Consumer Staples: Getting Trampled. Proverbs are great at conveying big ideas simply but colorfully. Consider this African proverb: “When elephants fight, it is the grass that suffers.” Simple, yet colorful.
Fighting elephants came to mind when Amazon announced this week its plans to offer folks on government assistance a reduced rate to become Prime members. It’s the latest salvo in the battle between Amazon and Walmart to dominate Internet shopping. While the two have been tusking for years, the fight has intensified in recent months, and their suppliers and competitors alike are likely to get trampled in the grass beneath them.
You’d never know the elephants are fighting by looking at the industries in the S&P 500 Consumer Staples sector, where many of the suppliers and competitors are housed. Many of them have outperformed in recent weeks and trade at lofty multiples relative to low-single-digit earnings growth expectations. Investors may be turning to the sector because it has historically been a safe haven during times of turbulence, and offers dividends that look attractive in today’s low-interest-rate environment. Could this be the quiet before many of the Consumer Staples industries get trampled?
Let’s look:
(1) The grocery showdown. There’s no mistaking it: Amazon and Walmart are making a big push to dominate Internet grocery shopping. They’ve both introduced a laundry list of new programs in an effort to woo customers. Personal outlays on food consumed at home totaled $939 billion (saar) during April (Fig. 1). Retail sales of food and beverage stores totaled $713 billion (saar) the same month. The difference between the two series is likely to be mostly the grocery sales of the warehouse clubs and super stores (Fig. 2). In other words, it’s a huge and natural arena for fighting elephants.
Amazon earlier this week offered a reduced rate for Prime membership—$5.99 a month instead of $10.99 a month—to customers on government assistance. The move comes as Amazon, Walmart, and seven additional retailers are participating in a pilot program that will allow food stamps to be used to purchase groceries online beginning next year, according to the US Department of Agriculture.
In addition, Amazon opened two grocery pickup locations in Seattle recently, and it lowered its free shipping threshold to $25—after Walmart lowered its threshold to $35, Recode reported on 6/6. Meanwhile, Walmart bought Internet retailer Jet.com for $3.3 billion last year, and it added discounts for anyone picking up packages in the store. Walmart is also testing a program where its workers are paid if they drop off packages ordered online on their way home from work.
The rapid succession of new initiatives gives the impression that both companies are throwing food at the wall to see what sticks. In the meantime, other retailers—whether they be grocery stores like Kroger, larger-format stores like Target and Costco, or dollar stores—have to be wondering what the grass will look like after the elephants finish fighting.
(2) Price slashing. Margins are already notoriously thin in the grocery business. But as Walmart and Amazon get even more competitive, they reportedly are asking suppliers to cut prices. According to a 3/30 Recode article, Walmart told some of its largest suppliers that it wants to have the lowest price on 80% of its sales.
“To accomplish that, the brands that sell their goods through Walmart would have to cut their wholesale prices or make other cost adjustments to shave at least 15 percent off. In some cases, vendors say they would lose money on each sale if they met Walmart’s demands,” the Recode article stated. “Brands that agree to play ball with Walmart could expect better distribution and more strategic help from the giant retailer. And to those that didn’t? Walmart said it would limit their distribution and create its own branded products to directly challenge its own suppliers.”
Amazon is also twisting arms. The Recode 3/30 article reports that Amazon has software that finds the lowest price online for an item and then matches it on Amazon, even if it means the sale is unprofitable. “Unprofitable items are known inside Amazon as [CR*P] products—the acronym stands for ‘Can’t Realize a Profit.’ … When Amazon warns suppliers that a product is pre-[CR*P], meaning it’s in jeopardy of being kicked off the site for profitability issues, it makes demands. Oftentimes, to lower wholesale prices. But that doesn’t always work, especially if a brand has the leverage of also selling into Walmart, which is still the biggest retail customer for many manufacturers.” So Amazon may move the product to a different part of its site that charges an additional shipping fee or prevent advertisement of the product on its website.
(3) Safety sells. Despite the upheaval in the retail space, the S&P 500 Consumer Staples index has turned in a strong performance over the past four weeks along with Utilities as defensive sectors have outperformed and Treasury yields have dropped. Here’s the performance derby of the S&P 500 sectors for the four weeks through Tuesday’s close: Utilities (4.7%), Consumer Staples (3.9), Tech (3.4), Materials (1.8), Health Care (1.7), Real Estate (1.6), S&P 500 (1.4), Telecom Services (0.9), Industrials (0.5), Consumer Discretionary (0.2), Financials (-1.6), and Energy (-2.3) (Table).
During the past four weeks, numerous industries in the Staples sector have outperformed the broader market, including: Tobacco (7.6%), Soft Drinks (5.0), Distillers & Vintners (4.8), Personal Products (4.5), Packaged Foods & Meets (4.1), Hypermarkets & Super Centers (3.8), Household Products (3.7), and Brewers (3.5). Meanwhile, the S&P 500 has returned 1.4% over the same four-week period from May 9 through Tuesday.
Before jumping into Consumer Staples, remember that the elephants are fighting and the sector’s forward P/E, at 20.5, is almost three times the 7.2% earnings growth analysts are expecting over the next 12 months (Fig. 3 and Fig. 4). That’s pricier than the multiple of earnings that investors are paying for stocks broadly: The S&P 500 sports a lower forward P/E of 17.6 yet higher forward earnings growth of 11.3%.
