From the June 2010 issue of Research Magazine • Subscribe!

Consumer Sectors: Ready to Spend

The economy continues to show signs of improvement, which means that consumers should open their wallets soon and start spending more.

Jon R. Andersen
William Blair & Company
312-364-8697
jandersen@williamblair.com

Alberto-Culver's (ACV) portfolio of leading personal care brands (No. 4 in U.S. hair care), brand-building talent (five-year compound annual sales growth of 8 percent), and track record of value-enhancing acquisitions position it as one of the better long-term growth opportunities among mid-cap stocks in consumer products, in our view.

We believe the company can improve margins at an average rate of 80 basis points per year, driven by favorable product mix and restructuring-related cost savings.

We project long-term annual revenue growth of 6 percent to 7 percent and EPS growth of 13 percent.

We believe upside is possible in the near term, given contributions from new products and restructuring, and for the longer term, as a conservative balance sheet and scalable infrastructure provide for accretive acquisitions and share repurchases.

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Mark Wiltamuth
Morgan Stanley
212-761-8589
Mark.Wiltamuth@morganstanley.com

Our Alphawise PBM (pharmacy benefit management) consultant survey suggests that CVS Caremark's (CVS) PBM business is stabilizing, with 47 percent of consultants indicating the company could gain share in the current 2011 selling season versus 19 percent expecting a share loss.

We continue to see valuation expansion potential in CVS shares as PBM prospects improve. Applying a drugstore valuation of 7.5 times EV (enterprise value)/EBITDA to the CVS retail operations, we estimate that the PBM is trading at 8.0 times EV/EBITDA, an approximate 30-40 percent discount to the PBM competitors Medco and Express Scripts (at 10.7 times and 12.0 times respectively).

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Neil Currie
UBS
203-719-3070
neil.currie@ubs.com

Based on recent state filings, it appears that CVS Caremark may have taken a $1 billion PBM contract from Express Scripts (ESRX) for a midyear 2010 renewal in the State of Massachusetts.

The state's Group Insurance Commission (GIC) voted recently to contract with CVS Caremark, thereby replacing Express Scripts, who held the contract for 8 years. The fact that CVS "is a local company with a large network of retail pharmacies" was cited as at least part of the reason for the switch.

The new contract with CVS will commence July 1, 2010, and will run for 3 years. Massachusetts GIC estimates the contract value at $1 billion.

Given that this contract likely generates annual gross revenues in the $300-350 million range, and if we further assume that mail penetration rates and margins are in line with current corporate averages, this contract is likely worth only $0.01 in incremental annual EPS for CVS.

We believe this contract is a major positive for investor sentiment (even though we estimate it only adds a penny to EPS); we are leaving our 2010 and 2011 EPS estimates of $2.84 and $3.20 unchanged.

We maintain our Buy rating on CVS as we believe the contract win and positive comments regarding the selling season made by management at a recent conference may improve sentiment. Our $40 price target assumes shares trade at 14 times our 2010 EPS estimate of $2.84.

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Edward Aaron, CFA
RBC Capital Markets
edward.aaron@rbccm.com
595-1127

Kellogg reported a sizeable Q1 beat. Q1 EPS of $1.09 compare to our estimate of $0.95 and consensus of $0.94 on sales of $3.318 billion (consensus $3.291 billion). Though sales were a touch light of our forecast ($3.327 billion), organic growth of 1.8 percent exceeded our 1.2 percent forecast.

With gross profit in line with our forecast, the beat relative to our estimate came mostly from SG&A ($0.10 benefit), helped by timing of ad spending, and a lower tax rate ($0.05 benefit).

"Upfront" charges were $0.03 in the quarter vs. our $0.04 estimate.

While there were puts and takes, overall trends appear decent. The snack business performed very well, and management confirmed significant operational improvements in the Eggo business.

Management reaffirmed constant currency EPS guidance (+11-13 percent) despite higher anticipated inflation pressures. Kellogg now anticipates +3 to +4 percent fiscal year (FY) '10 cost inflation (previously +3 percent), but expectations of strong productivity gains (4-5 percent of cost of goods sold) enabled management to maintain its 100 basis points gross margin expansion target.

We left estimates largely unchanged, but remain above the Street. Changes in timing of ad spend, buyback assumptions and currency preclude us from passing through much of the Q1 beat. Even so, our FY'10 $3.63 estimate is $0.08 above the high end of guidance and $0.04 above consensus.

Our $62 price target values Kellogg at 15.5 times our calendar year (CY) '11 estimated earnings of $4.01 and 10 times our CY'11 EBITDA estimate of $2.7 billion.

This valuation represents a premium to our sector target multiple of 15 times. In our opinion, a premium multiple is warranted for Kellogg due to its superior competitive positioning and quality brands, its track record of under-earning and solid re-investment in its brands and P&L benefits from recent restructuring.

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Vincent Andrews
Morgan Stanley
212-761-3293
Vincent.Andrews@morganstanley.com

We are maintaining our $3.57 estimate, which now incorporates a $0.02 foreign exchange (F/X) headwind relative to flat F/X guidance at 4Q09 and a $0.05 tax benefit that we expect to be offset by fewer share repurchases relative to previous guidance.

Investors' principal 2010 concern with Kellogg had been its "just" 2-3 percent organic top-line growth guidance as well as a likely back-half loaded year. With 1Q top line strong despite tough comps and a 4Q09 US cereal trade load, we believe those concerns are largely behind us.

Nonetheless, at this point in the year, we continue to model 3% internal net sales growth and 10% internal operating profit growth (both at the high end of management guidance).

Kellogg is one of the most predictable and the highest quality earnings growth companies within our packaged food universe driven by: (1) superior operating fundaments; (2) superior innovation; (3) broad-based market share growth; (4) above-average advertising spending (enhances business model sustainability); and (5) commitment to returning cash to shareholders (i.e., $1.3 billion in repurchase authorization available through 2010).

Management maintained its 2010 guidance that calls for 11-13 percent currency-neutral EPS growth. Management continues to guide to +2-3 percent internal net sales growth and expects 8-10 percent internal operating profit growth.

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