From the December 2009 issue of Research Magazine • Subscribe!

December 1, 2009

Strategically Positioned

The current economic environment means that a select group of companies can improve short-term results while executing long-term strategies.

Alexia Howard

Alliance Bernstein

212-407-5941

alexia.howard@bernstein.com

Packaged Food: We expect sales growth to increase slightly going forward. We expect operating margins to expand going forward.

The U.S. Packaged Foods sector expanded gross margins by 70 - 100 basis points annually during the '80s & '90s and by 45 bases points from '00 - '03, until the wave of input cost inflation that hit in 2003.

The U.S. packaged food group looks much more attractively valued today than it was in the fall of 2008.

Kraft: Outperform; target price of $37. Kraft's gross margins declined by 155 basis points per year in 2004/5 as commodity costs rose by more than $800 million per annum and then fell again in 2007 as dairy prices spiked.

Today, we are just starting to see the benefits of easing commodity costs on margins, especially as dairy prices roll over.

Moreover, a recovery in beverages and the EU is coming through now that the Tassimo [hot-beverage system] strategy has been revised. Over time, we believe that Kraft can improve its operating margins from 12.3% in 2008 to over 16% as margins normalize in U.S. beverages, U.S. cheese and Europe.

Volume/mix growth has been sluggish as of late, but we believe an improvement is imminent given: Increasing promotional spending and list-price reductions in select categories; lapping the anniversary of SKU reductions and elimination of inefficient trade promotional spending; and higher marketing spending in key categories as commodity pressures ease.

Campbell Soup: Outperform; target price of $41. Overseas, Russia and China hold huge potential for growth, given that the two account for more than 50% of today's global soup consumption.

An improvement in organic growth appears imminent in fiscal year '10, particularly given promotional activity as well as the re-launch of Chunky soup with a healthier focus. In the near-term, margins should start to benefit from slowing commodity cost inflation (from 7-8% seen in fiscal year '09 down to 2-3% in fiscal year '10) as well as productivity improvements.

Moreover, we believe that the "premiumization" of the soup category should benefit the company in the U.S. once the U.S. consumer recovers.


Kellogg:
Outperform; target price of $62. Kellogg has the strongest portfolio in the U.S. Food group given its strong market shares, its participation in high-margin categories, its strong track record on brand support and innovation, and its successful integration of large- and small-scale acquisitions in recent years.

Kellogg has an earnings growth engine in Latin America, where it maintains higher margins (~20%) than in its core U.S. business (~17%). There, there is ample room for cereal growth as well as the opportunity to piggy-back snacks into the market on top of existing cereal distribution infrastructure.

We are likely to see substantial margin recovery ahead of conservative management guidance given commodity cost pressures are easing and productivity improvements are kicking in.

We [also] rate Dean Foods: Outperform; with a target price of $26.

Andrew Lazar

Barclays Capital

212-526-4668

Andrew.lazar@barcap.com

Packaged Food: Thinking for a minute about what would matter most if investors removed themselves from the rapidly changing, near-term issues coloring the Packaged Food landscape (deflation, potential loss of pricing power, consumer weakness, etc.) and considered the industry in a more normalized environment, we cannot help but focus on the improving quality of earnings in the group.

In our view, this has been brought on by an evolving approach to productivity, with companies going from large restructuring waves (and associated one-time charges) to more consistent reinvestment against cost savings projects that is fully imbedded in their ongoing profits and losses.

By our estimation, we would expect non-recurring restructuring charges for the Packaged Food industry to correspond to approximately 1% of industry operating profits in 2010. This would put these one-time charges at the lowest level struck since 2003 and would represent a dramatic reversal from the double-digit levels of the late 1990s and early 2000s. Importantly, we think this phenomenon could be somewhat more sustainable for the group going forward, and therefore has positive implications for group-wide returns and associated stock performance.

From a company-specific perspective, we believe this thought process could be most impactful and positive for those food companies having only more recently made the transition to this approach, such as Kraft and Heinz.

Kota Yuzawa

Goldman Sachs

+81-3-6437-9863

Kota.yozawa@gs.com

Autos: A rash of larger-than-expected guidance hikes were announced with first-half results on better-than-expected production volume, cost cuts, and sales finance earnings growth. However, we think the market's focus is already shifting to a decline following the end of government support. We think Japanese automakers will post 5 percent volume growth in the fiscal year of March 2011 on growth in North America and Asia.

In response to first-half results, we have revised our coverage preference ranking based on regional and cost differences. We are most bullish on Honda among the Japanese Big Three, as Honda's operating margin improved to 3.2% in 2Q3/10 on relatively high capacity utilization and aggressive cost cutting.

The automakers in our coverage raised consolidated sales volume guidance by 830,000 units when they announced first-half results. They raised guidance by 160,000 units in Japan, 160,000 in North America, and 520,000 in Asia and other regions, while cutting volume guidance in Europe by 10,000 units. Inventory had been substantially reduced by end-March 2009, and a recovery in sales volume driven by government assistance measures meant retail inventory shortages in some regions. We think sales momentum will remain strong at least until March 2010.

Toyota: The positive catalysts we anticipated--an upward revision to FY3/10 consolidated sales volume guidance to 7.05 million units from 6.6 million, sharp earnings improvement in the sales financing business, and a return to quarterly operating profits in 2Q--appear to have all played out in 1H results.

With FY3/10-FY3/11 consensus estimates still 20%-30% below our forecasts, we think the overshoot in sales volumes has not been priced into the shares. We estimate one-off expenses in FY3/10, including the F1 withdrawal and NUMMI plant closure, will come to around ?100 billion. With these costs disappearing in FY3/11, we see strong prospects for an earnings recovery.

Toyota raised volume guidance significantly to 7.03 million units from 6.60 million units, close to our forecast of 7 million units. The company assumes a second-half U.S. seasonally adjusted annual rate of 9 million units, and we think it will raise guidance by another 200,000 units or so. Similarly, we think other automakers could raise sales guidance further, mainly for the United States.

Tom Gallucci

Lazard Capital Markets

212-632-1515

thomas.gallucci@lazardcap.com

Pharmacy Benefit Managers (or PBMs) remain in the sweet spot of secular trends. We view the pharmacy benefit management business as the strongest in our coverage universe, with the group well positioned to take advantage of key secular trends. Visibility on long-term earnings growth in the high-teens range or better remains very high due to a combination of factors, including rising generic penetration, robust growth of specialty drugs, and the continued motivation of payors to use the tools that PBMs have to offer in an effort to control drug spend.

Together, the positive underlying fundamental trends should drive high-teens long-term EPS growth, on average. That said, the group should drive even better growth in some years (i.e., 2011-2013) depending on market dynamics, with the single greatest variable being branded-drug patent expirations. From a stock standpoint positive fundamental drivers are well recognized, fostering the premium at which PBMs trade on certain valuation metrics relative to other healthcare services names.

However, the group currently trades near its historical low relative to the market multiple, not to mention well below its average P/E, P/E/G, and EV/EBITDA multiple over the past five years. In our view PBMs enjoy solid overall earnings visibility on growth that is as high as it has ever been and which is materially better than the market, suggesting the opportunity for shares to outperform over the next year.

CVS: While the 2010 earnings outlook is disappointing, the relative valuation of shares offers a positive risk-reward opportunity over the next year. We are adjusting our to $37 based on shares trading at 12 times 2011 estimated EPS over the next 12 months. Perhaps the number one issue for the stock over the next year will be how next year's selling season turns out, i.e., CVS' execution in the coming quarters. ?

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