Food and beverage producers are usually seen as non-discretionary items that are reasonably resilient during more difficult economic conditions, provided those conditions are not a full blown recession. But a Merrill report suggests that some of the valuations are overly optimistic. What should be a defensive play may not be because too many investors are using it as a defensive play, pushing up valuations. The de-leveraging is also not helping. Merrill is pretty bearish:
Growth over the past 6-12 months has been evaporating… Earnings growth for food and beverage producers and retailers operating in Australia has been declining over the past 2 to 3 years – with the rate of decline picking up markedly in the last 6-12 months.
Domestic food/beverage producers have suffered – highlighted by Coke Amatil’s Australian EBIT growth (in absolute dollars) falling from $48m 3 years ago to only $14m in the past year. And Goodman Fielder has recorded heavy falls in EBIT growth over the past 12 months…across all its Australian businesses.
Some multinational food producers (e.g. Kraft and Heinz Watties to name two) have seen relatively large earnings drops in recent years…with Kraft’s reported Australian EBIT falling from $116m in 2008 to $34m in 2010, and
Heinz’s reported EBIT falling from $87m in FY09 to $55m in FY11.
Food retailers needing to step up their earnings growth…a threat to industry profit… Given the investments made by the 3 Australian food retailers, their EBIT needs to increase by ~$1.3bn over the next 3 years if they are to make an acceptable return. And this is on a total EBIT pool of ~$4bn for the retailers.
In 1H12, the three food retailers delivered (collectively) ~$150m EBIT growth…far below the level of growth needed, in our view. A concern is that the retailers will step up their already intense efforts to increase earnings…causing, in our view, a worsening outlook for earnings for both consumer producers and retailers.
Can’t justify ~14x PER’s for stocks generating ~3% growthEarnings growth for Consumer companies look to be fading back to low single digit growth (at best) due to sustained price deflation (from over investment by retailers and a push by the retailers to increase profits via lower prices and increased volumes), and sustained increases in the cost of doing business.
Considering a dividend discount model, if earnings growth is 3% and the cost of equity is 10%, dividend yields should be around 7%. Currently dividend yields (broadly) for consumer companies are beneath 5%. And if capital spending does not generate acceptable returns, a further de-rating can be expected.
Food retailers to survive, suppliers facing even more painOur preferred stocks are Wesfarmers, Coke Amatil and Treasury Wine Estates… however, we highlight that in the current climate, there are risks to the earnings growth on the downside for all Australian consumer businesses.
Still in retail, Macquarie also has a pretty bearish view of Premier Investments, with only a neutral recommendation and saying that profits are hard to come by. Macquarie is forecasting 1H12 NPAT to be down 13% on the pcp. The reason it is not a sell is the cash state of the business:
PMV’s main attractions remain the balance sheet flexibility provided by the strong cash balance and the cost reduction programme underway that has the potential to provide some offset to the softer sales environment.
Not a bad tip about how consumer businesses should set up in the current environment.