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

portfolio 5th heaviest weighted sector after IT, Financials, Health Care & Energy in the S&P

Portfolio

Sector DemographicsSector 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 Top 10 Market Caps in the sectorsector SIM holds Wal-Mart stores, P&G, Pepsi and Philip Morris in its portfolio

Market Cap numbers in $ billions

Sector Returns for last 5 Sector Returns for last 5 yearsyears 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 & 2010Sector Returns 2009 & 2010 11.2% returns for the whole year of 2009 - 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 2030. 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 94-2010 Sector DPS 94-2010 Sector Cash Flow/share 01-2010

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 cuttingso 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 levelso 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 too 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 levelso 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