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Industry Spotlight: Consumer Sectors

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The share prices of some consumer-focused companies could improve in 2007, thanks to rising sales, improving margins and external factors, equity analysts say.


Terry Bivens

Bear Stearns


[email protected]

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

Raymond James


[email protected]

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.

Generic drugs continue to outpace branded peers — generic scripts increased by 12.5 percent year-over-year vs. a 5.4 percent decline for branded drugs. Generic drugs carry 1.5-times more gross profit dollars per pill than their branded counterparts. As such, we believe that efficient drug stores generate roughly $10 in gross profit on the average branded drug vs. $15 to $16 on the average generic drug, despite the fact that generics carry a significantly lower price than branded drugs.

Given this outsize potential, we think drug store profitability will increase in 2006 and 2007 driven by an estimated $35 billion in branded drug patent expirations over a two-year period.

Outperforms: CVS (CVS) and Walgreen (WAG)

Strong Buy: CVS

Why the CVS Upgrade: CVS and Caremark recently announced a transformational “merger of equals,” combining the largest pharmacy benefit manager (PBM) with the largest drug retailer. The roughly $21 billion price for Caremark equates to 1.67 shares of CVS for each Caremark share. The deal is expected to close in six to 12 months.

While we understand the short-term confusion around the transaction (particularly, the strategic imperative and timing, given the risks to AWP-based Rx pricing), we view the merger as a potential windfall for CVS shareholders.

The company, with pro forma PBM market share above 25 percent, will gain considerable channel power, particularly with branded Rx manufacturers and managed-care plan sponsors. It will also be a financial powerhouse, with some $6.7 billion in pro forma year-one EBITDA and $40-plus billion market cap.

Following CVS’ strong 3Q06 earnings release and merger announcement, we are raising our 2006 EPS estimate by $.01, (conservatively) maintaining our 2007 estimate; and initiating a 2008 forecast of $2.11, including a modest $0.02 merger accretion and Jan. 1, 2008, closing date.

Finally, given the cheap valuation, potential strategic shift, and improved (unmatched) financial position of the combined entity, we are upgrading CVS shares from Outperform to Strong Buy. Our $40 price target represents 19 times pro forma 2008E EPS, in-line with the average 2006 multiple for CVS.

We continue to recommend CVS due to accelerating same-store-sales growth and market share gains in the pharmacy, as well as potential upside to 2007 earnings estimates driven by the integration of the 701 acquired Albertsons drug stores, along with the final integration of the roughly 1,100 Eckerd stores.

Looking ahead, we anticipate Eckerd’s blended contribution will remain strong as pharmacy trends (stickier than front-end trends) at the store base continue to improve. During the remainder of 2006, we expect profitability to continue to increase at the acquired stores through shrink improvement during the remainder of 2006 and 2007.

Turning to Albertsons, management recently announced, with its 2Q06 results, that the deal is on track to be $0.10-$0.12 dilative per share in 2006 — but accretive in 2007, aided by strong top-line opportunities, purchasing synergies, shrink improvement and the roll-out of the company’s extensive health and beauty-product offerings to the new stores.

Also, we believe the company’s sizeable pharmacy benefit manager, PharmaCare, is performing well ahead of expectations, with 2Q06 revenue growth of 23.5 percent and operating- profit margins improving about 200 basis points sequentially to 8.5 percent (by our estimates). In the near-term, we expect continued acceleration with the inclusion of the prominent roughly 280,000-life Daimler Chrysler U.S. contract, a marquee client that could spur future large-employer contract wins.


Ron A. Tadross

Banc of America Securities


[email protected]

Area of Coverage: Automakers

Outlook for the sector: The Big Three (Ford Motor Company, Daimler Chrysler and General Motors) are starting to avoid further volume-stimulating, price reductions because they have no margin. Over the next few months and quarters, the Big Three will need to cut already weak 1H07 production plans. If they do, the next thing to look for will be more concrete plans to cut back on fleet sales, rentals first.

We think fleet sales are the most significant short lead-time contributor to the $3,000 per unit (and worsening) Big Three U.S. residual value disadvantage. If the Big Three take these steps it should drag down margins/burn cash before capacity can be right-sized; it could take years to see the benefits in better retail pricing power/slower share loss; supplier problems should be exacerbated; and fleet prices could go up.

None of these steps will be easy for the Big Three, but the alternative is a continuation of weak pricing/margin quarters like we expect for 3Q06 (due solely to tough year-to-year comparisons).

Top Picks: Honda (HMC) and Toyota (TM)

Our Favorite: Toyota

Why Toyota: The fact that Toyota recently raised its target operating margin from 9 percent to 10 percent makes it increasingly clear that the company is comfortable with a new target margin range of 9 percent to 11 percent (up from 8 percent to 10 percent). The company has strong control over its margins because its vehicles are already low-priced (i.e. best U.S. three-year cost of ownership), the company invests in numerous initially lower margin, long-term projects (i.e. hybrid vehicles) to sustain its competitive advantage, and Toyota has strong 2006-9 global new-product volume.

Driving the target margin change, Toyota appears to have more conviction on the benefits of its overall cost reduction efforts. As a result, we raised our 2008-10 Toyota COGS reduction rate to 2.1 percent from 1.5 percent, our 2010 operating margin to 10 percent from 9 percent, and our 2008-10 EPS by roughly 6 percent. Our 12-month target goes to $130 from $115 and our rating to Buy from Neutral. We favor Toyota over Honda and remain cautious on the Big Three and their suppliers.


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