The share prices of some consumer-focused companies could improve in 2007, thanks to rising sales, improving margins and external factors, equity analysts say.
Area of Coverage: Packaged Foods
Outlook: The next big thing we see ahead for the food industry is activism. We do not see the food industry returning to an era of large-scale acquisitions. This isn’t to suggest that deals cannot be done, but that they are likelier to be of the smaller, bolt-on variety.
Large-scale acquisitions increase revenues and sometimes benefit economies of scale, but they also carry significant integration risk. The hard lessons of some past deals — such as the General Mills acquisition of Pillsbury and Bestfoods by Unilever — may still resonate in the collective memories of management teams.
We believe that shareholder activists, frustrated by disappointing stock performances and lackluster earnings growth, could initiate the next dominant trend. Activism is a lower-risk strategy that requires less capital. Shareholder activist models could be similar to that of Nelson Peltz’s Trian Group, which is attempting to gain control of five seats on the H.J. Heinz Co. board of directors.
We think that this kind of activism could lift share prices. Our new tool, the “Activism Matrix,” estimates susceptibility to shareholder activism. It measures traits that shareholder activists might find attractive, such as deteriorating sales-to-assets and P/E ratios. Based on our analysis, we believe that Institutional Shareholder Services, an independent company whose core businesses include global proxy services for institutional investors, will recommend that investors approve at least part of Trian’s dissident proxy.
Although the food space should continue to outperform the S&P 500 over the next few months, we believe the party may be coming to an end. We think that Nelson Peltz has hit a nerve, and that further investor activism in the food group might be on the horizon. Because the group has underperformed expectations, in our opinion, it might be attracting interest from investors who desire direct board representation.
Outperforms: Campbell Soup (CPB), Dean Foods (DF), General Mills (GIS), Hain Celestial Group (HAIN), Heinz (HNZ), Hershey (HSY) and Kellogg (K)
Top Pick: Kellogg
Why Kellogg? This company remains one of the least risky stories in the food space. We are confident that Kellogg’s sales will continue to grow. The company has raised prices in numerous categories recently — most notably cereal in the U.S. — where list prices had not been lifted in two years. Overseas revenues continue to grow at a healthy pace (something not every food company can say), as Australia and the U.K. rebound and the market share expands in Latin America.
Kellogg’s valuation is at the large-cap group average — too low, we think, for a company in which EPS may grow 10 percent-plus each of the next three years. Taking into consideration, Kellogg’s commitment to spending on marketing and R&D, we see a relatively low risk of underperformance.
John W. Ransom
Area of Coverage: Health-Care Services; Drugstore Chains
Outlook: Drugstore chain stocks have recently experienced very substantial pressure, first with concerns over Wal-Mart’s $4 offering on 300-plus generic drugs, and then by news of the First Databank settlement and potential reductions to benchmark average wholesale prices (AWPs).
We do believe, however, that the larger drugstore chains are better insulated from these shocks than their sell-offs would indicate. For instance, Wal-Mart, CVS and Walgreen have already stated that market share erosion in the Tampa, Florida, test market has been limited to one prescription per store per day and that the average co-pay on the roughly 300 generics in question is already around $5.
This minimizes incentives for already-sticky customers to move prescriptions over to Wal-Mart. Furthermore, Wal-Mart’s offering covers older, low-cost generics that largely benefit the cash-pay customer, which comprises less than 5 percent of prescription-drug (or Rx) sales at both chains. There is some long-term risk associated with Wal-Mart’s decision to expand the offering later this year, as well as to continually update the generic list, but certainly this is a more manageable threat than originally feared.
Overall, we continue to regard drugstores as one of the most favorable investment opportunities within our coverage universe. The increasing utilization of generic drugs and Medicare Part D are key near-term catalysts for group profitability.