19
1 The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Drexel University The Dragon Fund Consumer Staples 2016 Q3 update Subsector to watch: Tobacco

Consumer Staples Q3 Report

Embed Size (px)

Citation preview

1

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee

Drexel University The Dragon Fund

Consumer Staples 2016 Q3 update Subsector to watch: Tobacco

2

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Executive summary The Consumer Staples team selects Tobacco as its subsector to watch for the upcoming quarter. Key investment positives

+ Health and wellness trends have reduced smoking rates in the US and Western Europe, but globally smoking rates grew 0.3% in 2015. Rising incomes in the developing world, coupled by urbanization drives this trend.

+ Historically low gas prices and rising wages have increased the buying power of low income. Consumers in the United States, increasing sales by 5.2% yoy.

+ Stocks in this industry are slightly underpriced relative to the sector. + New products such as non-combustible cigarettes, vapor devices are entering the market. + Producers can counter the fall in volume by raising prices, maintaining revenue growth. + The market mature, and highly consolidated therefore lowering the threat of new entrants.

Investment Risks

- Rising interest rates will reduce tobacco's use as a yield alternative, as investors look towards corporate bonds.

- Government regulations, and litigation which are generally seen as a cost of doing business, remain a lingering threat.

- FX exposure. Tobacco producers sell a great deal of products overseas. A strong dollar could increase the popularity of generic, locally produced cigarettes.

Consumer Staples Sub Sector Matrix

Source: Dragon Fund Analysis Our views on the subsectors are summarized in the above matrix. Quantitative and qualitative data of the six drivers are discussed in the report that follows.

Economic outlook for subsector:

Cyclicality (Beta) Valuation Long Term Growth

Short Term Growth

Smart money indicators

Food Retialing Negative Neutral Positive Negative Negative Neutral

Beverages Negative Neutral Negative Negative Positive Neutral

Food Products Negative Positive Neutral Positive Neutral Neutral

Tobacco Positive Neutral Positive Positive Negative Neutral

Household Produc Negative Positive Negative Neutral Neutral Negative

Personal Care Positive Neutral Negative Neutral Neutral Positive

3

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Sector review 1. Illustrated below are the weights of the different subsectors within Consumer Staples in the

S&P 1500 as of September 30, 2016

Source: Factset

Beverages, 22%

Food and Staples Retailing, 21%

Food Products, 8%

Household Products, 25%

Personal Products, 3%

Tobacco, 21%

Consumer Staples Breakdown in S&P 1500

4

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 2. The graph below displays the performance of Consumer Staples vs. the S&P 1500. During Q3 2016.

Consumer Staples was flat to slightly down relative to the benchmark.

Source: Factset

Headwinds include slowing global growth, geopolitical risk, FX exposure, and high likelihood of the FED rising interest rates. China, our second largest importer has dropped from double-digit economic growth to the 6-7% range. 6.7% as of last quarter down from 6.8% in Q1. Fears of China having a “hard landing” stoked fear in the markets earlier in the year sending staples soaring. Now, this seems not to be the case. The US economy is now into its longest period of economic recovery. The resulting strong U.S. dollar, has made US exports more costly overseas. Agricultural commodities and food products. Rising oil prices, up from historic lows in Q1 have raised costs for producers. Rising interest rates and concerns that the sector is overvalued relative to historic norms have added to the negative sentiment.

5

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 3. The sectors average forward P/E ratio is at a 22.2, a 10 year high.

Source: S&P Factset

Compared to the S&P 1500, the consumer staples sector is overpriced. The divergence began in the beginning of 2016 when the year started out with tumultuous markets. The FED had hiked interest rates for the first time in nine years in December 2015. In Q1 Brent crude fell to $27.67 a barrel, its lowest since 2003, while West Texas Intermediate fell to $28.36 a barrel. The ECB introduced negative interest rates. Deutsche Bank reported a loss for 2015, causing panic among holders of its CoCo bonds. European bank shares plummeted on fears of dilution. Enter consumer staples.

The sectors low cyclicality makes it an attractive investment. Market betas are typically negative to neutral. Historically low interest rates have also made Consumer Staples’ relatively high dividend yields attractive. The high likelihood of a rate hike in December, pushing investors back to corporate bonds, will likely cool this momentum.

6

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 4. Long term EPS growth for consumer staples is below that of the S&P 1500 and has declined over the

past decade.

Source: S&P FactSet

Long term EPS growth is below the S&P 1500. Growth is slow but consistent. Companies have benefited from low oil and commodity prices. Large players are divesting brands, and cost cutting. This has been seen as a positive from an efficiency standpoint, but we think it’s to shore up earnings in light of declining global growth.

7

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 5. US consumer confidence index is at the highest level since the Great Recession.

Source: FactSet

Increasing levels of consumer confidence lead to heightened spending by individuals, and while this is a strong sign for the economy, a majority of the products sold from companies within our sector are not dependent on the strength of the economy. I regardless of their feelings on the state of the job market and their personal financial situation & spending, consumers will still be driven to purchasing food necessities like eggs and milk, and products like beer and tobacco. Higher confidence may push individuals to purchase premium brands with higher margins.

