the next several years that should keep margin expansion on track. With an average 7.0% cash return, we expect patient shareholders will be rewarded.
Colgate-Palmolive | Wide Moat | Low Uncertainty | P/FV .86
Increased competition has put Colgate on the defensive and the firm hasn't helped matters much with its struggle to contain problems in Venezuela. The market is questioning how much investment Colgate will need to reinforce its leading market share position in Latin America. We expect top-line and margin pressure in coming quarters, but in our experience, Colgate shouldn't be underestimated. The firm has a deep knowledge of the oral care category and a best in class cost structure.
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