Factors to Weigh on Consumer Staples Stocks in 2018

The U.S. market is currently in good shape and favorable economic indicators are likely to aid the performance of consumer staples companies. However, the improved economic scenario may divert investors’ attention from these defensive stocks to other lucrative counters.

Further, the Fed’s recent rate hike may make the dollar stronger against a basket of currencies, which is likely to hurt overseas profits and create an unfavorable environment for emerging economies. Though some emerging markets have started to witness improved trends lately, risks associated with operating internationally continue to act as deterrents for consumer staples stocks.

Also, responding to consumers’ rapidly changing preferences creates significant competition, price wars and an intense promotional environment. This remains a threat to margins, which have been squeezed for a while now. So, investors must assess the possible issues in the sector, before placing their bets.

Troubles Looming Over Consumer Staples Stocks

Strained Margins

Many companies in the consumer staples sector have been plagued by strained margins, stemming from various factors. These include tough grocery market conditions, rising input costs, costs associated with meeting consumers’ changing demands and stiff competition that leads to aggressive promotions and price wars. From grocery chains like SUPERVALU (SVU), food companies like Campbell Soup to consumer products companies like Church & Dwight (CHD), Colgate (CL) and Kimberly-Clark (KMB), all remain troubled by squeezed margins.

The grocery industry has been grappling with challenges like stiff competition and aggressive promotions, which became more pronounced after Amazon’s takeover of Whole Foods Market. Traditional grocery companies are facing competition from rivals, which are strengthening their franchises and offering alternative outlets for food and other staples.

Also, customers are more inclined toward private label products, which are low-cost alternatives to national brands. This, in turn is hurting food companies. Evidently, SUPERVALU has been facing stiff competition from grocery rivals in terms of innovative food offerings and related services. Going ahead, management continues to expect its business to be impacted by competitive pressure and price sensitivity existing in the market.

Input Cost Volatility

Input costs play a major role in determining the performance of a company. An increase in input cost directly hits the company’s margins and profits. Moreover, any price increase to offset the same may drive consumers away. We note that many Consumer Staples companies are bearing the brunt of high input costs, which remains a concern for the future.

Evidently, Smucker has been struggling with the performance of its coffee segment, as price of green coffee, the raw material used in producing coffee, has been rising steadily for some time now, affecting this segment’s profitability and gross margin. Consumer goods behemoth, Colgate also anticipates persistent pressure from increased commodity and packaging costs to impact gross margin.

Also, input cost inflation remains a cause of concern for Campbell Soup, Dean Foods, Church & Dwight and Kimberly-Clark. In fact, Kimberly expects commodity costs to shoot up mainly due to higher prices for several raw materials, including pulp and polymer resin. Input costs for some companies like Procter & Gamble (PG) have also increased lately due to the detrimental impact of hurricanes. However, this is likely to be just a short-term hurdle.

Volatile Emerging Markets

The majority of the global population is clustered in emerging economies. Thus, food/beverage companies are increasingly investing in developing and emerging markets like India, China and Brazil which boast significant growth potential due to relatively low per-capita consumption. Another reason is the burgeoning middle-class population with rising income levels, which in turn is increasing the demand for convenience food and beverages.

Though emerging markets offer strong growth prospects, they are generally volatile due to fluctuating currencies and other structural and political issues. Moreover, any unprecedented event that may impact economic conditions in countries like China, Brazil, Russia, remains a threat.

Higher Operating Expenses to Limit Profits

Consumer staple companies tend to spend heavily on marketing and advertising. As demand for staples is usually consistent, companies strive to increase sales and market share through innovations, promotions and efficient marketing and advertising. Though advertising strengthens brand appeal and helps to counter competition, it severely hits the profit margins of these companies. Also, efforts to keep up with consumers’ changing needs entail significant costs. In this regard, costs related to e-commerce development and marketing are likely to impact profitability.

Companies like Kimberly-Clark, PepsiCo (PEP) and Procter & Gamble have significantly stepped up their investments in marketing, innovation, R&D, supply chain and capacity additions, which may hinder profits. Pinnacle Foods has also been witnessing escalated marketing costs, and it expects higher freight rates associated with the hurricanes to linger.

Competition Rife

Consumer staples companies face stiff competition with respect to innovation, pricing, brand strength, promotions and responsiveness to evolving consumer trends. This results in lower pricing power and a decline in market share, which in turn compresses margins and earnings. For example, Kimberly-Clark’s diaper segment faces significant competitive activity, which puts the company’s market share at risk. Dean Foods also battles stiff competition, not only with various dairy processors for shelf space, but also with various beverages and nutritional products. Further, the beauty and beauty-related products industry is highly competitive, which remains a challenge for players like Avon Products and Coty.

Declining Volumes

Many consumer staples companies are struggling with declining volumes or soft volume growth, which is hurting their top line. Mondelez’s volumes have been weak since 2014 due to volume erosion from higher pricing and category weakness because of lower demand. Further, growing health and wellness consciousness has resulted in volume declines of carbonated drinks of PepsiCo and Dr. Pepper, while it has also been hurting shipment volumes of smokeable products of bigwigs like Altria (MO) and Phillip Morris. Another company that has long been battling soft volumes is dairy products company, Dean Foods.

Government Restrictions

Tobacco companies like Altria Group, Philip Morris and British American Tobacco are facing constant government regulations to make consumers aware of the health hazards associated with tobacco products. Per the court orders issued in November 2017, cigarette manufacturing companies will be forced to acknowledge the perils of smoking through corrective advertisements circulated via television channels, newspapers, websites, store displays and cigarette packs.

Moreover, in July, the FDA directed companies to lower nicotine in cigarettes to non-addictive or minimally-addictive levels. Additionally, cigarette consumption rates have declined globally due to precautionary labels and higher tax rates.

Further, the FDA had announced that tobacco makers must seek marketing authorization for any tobacco product introduced after Feb 15, 2007. In May 2016, the FDA expanded this restriction to include e-cigarettes, pipe tobacco, cigars and hookah alongside traditional tobacco products. Moreover, the European Union and the FDA have proposed a ban on menthol in accordance with the Tobacco Control Act which essentially states that menthol cigarettes have an adverse impact on public health.

These restrictions have lowered cigarette consumption and have significantly dented volumes. While this was for tobacco companies, alcohol stocks also remain vulnerable to government regulations. Distilled spirits are subject to excise tax in various countries. Thus, rising fiscal pressure in the United States, European and emerging markets may lead to increasing risk of a potential excise tax on spirits by governments of the respective countries.

Bottom Line

Though the consumer staples industry is faced with a number of problems, does the sector have anything to offer to short-term investors?

Check out our latest Consumer Staples Outlook for more on the current state of affairs in this market from an earnings perspective and the trend in this important sector of the economy.

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