8

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 6. One Year Commodity price and volume

Source: Bloomberg.

The table above details the volatility in the commodity markets over the past twelve months. Prices for certain products, such as sugar - driven by a season of bad crops due to weather - and orange juice have increased dramatically. This puts pressure on the profit margins of food producers in the short run, leading to higher prices for retailers, and eventually consumers. In addition, the price of gasoline is up in excess of 10% for the year, while price per barrel is still low, benefits from excessively low oil prices in Q1 are drying up. Thus, decreasing the excess profit margin producers and retailers were able to enjoy in the first half of the year.

An unsettling trend is food price deflation. The decline in prices of key agricultural commodities is at its longest stretch in 50 years. This is good for consumers, but puts a strain on farmers and grocery stores. Wheat, milk, eggs, cattle, hogs, rice are predicted to be in decline until years end. This phenomena can be attributed to weaker demand in China due to a strong dollar. The US Foreign Agricultural Service estimates agricultural exports to China at $20.2 billion annually.

9

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee 7. It is likely the FED will raise interest rates on December 16th, according to economist’s consensus.

Source: Wall Street Journal

This will be first rate hike since last December when rates went from 0% -where they had been since the Great Recession- to .25%. This will impact the Consumer Staples sector in three ways. First, the sectors high dividend yields have made it an attractive investment in the low rate environment. As corporate bond yields become more attractive this will tilt investors out of staples. Second, many companies in the industry are conglomerates that grow through M&A activity. These acquisitions are mostly debt financed. Higher rates, raise the cost of growing this way. Finally, higher returns attract foreign capital, increasing the demand for the dollar, thus driving up exchange rates. This will hurt US companies with business overseas.

10

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Subsector review and outlook

During the third quarter Tobacco was the largest underperformer losing 6.8% of total return within the sector. Three other sub sectors also experienced a decline, including Beverages, Food & Staples Retailing and Food Products. Household and Personal Products experienced positive quarterly returns.

Tobaccos decline can be attributed to stringent EU regulations that were passed in May. However analysts predict the risk to the industry remains minimal. The other sub-sectors experienced headwinds related to FX and commodity price exposure.

Subsector Weight Q3 Total Return

Subsector Beta Cyclicality

Beverages 22% -2.4 0.75 Neutral Food and Staples Retailing 21% -4.9 0.65 Defensive Food Products 8% -3.7 0.75 Neutral Household Products 25% 2.1 0.63 Defensive Personal Products 3% 1.7 0.96 Neutral Tobacco 21% -6.8 0.72 Neutral

Source: FactSet Household Products and Personal Products sub sectors, gained 2.1% and 1.7% respectively over the quarter. Both sectors were bolstered in part by overseas sales. With a low euro and pound, travel overseas has increased and there has been an increased reliance on foreign sales. With rising oil costs (higher than recent historic lows), many large producers have had to re-channel free cash, thereby cutting expenditures such as heightened advertising and overseas expansion. This was due to industry wide cost cutting measures, most notably from Proctor and Gamble, which will have divested 105 brands by 2017.

11

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Valuation vs Growth

The charts below detail forward Price-to-Earnings ratios and long-term growth estimates for the six sub sectors we’ve covered within Consumer staples.

Source: FactSet, Dragon Fund estimates based on current S&P 1500 constituents

The charts above illustrate forward P/E ratios for the six sub sectors within Consumer Staples.

12

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee

Deconstructing forward P/E ratios over the previous six months, we can see that the Beverages and Personal Products subsectors had ratios higher than the Consumer Staples sector average. This points to a valuation lower than the overall sector. The Tobacco and Food Retailing subsectors had P/E ratios that lied below the sector average. The Food Products subsector stayed in-line with sector P/E, while the Household Products subsector converged to end the month in-line.

Shifting towards EPS Growth, both the Beverages and Food Retailing subsectors experienced EPS growth below that of the overall sector. Tobacco, food products, and personal products however, saw growth in EPS that was stronger than the consumer staples sector.

EPS Revisions over the previous 6 months

Source: FactSet consensus The above chart shows the sum of one month EPS revisions for the past 6 months. Note that this graph does not show the consistency or inconsistency of month to month revisions. Food & Staples Retailing was revised downward overall making it the only subsector to do so amongst the industries we’ve analyzed. The Beverages industry, in addition to Food & Staples, remained close to consensus showing that short term growth is in line with investors’ expectations. For Household Products, Food Products, Personal Products & Tobacco, the consensus EPS were revised significantly upward compared to the overall Consumer Staples sector. An upward revision indicated that the subsector outperformed estimates. This shows a momentum in earnings but also indicates a level of pessimism given the low estimate.

13

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Short Interest

Source: FactSet Short interest in the sector has mostly declined over the course of Q3. Tobacco has remained flat and has the lowest level of shorts out of all the subsectors.

