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Five Things You Need to Know: Pricing Power Continues for Consumer Staples


Not every company is committed to taking pricing actions.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

1. Consumer Spending: Good News/Bad News

Good news, the consumer is still spending. Personal consumption increased by 0.4% in March, according to the Commerce Department, doubling the rate of increase most economists expected.

Now for the bad news, and there's a lot of it. Consumer spending, which makes up more than two-thirds of Gross Domestic Product, increased just 0.1% when adjusted for inflation. And, the bulk of the spending is going to staples, not discretionary purchases. Non-durable good spending increased 0.4% in March, while durable good spending decreased 0.4%.

Related to the increased spending on staples, the personal savings rate as a percentage of disposable income declined to 0.2%.

We can't emphasize enough how important the personal savings rate is given a tightening credit environment. The fact that savings are still rising, even in the face of select commodities price increases impacting food and energy, stands in sharp contrast to the low and often negative personal savings rate we saw over the past five years with consumer discretionary sales booming.

2. Process Vs. Event: Consumer Spending Cutbacks

One thing to keep in mind is that what we believe is a long-term shift in consumer spending habits is part of an ongoing process, not an event. As a result, the behavior shifts will be incremental, carried out over time as opposed to appearing as a single data point in corporate earnings report.

Some of the better-managed companies out there have been anticipating this shift and reducing the impact of consumer discretionary to their earnings. Take, for example, CVS (CVS).

During the company's call today, David B. Rickard, Chief Financial Officer, noted how the front-store business at CVS, the retail item business, now makes up only 15% of revenues and even of that only 20% is considered discretionary. Even so, the company said it has yet to see any truly meaningful impact in slowing discretionary sales.

"I can report that we recently looked at the discretionary versus non-discretionary categories to evaluate whether there was any change in trend," Rickard said. "Our data shows no evidence of a consumer slowdown based on this analysis." However, Rickard added: "My interpretation is that consumers are making tough choices on big ticket purchases but they aren't yet focused on Snickers bars."

That will come as good news for Warren Buffett and Berkshire Hathaway. Mars manufactures the Snickers bar.

3. Pricing Power Continues for Consumer Staples

Among consumer staples companies, the tale of the tape continues to be those with pricing power, and those without it. Kraft (KFT) is an example of a company with some degree of pricing power.

On the company's conference call yesterday, Irene Rosenfeld, Chairman and Chief Executive Officer, noted that pricing contributed more than four points in revenue growth in the first quarter, versus only two points in the fourth quarter and 1.6 points for all of 2007. Rosenfeld indicated that the company will take additional pricing actions across their categories to cover rising input costs that are expected to come in as high as 12% for the year.

Interestingly, Kraft continued to gain market share during the quarter in categories where they increased prices; a testament perhaps to brand strength.

As for consumers trading down, Rosenfeld said, "we're certainly seeing a trend in people eating away from home less and eating at home more which we believe is a positive for our business. But, don't forget the reality is there has been essentially little to no inflation in food prices for ten years, and so the reality is we've now introduced some pricing into the marketplace." Rosenfeld said the company does believe there is going to be some "short-term dislocation" as consumers adjust to those higher price points.

4. Inside the Numbers

During the call, as part of the presentation materials, Kraft presented an interesting chart on commodities price increases worth taking a look at:

Commodities Pricing Chart, from Kraft earnings call

Timothy McLevish, Executive Vice President and Chief Financial Officer for Kraft, explained the chart:

"This chart shows commodity prices in each year versus the 10-year average for each of our 11 largest commodity inputs. Compared to numbers as recently as January, you can see that the prices of many commodities have increased further. To put this in context for Kraft, for the quarter our input costs were up about $460 million over last year and we now
expect them to be up almost 1.7 billion or about 12% for the year. That's higher than we anticipated in January and greater than the 1.3 billion increase we saw in 2007. Because of this, we have taken and are taking additional pricing actions. This pricing together with further overhead leverage will deliver operating margin expansion in 2008 although more modestly than we had originally anticipated. Said another way, we expect our actions to deliver our expected earnings dollars, but there will be greater pressure on margins as we take additional pricing actions to cover these costs."

Ok, so the company expects margins to come under greater pressure even with pricing actions the company will take to cover costs. Fair enough.

Here's the bottom line: we've listened to the conference calls for virtually every one of these consumer staples companies since they first popped onto our radar last year. There is one question that have yet to hear asked on these calls, What happens if commodities stop going up, or even decline during the second half of the year? Instead the question is, How much higher do you expect commodities to move during the second half of the year?

If, as we expect, commodities prices do come down in the second half of the year, then the consumer staples companies with pricing power may find themselves in the middle of a recessionary environment with expanding margins. If that comes to pass, then this will no longer be a simple paired trade - short consumer discretionary, long consumer staples, a trade we should add is already beginning to be unwound - it will be a trade where these companies are seeing margin expansion and increased profitability in their own right. Something to think about.

5. But...

Isn't there always a but? Not every company is fully committed to taking pricing actions. Take Kellogg (K) for example. It was pretty clear on the Kellogg's call that the company is not excited about taking additional pricing.

David Mackay, President and Chief Executive Officer, said that while the company did take some pricing in the first quarter, for the balance of the year the focus will probably be on increased productivity and the momentum of the business. "We feel, as we said on the call,
very confident about the year," Mackay added. "Commodities remain volatile; we think we are over 80% hedged. There clearly are some things you can't hedge, so we feel in pretty good shape for the year."

John Bryant, Executive Vice President and Chief Financial Officer, added more detail. "The 15 pennies of commodity increase, we're probably covering about 5 pennies of that from things like lower shares outstanding and foreign exchange, good news versus where we were probably three or four months ago, and the remaining 10 pennies we are going to cover through underlying business momentum, which include all range of activity such as cost saving initiatives, margin improvements and pricing." We're reading between the lines that the fact pricing is last in that list of initiatives reflects some degree of prioritization.

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