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September 4, 2012

Earnings Roundup: Mining the Consumer Staples Sector for Earnings Growth

by Greg Harrison.

Where’s the growth? In general, corporate management teams are even more bearish than analysts heading into the final weeks of the third quarter – except, that is, in the consumer staples sector.

With only four weeks left in the third quarter, and analysts and corporate CEOs and finance officers taking a decidedly bearish view of their prospects for third-quarter earnings, investors are trying harder than ever to identify pockets of earnings growth. On the surface, that looks as if it will be hard to do: overall, analysts are calling for earnings for companies in the S&P 500 index to fall by 2% over year-ago levels, and expect revenues to decline by 0.1%. Corporate forecasts take an even more dismal view of the future: the just-completed earnings season has produced 4.2 negative preannouncements for every positive one.

Nonetheless, while analysts forecast that five of the ten sectors of the S&P will see their profits fall for the third quarter, that means that the other half will see some gains – and some will hold up better than others, analysts believe. One of these is the consumer staples industry, which tends to hold up reasonably well during difficult environments as consumers continue to spend – but only on essentials.

As with most other sectors of the S&P, companies in the consumer staples group have seen earnings growth rates decline over the course of the last year, as seen in the chart below. Once again, analysts predict that the sector’s third-quarter profits will be lower than last year, and they have continued to trim their growth forecast from 5.2% in early July to only 1.9% today. However, guidance provided by the companies themselves suggests that analysts may not be giving them enough credit – a contrast to the typical picture of the picture in the third-quarter. During the fourth quarter of 2011 and the first quarter of 2012, guidance in this sector was far more negative than it was for companies in the rest of the S&P 500 index, but that shifted beginning in the second quarter, as managers began to take a more upbeat view of their prospects. Indeed, as of today, the consumer staples group is the only S&P 500 sector to be able to boast that more of its companies have provided positive guidance than warnings.

There are reasons for this improving sentiment. An uncertain economic outlook causes consumers to think about eating at home instead of dining out – a boon for grocery store chains. (Admittedly, this is a limited source of growth for companies catering to these consumers.) In emerging markets, however, we have seen an increase in average incomes and general prosperity bring many of the products sold by these companies within the reach of large segments of the population who previously couldn’t have afforded them, from imported toothpaste to packaged foodstuffs. What appears to be a mundane purchase at Wal-Mart Stores (WMT.N) for an American shopper can be an exciting rite of passage for a newly-affluent member of China’s burgeoning middle class.

H.J. Heinz. Co. (HNZ.N) is another company to benefit from the growing ability of Chinese consumers to afford mass-produced food products. The company beat analyst estimates in the second quarter, announcing earnings that were nearly 8% above analysts’ forecasts, and promptly raised its outlook for third-quarter earnings to 89 cents a share, above analysts’ estimates that the company would earn 84 cents a share. While China’s growth rate may have slowed, Heinz’s CFO, Art Winkleblack argued that the company is in a good position to take advantage of an “exploding middle class in these emerging markets … just coming into their own in terms of (their) ability to afford packaged food.”

Wal-Mart, too, remains focused on emerging markets as a source of growth. “We still have challenges in Brazil and China, and results won’t be quick,” said Charles Holley, the company’s CFO, during the second-quarter conference call. But, he added, “with the leadership teams in place, along with our focus on everyday low prices, we believe we are on the right path.” Within the United States, Wal-Mart continues to battle dollar stores for market share, but nonetheless, the U.S. operations contributed to the fact that it beat its second-quarter earnings and revenue estimates by 8.3% and 4.5%, respectively.

As consumers in the United States continue their relentless quest for value and discount pricing, and the emerging middle class in markets such as China continue to trade up and buy more imported consumer goods, the consumer staples sector is well positioned to end the third quarter as one of a handful of bright spots. It may well be worth examining companies that fall into this category for more opportunities, as the guidance companies are providing today suggests there may be more positive earnings surprise still to come.

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