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

- 12mo - 11mo - 10mo - 9mo - 8mo - 7mo - 6mo - 5mo - 4mo - 3mo - 2mo - 1mo Now

Consumer Staples Short Interest

Food & Staples Retailing Beverages Food Products

Tobacco Household Products Personal Products

Consumer Staples

14

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Tobacco: Resilient and Dynamic The tobacco industry is a tale of resilience in the face of health and wellness trends, and government regulation. Smoking rates in the US and Western Europe, are in decline over the past several decades, but these declines do not appear to be accelerating. Globally smoking rates have increased .3% from 2014-2015.Rising incomes in the developing world, coupled with increasing urbanization drives this trend. Average price per pack is $3.07 ex China, and $6.00 US. Cigarettes remain largely affordable.

Sales volume has been on a steady decline in the US and Western Europe over the past decades, but globally tobacco sales grew in 2015. US. Sales increased 5.2% in 2015 this was a positive surprise. Bloomberg Intelligence attributes this to low gas prices giving low income consumers more disposable income. Wages are also up 2.6% over the past year. More discretionary income coupled with higher minimum wages in some states will increase sales of premium tobacco brands.

Source: Bloomberg

To support future revenue companies are trying to develop non-combustible tobacco products. Industry leader Philip Morris International is testing its iQOS device, a non-combustible set to be launched in 2017. Marijuana legalization is a potent development for the industry. Six states are now considering ballot measures this November. However, the major players will not officially take stakes until legalization is nationwide. These gains won’t be seen for another 5-20 years depending on the political climate.

5550

5600

5650

5700

5750

5800

5850

5900

5950

6000

6050

240

250

260

270

280

290

300

310

320

2015 2014 2013 2012 2011 2010 2009

Cigarettes Consumed in Billions

United States World Total

15

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee The real growth driver since 2008 has been rising operating margins. Average operating margins were 22.12% in 2008, by 2015, operating margins grew to 31.9%. Paradoxically, heavy regulation may be causing rising margins. In the past, making money was easy. Companies relied heavily on advertising expertise to grow sales. Aiming for ever greater operating efficiency wasn’t necessary. Since heavy regulations and industry scrutiny, Tobacco companies do everything they can to continue rewarding shareholders. Striving for higher margins is an integral part of the industries DNA. Two drivers from margin growth are the addictive nature of the product, and pricing power. With severe advertising restrictions in place, legacy brands like Marlboro are relatively safe from competition. Strong brand awareness coupled with nicotine addiction means consumers will pay higher prices for cigarettes. The focus on margins drives growth with little reinvestment required. These cash flows are passed directly onto shareholders. Every time someone buys a pack of cigarettes 80% goes to shareholders. It is no surprise that Tobacco stocks are high yield. The industry average dividend yield is 4.2% – more than twice the S&P 500’s dividend yield.

16

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Appendix

Source: S&P

Source: US Energy Information Administration

Phillip Morris International,

43.42%

Altria, 35.63%

Reynolds America Inc, 19.70%

Other, 1.25%

US Tobacco Firms

17

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee

Source: Dragon Fund Analysis

Source: FactSet Data

12

14

16

18

20

22

24

26

Oct 2015 Nov 2015 Dec 2015 Jan 2016 Feb 2016 Mar 2016 Apr 2016 May 2016 Jun 2016 Jul 2016 Aug 2016 Sep 2016

World / Tobacco -IND - Div - LTM S&P Composite 1500 / Consumer Staples - SEC - Div - LTM

Dividends Per Share Tobacco vs Consumer Staples

18

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee

Source: Factset

5

10

15

20

25

30

35

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

World / Tobacco -IND - Operating Margin - LTM S&P Composite 1500 / Consumer Staples - SEC - Operating Margin - LTM

Operating Margins Tobacco vs Consumer Staples

19

The Dragon Fund Consumer Staples update October 2016 Amthony Gerelli, Elizabeth Cahill, Ryan Lee Works Cited Bloomberg L.P. (2016). “BI Industry Primer: Global Tobacco” Bloomberg database. Drexel University LeBow College of Business, Philadelphia, PA. Accessed: October, 2016. Factset. Philadelphia, PA: FactSet Research Systems Inc, 2016. Internet resource. Haddon, Heather. "Food Price Deflation Cheers Consumers, Hurts Farmers, Grocers and Restaurants." WSJ. Wsj.com, 29 Aug. 2016. Web. 10 Oct. 2016. Mossavar-Rahmani, Sharmin, Brett Nelson, Matthew Weir, Maziar Minovi, and Farshid Asl. The Last Innings. Rep. New York: Goldman Sachs Investment Strategy Group, 2016. Print. Lewandowski, Lisa K., and Bryan Spillane. Tobacco Fact Book: The Black Book on Tobacco, 2016 Edition. Rep. New York: Bank of America Merrill Lynch, 2016. Print.