Panchanathan Arthaballe C. Nishanker Damodara Student Investment Management

 Sector Size and Composition  Business Analysis  Economic Analysis  Valuation Analysis  Financial Analysis  Portfolio Recommendation

 A category of industries comprised of those companies which sell the most common consumer products, such as food, beverages, house wares, clothing, tobacco and prescription drugs. (Investorwords.com)  Sector’s products are viewed as basic needs, so demand is inelastic and relatively constant.  At what point can you not afford to buy toilet paper?

Size of the sector  S&P Market Cap - $1.1 trillion  5 th heaviest weighted sector after IT, Health Care, Industrials & Energy in the SIM portfolio  5 th heaviest weighted sector after IT, Financials, Health Care & Energy in the S&P Portfolio

Sector Demographics Industries segments in the sector  Agricultural Products  Brewers  Distiller & Vintners  Food Distributors  Household Products  Hypermarkets & Supercenters  Packaged Foods/Meats  Personal Products  Retail Drugs  Retail Food  Soft Drinks  Tobacco

Top 10 Market Caps in the sector  SIM holds Wal-Mart stores, P&G, Pepsi and Philip Morris in its portfolio Market Cap numbers in $ billions

Sector Returns for last 5 years  Had positive returns despite deep recession  The returns show gradual and consistent growth for the last 5 years and next 2-3 years

Sector Returns 2009 & 2010  11.2% returns for the whole year of Modest returns when compared to other sectors  -1.25% returns YTD (QTD, MTD) in 2010 – compared to -3.6% returns for all stocks in S&P

 Non-cyclical ◦ Inelastic demand of products makes sector a defensive play. ◦ Underperforms broader market during economic expansions. ◦ Outperforms broader market in times of economic contraction.  Competitive Pricing ◦ Pricing usually drives market share. ◦ Price usually supersedes branding as most important consumer consideration.

 High Barriers to entry ◦ Large initial capital outlays require EOS. ◦ New entrants face discounting barriers from established companies.  Substitution ◦ Undifferentiated, borderline-commodity products ensure customers are ready and willing to substitute.

International Domestic  Domestic Business: Mature Phase  International: Growth Phase

 Note: Figures are net revenues excluding excise taxes and the effect of currency fluctuations and acquisitions.

 Emerging markets ◦ “The World Bank estimates that the global middle class is likely to grow from 430 million in 2000 to 1.15 billion in The bank defines the middle class as earners making between $10 and $20 a day -- adjusted for local prices -- which is roughly the range of average incomes between Brazil ($10) and Italy ($20).”  Brand differentiation ◦ Hefty Brand Trash Bags vs Giant Eagle Trash Bags  Product customization ◦ P&G in the Philippines

 Supplier-Retailer Relations ◦ Margin Compression: the Walmart Effect ◦ Global Consolidation in Retail Space:  Walmart  Carrefour  Target  Excess Capacity ◦ High fixed costs ◦ Under utilization = worsening margins

 The Takeaway: the constant upward trend in revenues, DPS, and cash flows shows that the sector’s growth and performance is remarkably insulated from poor economic conditions. ◦ Despite two major contractions in last decade, the trend is consistently upward.  Sector Revenues  Sector DPS  Sector Cash Flow/share

 Macroeconomics over Microeconomics ◦ Unemployment rates ◦ GDP growth ◦ Commodity prices: inputs and energy ◦ Interest Rates  Exchange rate fluctuation. ◦ “Foreign exchange reduced P&G’s fiscal 2009 sales by about four percentage points, or approximately $4 billion, and profit by more than $1 billion.” (2009 Annual Report) ◦ Currency fluctuations can help or hurt the sector.

Financial Analysis

Revenue (Per Share)  Revenue per share expected to increase gradually in the coming years  At the S&P level, revenues are still decreasing post-Lehmann collapse

Earnings Per Share  EPS is set to increase due to o Consolidations in industries like soft drinks, packaged foods etc. o Realizing the value of job cuts and other cost cuttings o Expansion into relatively inexpensive global markets

EPS – Relative to S&P 500  EPS relative to S&P would decrease due to o EPS in other industries bouncing back to non-recession levels o The defensive nature of the sector

EBITDA Margin - Absolute  EBITDA margins have been increasing and is expected to increase for one or two more years due to o Consolidations in industries like soft drinks, packaged foods etc. o Cost cutting activities, employee layoff, outsourcing etc.

EBITDA Margin relative to S&P  EBITDA margins are always less than the overall S&P average due to the nature of the business in the sector – most of the products are commodity products and compete based on price and hence have lower EBITDA margins  EBITDA margins has been improving for the last two years as revenues have been increasing and hence achieving economies of scale

Net Profit Margin - Absolute

Net Profit Margin relative to S&P

Return on Equity - Absolute

Return on Equity relative to S&P  ROE relative to S&P would decrease towards historical levels due to o Revenues in other industries bouncing back to non-recession levels o The defensive nature of the sector

 Revenues is expected to increase gradually and also relative to S&P  EPS is expected to increase  EBITDA Margin are expected to improve towards normal non- recession levels  Net Profit Margin is to increase gradually and also relative to S&P  ROE is expected to increase slightly but decrease overall relative to S&P

Valuation Ratios - Absolute  All the current valuation ratios are less than the median values for the past 10 years  P/FE, P/TE are very much less than the average because of doubts in  Long term growth potential (especially in volatile international markets)  Changing consumer habits

Valuation Ratios relative to S&P  All the current valuation ratios are less than the median ratios  Historically almost all valuation multiples for the consumer staples sector is greater than the overall S&P average

Forward P/E – Industry breakup  Brewers and Retail Drugs are trading at a very low P/E compared to their medians  Walgreens and CVS (Retail Drugs) are expected to a grow at much lower rates than pre recession levels

P/E – Trend over last 10 years

 All current valuation ratios are lower than the historical median  The valuation ratios have been expanding from the start of 2009  The ratios are expected to expand as doubts about economic recovery in various markets, consumer habits etc., are cleared over a period of time  Certain industries like Retail drugs, breweries are not expected to have pre-recession growth levels and hence valuation ratios are expected to be well below (contraction) the median for these cases

 The market has recovered too quickly and current valuations are inflated due to overly optimistic assumptions about the speed of a future recovery. ◦ History repeats itself… to a certain degree.  Expect a sharp correction in the near to midterm to be followed by very gradual growth.

 What should be a robust recovery will be hampered by: ◦ 1) Record government deficits. ◦ 2) Higher taxation. ◦ 3) Weakness in consumer spending. ◦ 4) Limited credit and lending due to higher lending standards. ◦ 5) Potential for inept government actions.

 Increase weight of Consumer Staples sector by 30 basis points to 12.26%. The current weight of the sector is 11.96% compared to S&P’s 11.65%.  Provides a defense against a market pullback.  Still in a position to benefit from the emerging markets growth story.  Market direction is currently uncertain and until it becomes more clear, it will be best to remain defensive. ◦ Signs of direction:  Unemployment figures.  Consumer spending and confidence data  GDP growth  Energy prices  Interest rates and FOMC minutes