The Consumers Staples sector served its purpose as a refuge of sorts from the collapse in equity prices in 2008, falling "just" 17.7% compared to a 38.5% for the S&P 500. Given its lack of sensitivity to the overall economy (better earnings stability) and higher dividends than most other sectors, we shouldn't be surprised by this performance.
The members of the group have well-known brands and strong reputations and pay high dividends relative to the market (3.3% dividend yield now compared to 2.9% for S&P 500). It's 41 members comprise 8% of the stocks in the S&P 500 and now almost 13% of its market cap, historically a high percentage. At the end of 2000, the sector was a rather low 8.1% of the market cap, while at the end of 2002 (after the Bear Market ended), it was just 9.5%.
While it is difficult to wonder why many of the stocks have held up well, one has to question if perhaps investors are not considering some of the potential negatives within this group. As you can see in the table below, the top 10 names, which represent almost 3/4 of the market cap of the sector, are indeed well-known names, with reasonable PE ratios and fairly generous dividends.
In the far columns, I share some data regarding my concerns about companies in general but perhaps especially in this sector, where many have sought to hide without necessarily thinking through how this economic crisis could impact the group. These companies tend to have a lot of debt and little or no tangible equity. While it is hard to envision dramatic sales declines for many of these brands, I do see several sources of potential earnings pressure:
- Substitution of generic goods
- Price competition as input prices potentially fall
- Higher corporate taxes
Most importantly, higher interest costs as debt is rolled over
In November, I shared my views on a Consumers Staple stock that I thought was relatively attractive to the group, Hormel (HRL). The article inspired a comment asking my opinion of one of the members of the broad peer group that I had included, Kraft (KFT). I appreciated the inquiry, as it got me to focus on they type of stock upon which I don't normally invest a lot of time or thought and, in fact, provoked me to start hunting for stocks that have too many financial obligations that don't seem to be properly reflected in the stock valuation.
After looking at KFT in more depth, but still from a 10k-foot view, I believe indeed that the stock is overvalued. The crux of my argument isn't that the company will encounter any problems that ultimately impact its operations, but rather that declining profitability, primarily due to lower earnings, could pressure the stock and potentially yield a cut in the dividend.
KFT began its public life (again) in 2001, when it was spun out of Phillip Morris (MO). It's been pretty much a non-event in almost all regards thus far, with the price not too far from its initial $31 IPO level, weakening margins offsetting some sales growth (some of which has been through acquistions) and valuation in a narrow range:
One can't dispute the incredible cache of brands in its stable, with 9 of them $1+ billion: Kraft, Oscar Mayer, Philadelphia, Maxwell House, Nabisco, Oreo, Jacobs (cofee), Milka (chocolate), and LU (biscuits). The business is primarily NorthAmerican, but International growth has been strong over the past few years (especially with weakening dollar and a large acquisition and disposition discussed below). Since the end of 2005, European sales have grown from 14.6% to 26.6%, while Developing Markets revenue has increased from 8.1% to 16.5%. The company, which has been restructuring significantly, now reports 6 North American segments:
- Beverages (7% of sales)
- Cheese (9% of sales)
- Convenient Meals (10% of sales)
- Grocery (8% of sales)
- Snacks (12% of sales)
- Canada and Foodservice (10% of sales)
Clearly, the North American business is quite diversified. On the one hand, the company could benefit from the shift towards home-prepared meals, while on the other hand, many of its brands could be subject to down-trading as well as lower demand (snacks, for instance). The international business is now huge and faces difficult year-over-year comparisons given the strengthening of the dollar.
The major events impacting the company besides the restructuring are the disposition of Post cereal late last year for $2.8 billion as well as the purchase of LU for EUR5.1 billion (about $7.6 billion). The company issued a boat-load of debt to pay for LU and then used the Post proceeds to purchase a ton of stock. The company's booked gain boosted GAAP profits and the share repurchases, all at higher prices, have helped improve the EPS outlook to some degree. One has to wonder if these two factors have shielded the stock somewhat. One also has to question the timing of getting out of something as basic as cereal and into the more discretionary "biscuit" area (as well as increasing exposure to the Euro at elevated levels).
The 10-K lists several risk factors, some of which merit mention:
We operate in a highly competitive industry, which may affect our profitability.
Our brand image may be challenged to compete against lower−priced private label items, particularly in times of economic downturns.
Consolidation of retail customers may affect our operating margins and profitability. In addition, the loss of a significant customer could significantly affect our results of operations.
In an economic environment like the current one, especially in an industry where levels of indebtedness are quite high, margin pressure should continue. Trade-down is happening in many ways already, and continued pressure on the consumer should only exacerbate this trend. Finally, as Wal-Mart (WMT) continues to gain share and marginal stores close their doors or retrench, suppliers, like KFT, lose bargaining power.
The picture I am trying to paint is that the company will struggle to grow sales and earnings. Sales growth of 21% this year has been boosted by LU (9.2%), higher pricing (6.4%) and currency (5.0%). Adjusting for other factors, organic unit growth has been slightly negative. The company currently has $20.6 billion of debt (and $700mm of cash), up from $12 billion in net debt a year ago. Annual interest expense has ballooned to about $1.2 billion, leaving the company in a weaker position should sales or margin pressures emerge. The company has shifted a great portion of its short-term borrowings to longer-term already, pressuring overall borrowing costs by moving out the curve. The company has principal payments of about $700mm in each of the next 3 years, but a much larger amount due in 2012-2013 of $7 billion. While clearly there is no imminent threat, one has to question future profitability if growth remains tepid or deteriorates and borrowing costs remain high.
Many of the growth drivers should be questioned as the tough economic environment lingers. Should the company continue to payout 61% of its earnings to dividends, a level that is quite high even for the sector? Does it make sense for the company to continue to repurchase stock? Can they keep doing "accretive" acquisitions (i.e. borrow even more)? Can they sell assets to reduce their debt levels? I have believed for many years that the companies in this sector have borrowed way too much money to boose return on equity. KFT certainly fits the bill. It seems like the stock has many things working against it, including tougher comps as LU acquistion and the Post divestment anniversary, currency headwinds, potentially weaker demand in many of their segments due to trade-down or shift in preferences, the risk of higher refinancing costs on its debt (6.75% for 5 years a few weaks ago, well above the current average of about 6% on the rest of its debt), increased buying power among its consolidating customer base, the prospect for higher taxes (affects more than just KFT) and a large valuation premium to the overall market.
While the scenario I have discussed would probably lead to a decline in the stock price, it is worth considering the alternative of a rapidly recovering economy. In that scenario, one has to wonder how fast the exit doors would be swinging as investors piled into bargains in other sectors. The only scenario that probably justifies continued investment in KFT is a continued weak economy with more crowding into the sector. I conclude that the market is somewhat blind to the risk at KFT. I would take the 5-year bonds yielding over 6% compared to the stock with its 4.24% dividend yield.
Disclosure: No position in KFT, but long HRL