Dont count on the consumer
Avoiding companies dependent on consumer spending has been crucial over the past year.
Our Focus List, Buy List, and Long-Term Buy List have all outperformed the S&P 500 Index over the past year, partly because they held no or few consumer-discretionary stocks.
The S&P 1500 Consumer Discretionary Sector Index has slumped 28% over the last 12 months, versus 17% for the broader S&P 1500 Index. Not all consumer stocks have lagged, however. The S&P 1500 consumer-staples sector, which contains companies selling such products as food, beverages, household goods, and tobacco, has lived up to its defensive reputation with a 12-month decline of 1%.
The outlook for consumer-discretionary stocks, accounting for 9% of the S&P 1500’s stock-market value, remains cloudy. Despite recent improvements in retail sales sparked by federal income-tax rebates, Wall Street continues to punish consumer-discretionary stocks, apparently in the belief that consumers will soon put away their wallets. With food and energy prices on the rise and home values slumping, we see little reason to expect consumers to splurge on discretionary items.
The Forecasts has found few appealing choices in this sector and currently recommends only one consumer-discretionary stock, Disney ($30; NYSE: DIS), a Long-Term Buy. Reviewed on page 4 is troubled automaker General Motors ($14; NYSE: GM), rated Underperform.
Consumer-staples stocks (10% of the S&P 1500’s market value) have their own problems. Rising costs for food and energy have pinched profit margins, and most companies have had a hard time passing on those costs. Still, sales growth has been solid, with inventories declining and new orders rising. Solid defensive picks include PepsiCo ($66; NYSE: PEP), Wal-Mart ($59; NYSE: WMT), and Walgreen ($34; NYSE: WAG), reviewed below.
General Motors’ ($14; NYSE: GM) woes are well known. After years of relying on trucks and sport-utility vehicles, the company is seeing sales shift to fuel-efficient cars, which are less profitable. In addition to the unfavorable shift in its product mix, GM’s vehicle deliveries fell more than 16% in the six months ended June, with truck sales down 21%.
To combat persistent rumors weighing on the stock, GM said on July 10 it has no plans to file for bankruptcy or divest brands other than Hummer — and that it has enough cash to cover expenses through the end of the year. The statements did little to reassure investors. However, the stock has jumped 53% since July 14 on the strength of an aggressive cost-cutting program — including production cuts and a suspended dividend — as well as price declines in oil and metals. Despite the recent strength, GM shares are down 42% since year-end 2007.
GM’s troubles don’t end with the difficult consumer environment. The 49%-owned GMAC financing arm is losing money, and a strike at supplier American Axle ($7; NYSE: AXL) has cost GM $2.8 billion in lost earnings and settlement costs. A labor agreement signed in 2007 shifts the burden of health-care costs to union workers, but GM won’t see any benefits until 2010. Consensus estimates project a per-share loss of $6.23 in 2008. GM is rated Underperform.
PepsiCo ($66; NYSE: PEP) has been able to offset rising commodity costs by increasing the price of its snacks and decreasing the amount of food in each bag. In June, the Frito-Lay division raised snack prices 12.2%, versus an industrywide increase of 10.6%. The company is also raising prices on soft drinks, though less drastically.
Such aggressive price increases are new to the company, and PepsiCo says it is too soon to determine how the higher prices will affect sales. However, with other companies also boosting prices, consumers have yet to meaningfully switch away from Frito-Lay to other products. With input costs expected to rise 9% to 10% this year, the company is pursuing hedges to lock in raw-material costs. This should help maintain profit margins in the near term, as it can take three to six months to implement price increases.
PepsiCo earned $1.03 per share in the June quarter excluding commodity-price gains, up 11%. Sales rose 14% to $10.95 billion, powered by volume growth of 5% and price increases. All of the company’s business units managed sales growth in the quarter. Despite a slowdown in volume growth, Wall Street expects PepsiCo’s per-share profits to grow 10% this year. At 17 times estimated year-ahead earnings, PepsiCo shares trade below their five-year average forward P/E ratio of 19. PepsiCo is a Buy and a Long-Term Buy.
Shares of Wal-Mart Stores ($59; NYSE: WMT) have been more than recession-resistant, gaining 24% so far this year. Wal-Mart’s price/earnings ratio steadily declined from 1999 through 2007 on investor worries that growth would stall. But Wal-Mart seems able to find new opportunities in its mature domestic business as well as international operations. In June, same-store sales rose 5.8%, well above the consensus estimate of 3.8%. Wal-Mart also raised expectations for July-quarter profits.
In the U.S., Wal-Mart is trying to squeeze profits out of existing stores rather than opening new locations. In fiscal 2009 ending January, the company plans to open 170 supercenters, versus 281 opened in fiscal 2007. Relocations or expansions of existing stores will account for more than half of that construction. Wal-Mart expects to open even fewer stores in fiscal 2010. The decline in capital expenditures should leave more cash for international growth, higher dividends, and a $15 billion share-repurchase program. With consensus estimates projecting 11% per-share-earnings growth this year, Wal-Mart is a Long-Term Buy.
Walgreen ($34; NYSE: WAG), which has been expanding aggressively for several years, said it plans to cut back on new-store openings. The drugstore chain now plans to increase square footage by about 5% a year starting in fiscal 2011 ending August, down from an earlier target of 8% growth. Expansion will slow gradually over the next three years. By 2010, Walgreen should operate more than 7,000 stores, and the reduced emphasis on growth should help improve profit margins. New stores add revenue but take three years to gain profitability.
Walgreen generates roughly 80% of its revenue from prescription and over-the-counter medications, one reason its stock is considered a good defensive name during an economic downturn. Drugs provide a steady long-term revenue stream, though sales have been hurt in recent months by a light flu season and a dearth of generic-drug launches. However, sales of other goods remain solid, helped by Walgreen’s focus on consumer staples — such as food, cosmetics, and personal-care products — rather than items consumers can easily stop buying.
Consensus estimates project per-share-earnings growth of 8% in fiscal 2008 and 12% in fiscal 2009. Walgreen, a Long-Term Buy, is well-positioned for solid profit growth even in a tough consumer environment.
Consumer news update
Below we present a few short news items from Neutral-rated consumer companies:
Coca-Cola ($51; NYSE: KO) earned $1.01 per share in the June quarter, up 19% excluding a $1.1 billion write-down in the value of its investment in bottler Coca-Cola Enterprises ($17; NYSE: CCE). Revenue rose 17%, or 6% excluding acquisitions and currency gains. Beverage volumes rose 3% . . . In the June quarter, McDonald’s ($60; NYSE: MCD) same-store sales rose 6.1%, with 3.4% growth in the U.S. Per-share profits increased 31% to $0.94 per share excluding the gain on an asset sale . . . A decline in demand for motorcycles drove Harley-Davidson’s ($38; NYSE: HOG) June-quarter per-share profits down 17% on a 3% decline in revenue. Quarterly results topped consensus estimates, but the company reiterated expectations for a 15% to 20% profit decline this year . . . Shares of Costco Wholesale ($64; NASDAQ: COST) plunged on news that the retailer’s August-quarter profits would fall “well below” the $1.00-per-share consensus. Costco blamed the weakness on inflation, particularly high energy costs . . . Philip Morris International ($52; NYSE: PM) topped June-quarter estimates with per-share profits of $0.85 per share excluding asset impairments, up 16%, or 3% excluding currency gains. Revenue jumped 20%. Cigarette shipment volumes rose 0.3% excluding acquisitions.