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--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 (200014)

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 (200812) Crisis
others (2013) Stability
others (2014YTD**) 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 (200014)

Source: Bloomberg
During 200809, 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 stapless 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.*
2
0
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4
6
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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 countrys 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 rate
1
in India estimated to increase to 40% by 2030 from 30% in 2008 (source: 2010 Mckinsey
Report Indias 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
Nigeria
Bangladesh
Mexico
Philippines
Ethiopia
Vietnam
Egypt
Iran
Germany
Turkey
Myanmar
Thailand
UK
France
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%
G
D
P

g
r
o
w
t
h
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 companiess 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 USD70100 million by
improving operational productivity.
Snacks & Beverages Pepsi Co.
Pepsi Co. announced a five-year annual productivity plan for 201319. 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 USD550600 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 targets 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 Cos new soda dispenser, Spire, allows customers to create up to 1000 different soda drinks.
This dispenser was primarily launched to improve competitive positioning vis--vis Coca-Cola that has been operating Freestyle
Africa/Middle East Asia-Pacific
Europe Latin America and Caribbean
US and Canada
11.2
10
8.9
10.7
10.9
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10
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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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October 17, 2014

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