Sector Spotlight

April 2007

Consumer Staples

By Avo Kamberian

During an economic slowdown, investors rotate out of economically sensitive or cyclical companies into more defensive businesses that offer sustainable growth prospects, like the consumer staples industry – the most defensive sector against a decelerating economy.

One current benefit of investing in the group is cost containment. Since January, aggregate materials costs have risen only slightly. Consequently, we expect industry gross margins to improve; allowing other industry cost-cutting moves a better chance to affect the bottom line. Additionally, these companies are natural hedge against weakness in the US dollar. Since most consumer staples companies have significant operations outside the US, dollar weakness brings a substantial earnings benefit to the sector, or at least protect earnings downside – like the 2.2% positive impact from currencies in 4Q06.

The following is an investment summary for some leading companies in the group:

Anheuser-Busch (BUD)
Several years ago, BUD faced fundamental challenges. Its main source of profit, domestic beer, was losing market share to other brewers around the globe, and more broadly, to rival alcohol formats like wine and spirits. Also, after concentrating on the US beer segment for growth for years, the company had ignored the global pool of alcohol revenues.

Recently, however, we have been impressed with BUD’s global expansion strategy. Acquiring the European brewer InBev provides geographic diversification and profit potential outside BUD’s historic markets. Further, we expect benefits from integrating newly acquired brands into its vast retail and wholesale network, reducing dependency on domestic beer sales – a process that is ahead of schedule. Moreover, recent price trends have been encouraging. In February, domestic beer CPI growth accelerated to 2.5%, vs. total CPI gains of 2.4%. This is the first time since 2004 that beer CPI growth had outpaced total CPI growth.
In conclusion, we believe these new profit streams will form a foundation for delivering better than 10% earnings growth over the next 3 years.

Coca-Cola (KO)
Their latest earnings release demonstrates KO is delivering improved operating performance. In the last quarter, the company captured an exceptional volume increase of 4% and an operating profit of 10%. These are at the top of the range and above long-term growth prospects – despite weakness in North America and Japan.

Management indicated that macro and micro drivers continue to favor emerging markets and prospects for a more robust new product pipeline as 2007 progresses. On the profitability front, 2007 points to better cost containment than previous years. Declining sugar prices and changes in product mix reduce the negative impact of aluminum inflation and benefits from lower PET prices.

As a result, bottling cost increases will be normalized particularly in international markets while domestic partners’ costs will be contained. In conclusion, a new product pipeline, fast growing developing markets, and limited cost pressure should enable the company to grow its earnings per share at 10% rate for the near future.

Procter & Gamble (PG)
With its depth of products and global presence, PG is one of the best defensive names in the group – the company recently achieved solid 6% revenue growth. Global brands continue to drive growth with names like Tide in laundry detergent, Bounty in paper towels, Tampax in feminine care, Crest in toothpaste, Swiffer in cleaning and Prilosec in antacids.

Recently launched innovations such as Crest Pro Health, Olay’s Fusiona/ Phantom for facial anti-aging, Fabreeze air fresheners, and Pro-Health dental rinse are extending their gains. In fact, 50% of PG’s growth now comes from smaller categories (each less than 3% of sales), a platform for robust growth for the next several years.

PG has a track record for innovation, experience in developing new markets, and distinct advantages in industry consolidation. These factors, along with the benefits of integration and its ability to extend and tier-off existing categories, will continue to drive PG to deliver industry-leading 15% earnings growth for the foreseeable future.