From the December 2008 issue of Research Magazine • Subscribe!

Ports in the Storm

As prices for raw materials fall and consumers look for bargains, certain industry sectors, sub-sectors and companies are poised to benefit, equity analysts say.

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Alexia HowardAllianceBernsteinAlexia.howard@bernstein.com212-407-5941

U.S. Food: After six years, commodity cost inflation looks set to ease: Food companies look poised to see significant relief as year-on-year dairy inflation has already fallen below zero in recent months.

Class 1 milk prices have dropped to $15.53 for October [as of October 13], which represents a 28 percent year-on-year decline, and cheese price inflation on the spot markets is now negative. Wheat is by far the most important grain input for the U.S. packed food companies, since wheat flour is used in many different categories including cookies and crackers, cereals, refrigerated doughs and waffles.

Year-on-year wheat inflation on the spot market has now turned negative for wheat after spiking to $10 per bushel at the end of August 2007. Today, wheat prices are sitting at just over $7 per bushel.

If history repeats itself, a recovery in margins could be quite quick: Historically, the U.S. food group has tended to outperform the S&P 500 as commodity costs have moderated. In years when commodity cost pressures ease, gross margins have expanded quickly, for example, in 1981-82, 1985 and 1990.

Whenever commodity costs rise sharply, as they did in 2007, companies are often locked into promotional price points with retailers for some period of time, perhaps as long as four to five months in some categories.

The companies, therefore, experience a period where they are bearing the brunt of input cost inflation, but are unable to take pricing to compensate for this. As a result, margins typically get most compressed when commodity costs first begin to rise, but this effect is reversed once the anniversary of the initial input cost increase is reached, creating a "sweet spot" of rapid margin recovery.

The top line should remain strong for the U.S. packaged food group, although "trading down" will likely suppress volume growth: In contrast with investor concerns, we do not expect a sharp slowdown based on our analysis of the market data, since:o Branded packaged food companies have not seen a significant slowdown in dollar sales growth momentum, despite the recent acceleration in price growth.o Price elasticity of demand remains low.o Although we are seeing share losses for some companies, these have been modest and generally more than offset by strong category growth. o For many categories, we are actually seeing an improvement in volume trends once the anniversary of the initial price increase in the category is reached.

In 3Q08, we expect strong earnings results from Kraft Foods and Dean Foods, with weaker results for Sara Lee, Kellogg and Hershey. In general, we expect strengthening performance among the packaged food companies, especially among those that have seen significant margin pressures in the past year from rising dairy costs. However, we expect continued weak performance from Hershey. We rate Dean Foods, Kellogg, Kraft and Sara Lee Outperform with target prices of $31, $63, $41 and $18 respectively. We rate Hershey Underperform with a target price of $31.

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Andrew LazarBarclays Capitalalazar@barcap.com212-526-4668

Food: Perhaps the most important takeaway from our updated commodity-cost analysis is the sizeable directional shift in inflation from '08 to '09. While '08 levels of inflation remain quire onerous despite the recent easing in key inputs, our early take on '09 pains a much more moderate (1.2 percent) inflationary picture.

Specifically our early estimates for '09 suggest inflation at a much more moderate pace of around 1.2 percent. ... [I]t's clear to us that '09 is setting up to be a year of much more modest inflation for the group than the food industry has seen in the last several years, but still inflationary nonetheless.

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Neil CurrieUBSHYPERLINK "mailto:Neil.currie@ubs.com"Neil.currie@ubs.com203-719-3070

U.S. Drug Retail: Rite Aid Corp. (RAD) and Walgreen's (WAG) reported September sales with varied results. Rite Aid reported a total [comparable sales growth figure] of 1.2 percent including a 1.0 percent [jump] in prescription and 3.4 percent in front-end, driven by front-end improvements at acquired stores. Walgreen's reported a total of 4.7 percent, 6.5 percent and 1.3 percent [respectively], yet after adjusting for calendar shift, results were disappointing in our view.

Valuations in the industry are down; we reiterate our Buy on CVS Caremark in part due to its superior retail execution and inexpensive valuation.

We feel investors have not given CVS credit for its pharmacy-benefit management (PBMs) business, nor its superior retail execution. CVS trades at 9.8 times our CY09 EPS estimate of $2.69 [as of October 30], a 5.1 percent discount to Walgreen's and a 26.8 percent discount to an average of pharmacy-benefit managers.

CVS reported 3Q08 adjusted EPS from continuing operations of $0.60. Results of 60 cents were inline with Street expectations, which conveys to us a quarter that demonstrates a level of consistency not seen from many retailers today. The quarter included solid performance from both the retail and pharmacy-benefit management segments.

Sales held, but profitability was the bigger story. The company reported total comparable sales of 3.7 percent, prescriptions of 3.8 percent and front-end of 3.3 percent, which met with consensus in total but with weaker than expected prescription and a stronger front-end. However, gross margins picked up 60 basis points year-over-year to 30.4 percent, which helped the company meet expectations despite the broader macro backdrop.

Pharmacy-benefit management performance is strong. Revenues and operating profit came in largely as we expected, marking a solid quarter, which was void of PBM news or catalysts. We believe 2009 will be a pivotal year for the segment and anticipate more detail on net new contract wins for the upcoming year.

Valuation is inexpensive; we reiterate Buy and our $46 price target. We feel investors have not given CVS credit for its PBM business, nor its superior retail execution. CVS trades at 9.8 times our '09 EPS estimate of $2.69, a 5.1 percent discount to Walgreen's and a 26.8 percent discount to an average of PBMs (Medco Health Solutions and Express Scripts). Our $46 price target assumes shares will trade at 17 times our '09 estimate, derived through a P/E valuation.

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Eric BenderBrean Murray Carret & Co.bedere@bmur.com212-702-6619

We are maintaining our Buy rating and $10 target price on 1-800-Flowers.com (FLWS) and marginally tweaking our estimates after the company announced better-than-expected 1Q09 results, reiterated bottom-line and EBITDA guidance, but trimmed top-line growth expectations.

We believe management continues to do the right things in this current environment by focusing on operating drivers to register strong bottom-line results. We also view the material expansion into gift baskets and taking advantage of [rival United Online's] FTD merger to grab greater market share at [the floral-ordering wire service] BloomNet as key positives for the future.

We believe FLWS remains in solid shape to materially beat out projections when the consumer returns; given current valuations of approximately 10 times our FY10 EPS projection, we are more than content to wait.

The company's key gift basket division, DesignPac, will be the key to holiday upside and will emerge as a materially more important driver going forward. After a dilutive quarter, DesignPac is set to shine in its primary selling season (Christmas); we believe it will provide the vast majority of our protected 14.7 percent revenue increase for 2QFY09. Looking forward, we believe DesignPac will allow for a number of future synergies for the company, which should drive higher margins and top-line growth.

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Janet Levaux, MBA/MA, is the managing editor of Research; reach her at jlevaux@researchmag.com.

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