Research Consumer-Sectors Companies: CVS Caremark Corp., Kellogg Co.
Food: We continue to look for around -10 percent deflation on an unhedged basis for the packaged food group on average. This might be surprising to some who have been following the small bounce of the bottom that certain pockets of the commodity set – like grains, dairy and energy – have experienced. But we’ll remind investors that it takes a while for current commodity levels to work their way through the industry’s supply chain, and there’s typically a lag involved between what we see in the market and what we see show up on the companies’ P&Ls.
More importantly, there’s also the element of hedges currently in place that likely distorts much of this underlying picture. As a reminder, most food companies are currently guiding to low- to mid-single digit levels of inflation for 2009, much of which is likely skewed to the first half as a result of higher cost hedges which don’t roll off until late spring/early summer. While there’s been less talk of late around hedging practices, we believe investors can be sure that the industry is being opportunistic at the current moment and using the much lower commodity levels of late to hedge into 2010.
Kellogg (Overweight): In our minds, behind the better-than-anticipated trends [that impacted 1Q09 results] were three key factors: (1) a very healthy cereal category clearly benefiting from at-home eating trends and growing at 6-7 percent by Kellogg’s calculations; (2) stronger-than-normal productivity savings beginning to flow through, and (3) a period of peak pricing (+5.8 percent at the corporate level) that has very favorable P&L leverage implications.
Kellogg announced [April 30] that it will be reinvesting more than previously anticipated in its upfront productivity initiatives so as to generate a cumulative $1 billion in related savings over the next three years.
Food: In setting the stage for our discussion on the prospects for upcoming earnings and 2009, we point to a few items that we believe investors should watch closely including: (1) input costs, which are down in most cases, but cost inflation will still likely be up solidly in 2009 (first half) due in part to hedging; (2) private-label market share has accelerated due to the weak consumer environment; (3) slower relative EPS growth for the food group vs. staples; (4) the acceleration in food at-home dining vs. away-from home is creating a stronger growth environment for food companies; (5) foreign-exchange conditions have weakened substantially; (6) advertising-rate deflation could ease the burden on operating-profit in 2009; and (7) rising pension expense and cash needs.
The winners (or perhaps more aptly termed, the “survivors”) in this war will be the companies with the strongest brands (#1 or #2), the lowest share of private label in their categories, greatest marketing/R&D commitment, and the strongest new product pipeline, in our view. This analysis tracks those companies where we believe the private label threat is most salient: Campbell Soup, ConAgra Foods, Kellogg, Kraft Foods, General Mills, H.J. Heinz Co., and Sara Lee.
Kellogg (Buy): Kellogg maintains a 25 percent overall market share in its categories and has the lowest corresponding private label exposure (8.9 percent). This high relative market-share position provides Kellogg with a distinct advantage as a clear market leader in its categories, affording it more control over the shelf, merchandising and pricing.
Kellogg reported strong first-quarter earnings that were up 4 percent to $0.84 per share and six cents ahead of our estimates and the consensus estimate.
We believe 2009 will likely feature slower growth in Kellogg’s marketing spending vs. previous years, and we could well see this expense down for the year. This stands as an opportunity to produce stronger earnings growth for the company in 2009, in our view.
Kellogg is presently trading at less than 13 times our 2010 EPS estimate of $3.30 per share. We keep our Buy rating and $51 target price in place.
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Drug Stores & Pharmacy Benefit Managers: Generic-drug conversions are very profitable for PBMs due to their higher margins vs. branded drugs. We note PBMs typically make greater profit after the 180-day generic exclusivity period, as they typically benefit from purchasing power and increased reimbursement rates over time.
In this case, generic Lipitor [which goes off patent in 2011] from multiple vendors may continue into 2012 onwards. As a result, we believe some PBMs, including CVS Caremark, are either now or will soon be renewing PBM contracts early to capture market share ahead of Lipitor going off patent and the return of the generics boom beginning in 2011 and into 2012.
CVS Caremark (Buy/Medium Risk): CVS reported 1Q09 EPS of $0.55, in-line with our estimate of $0.55 and guidance of $0.53, and above consensus of $0.54. Management noted that there are plenty of new PBM business opportunities for 2010, and they are pleased with the early results of the 2010 selling season. We continue to believe the retail/PBM model is gaining traction, as CVS’ scale and breadth of offerings are leading to incremental PBM clients and best-in-class retail execution and market-share gains.
CVS Caremark (Overweight): We continue to believe CVS’ new “Maintenance Choice” mail or retail 90-day prescription option will be a market-share driver for the retail business. 200 PBM clients have signed up to date, and management indicated that this program is more profitable than 30-day prescriptions (implying new customer conversions, and a boost from acute prescriptions and front-end purchases for retail stores).
The Longs acquisition, which was expected to be $0.06-$0.07 dilutive, is now expected to be $0.04-$0.05, prompting a $0.02 boost to guidance to $2.55-$2.63 per share for 2009.
Solid execution, merger synergies and capital deployment provide ample possibility for earnings growth despite secular headwinds. The company’s Caremark subsidiary is the most competitive PBM and stands to remain a share gainer in this highly profitable industry.