(4) Food retailers. Given the battle between Walmart and Amazon, it’s ironic that one of the Consumer Staples’ industries with the most stretched valuation is S&P 500 Food Retail (KR, WFM). It has forward earnings growth of only 3.4%, yet the shares trade with a forward multiple of 15.4 (Fig. 5 and Fig. 6). Its earnings growth rate has come down from north of 10%, where it routinely stood from 2012 to 2014. The last time earnings growth was this low was in 2009, when the P/E was much lower at 8.7.
In addition to the Amazon/Walmart battle, there’s a new company entering the fray. German grocer Lidl is opening its first 10 stores in the US this month. Over the next year, the company plans to open a total of 100 stores, and its ultimate goal is to have 600 stores in the US to complement the 10,000 stores it has in 27 European countries, according to a 5/17 Business Insider article. Food retailers have been slashing prices in response to increased competition. Declining prices led Kroger to report its first earnings decline in 13 years for Q4-2016, the 3/2 WSJ reported.
Hypermarkets & Super Centers (COST, WMT), which is expected to grow earnings by 5.0% over the next 12 months, sports a forward P/E of 20.8 (Fig. 7 and Fig. 8). Dollar stores and Target are in the Consumer Discretionary sector, but we thought we’d mention them anyway. They’re in the S&P 500 General Merchandise Stores industry (DG, DLTR, and TGT), which has already fallen 12.4% ytd. Analysts are calling for forward earnings in the industry to fall 1.4%, and the industry’s P/E has dropped to 14.6 from a recent high of 19.6 in 2015 (Fig. 9 and Fig. 10).
(5) Pricing pressures? As Walmart and Amazon race to offer Internet shoppers products with the lowest prices, their suppliers’ profits are at risk of being squeezed. Yet investors in the S&P 500 Consumer Staples Household Products index (CHD, CL, CLX, KMB, PG) don’t appear concerned. The industry has a forward P/E of 22.1, even though it’s expected to grow earnings by only 6.6% over the next year (Fig. 11 and Fig. 12).
Along the same lines, the S&P 500 Soft Drinks industry (DPS, KO, MNST, PEP) is projected to boost earnings by 4.8% over the next year, but it has a forward P/E of 22.8 (Fig. 13 and Fig. 14).
(6) Better prospects. There are some Consumer Staples industries that offer faster growth and lower multiples than the ones mentioned above. Not surprisingly, many of them don’t sell their products through Walmart or Amazon. Agricultural Products (ADM), for example, has a forward P/E below its earnings growth rate. The industry is expected to grow earnings by 16.6% over the next year and has a forward P/E of 14.6 (Fig. 15 and Fig. 16).
Similarly, the S&P 500 Brewers (TAP) is expected to grow earnings by 23.8% over the next 12 months because Molson Coors Brewing acquired SABMiller’s 58% stake in MillerCoors. The industry has a forward P/E of 14.2 (Fig. 17 and Fig. 18). As the deal is anniversaried, the industry’s earnings growth rate is expected to decelerate to 6.5% in 2018. Shares of Molson Coors fell 6.5% yesterday after the company said costs would rise this year and its EBITDA margin estimate disappointed investors, the FT reported.
Two other industries with lower valuations are Drug Retail and Tobacco. The S&P 500 Drug Retail index (CVX, WBA) peaked in 2015 and has fallen 25.0% since then (Fig. 19). When the shares were at their peak, the industry’s forward P/E was roughly 21. Today, its forward P/E has fallen to 13.6, and earnings growth has tumbled to 6.8%, down from double digits in years past (Fig. 20 and Fig. 21).
The best-performing Consumer Staples industry is Tobacco, up 22.5% ytd, followed by Distillers & Vintners (20.1%) and Personal Products (18.5) (Fig. 22). Tobacco companies have had strong results in the US because they’ve increased prices to more than offset declining volumes of cigarettes sold. “The number of cigarettes sold in the U.S. fell by 37% from 2001 to 2016, according to Euromonitor. Over the same period, though, companies raised prices, boosting cigarette revenue by 32%, to an estimated $93.4 billion last year. An average pack in the U.S. cost an estimated $6.42 in 2016, up from $3.73 in 2001, according to TMA, an industry trade group,” the 4/23 WSJ reported.
In addition, Tobacco stocks have been helped by M&A activity. There is speculation that Philip Morris International will buy Altria, and Reynolds American is in the midst of being acquired by British American Tobacco. Companies are also developing products that heat tobacco and release nicotine in a vapor. “Philip Morris says its internal studies have shown that by avoiding combustion, the product prevents or reduces the release of many harmful compounds. The company has asked the FDA for authorization to market IQOS as less harmful than cigarettes through a partnership here with Altria,” the WSJ article stated. Even though vaping products are not marketed to kids, kids are vaping, presumably drawn to the practice by fruity flavors and the desire to be like their friends. Hopefully, history isn’t about to repeat.
The S&P 500 Tobacco industry (MO, PM, RAI) is expected to boost earnings 9.4% over the next year, and its forward P/E has climbed to 23.0, the highest it has been over the past 22 years (Fig. 23 and Fig. 24).
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.