After weathering a significant downturn in consumer spending through 2008 and 2009, it would seem household and personal product firms would be poised for accelerated top-line and earnings growth. Unfortunately, this scenario isn't necessarily playing out and headwinds persist. Even though moderating input costs have benefitted consumer product gross margins recently, we expect input cost inflation to return as developing and emerging markets increase their demand for commodities.
Additionally, sovereign debt issues in Europe could further dampen already weak Western European markets should austerity measures put any resurgent consumer spending on hold. The translational impact of a euro potentially headed to parity with the US dollar by the back half of the year will also impact both sales growth and margins at companies like Procter & Gamble, Avon, Estee Lauder, and Colgate-Palmolive, all of which have significant exposure to the continent.
For as much as we believe brands matter, the economic downturn made clear that for the consumer every purchase is discretionary. Shoppers are switching to more-affordable channels, such as hard discounters in Europe, and consumers will trade out of brands in many categories. While not alone, consumer product firms have significant exposure to Europe and remain vulnerable to volatility in the region.
Despite the impact that negative foreign exchange translation and rising commodity costs are likely to have through the remainder of 2010, the outlook for the industry isn't entirely gloomy. Over the past five years, household and personal care firms have pursued strategies of consumer trade-up, edging shoppers toward sales of higher-margin products. We expect their energies are now focused on keeping market share healthy and profitable while serving a consumer demanding a more compelling value proposition.
It remains to be seen whether these effects will lead to more margin compression, but we've been impressed so far with the ability of household product firms to reduce costs and eliminate inefficiencies. This is not the first time the industry has been forced to navigate such a difficult operating environment, and volatile foreign currency movements (such as in Venezuela) and fluctuating commodity costs are familiar challenges. At some point, however, we will need to see the consumer return to healthy spending in household product categories, particularly in mature markets, and we don't see that on the horizon just yet.
Competitive Analysis of This Industry
The last decade brought about significant changes in the household products and personal care industry. Retail consolidation, which began in the 1990s with the ascent of shopping supercentres such as Wal-Mart and Costco, increased competitive pressure in the industry. The fortunes of these firms are intertwined with the big-box retailers as the stores drive the majority of industry sales and volumes and are able to force manufacturers to alter everything from product assortment to packaging size.
Additionally, blistering growth in developing and emerging markets has resulted in rapid overseas expansion. In response, companies such as Unilever, P&G, Colgate, Clorox, and Estee Lauder have added and divested brands to reposition their product portfolios to hold winning brands with the greatest cash-generating abilities in growing categories. Building strong brand equities is a cornerstone of competitive advantage in the household products industry, since branded products typically sell at higher prices and are more profitable. In the mass retail channel, however, shelf space in many categories is limited to just two branded choices and one private-label offering. So while household product firms can build moats and generate excess returns by developing successful brands, maintaining brand health--and retaining a coveted spot on store shelves--requires ongoing investment.
Over the past two years the market for household products has been particularly challenging as cash-strapped consumers exerted their influence by switching brands, trading into private-label offerings, or pulling back on spending altogether. These trends, while not new, accelerated during the economic downturn, and it remains to be seen to what degree consumers will return to the same brand-buying behaviors in place before the recession.
As sales growth rates have slowed in categories such as hair care and skin care, for example, market share battles have intensified. Less concentrated, high-margin, high-growth categories with few private-label entrants have always been ripe for promotional turf wars, but commodified categories such as household batteries, paper towels, and toilet paper have suffered as well. Energizer and P&G "upsized" their offerings to include more batteries, for example, effectively reducing prices by almost 13% during the first quarter of 2010 compared to the year-ago period. Both firms are fighting for market share and shelf space as retailers have rationalised space in the category and private-label market shares have strengthened.
Aggressive price tactics are certainly part of the arsenal that branded household product firms use to combat retailer and consumer pressures, but they are short-term tactics that often drive volume growth at the expense of margins. Consumers can become conditioned to expect lower prices, and weaning them from these behaviors is a challenge. Over the long run, it is incumbent on household product firms to fashion new product innovations and brand extensions to keep profits intact.
Industry Growth Prospects
From 2004 to 2008 sales in the $360 billion global personal products market increased approximately 3.7% annually (1). New product categories, brand extensions, new overseas markets, and increased pricing all contributed to growth. For the household products companies that Morningstar covers, sales increased 6.3% annually, on average, over the past five years, including acquisitions. Since Morningstar's coverage includes most of the widest moat firms in the industry, this solid mid-single-digit sales growth isn't terribly surprising. It also includes small tuck-in acquisitions such as Church & Dwight's acquisition of Oxiclean in 2006 and transformational acquisitions like P&G's purchase of Gillette in 2005.
From a geographic standpoint, over the past five years many household product firms aggressively expanded into Eastern Europe, China, India, and Brazil, as growth rates in mature markets such as Western Europe and North America slowed. Disproportionate sales growth from emerging markets has a negative mix impact as unit sales from these regions are typically lower priced and lower margin, reflecting the purchasing power of the majority of the populations in these countries. While on a pretax basis mature markets may be more profitable than developing markets, on an aftertax basis this isn't always the case.
A number of strategies appear to be keeping revenue growth healthy, but we question whether strategies to push gross margins higher are working. Companies such as Colgate and Reckitt-Benckiser have repositioned their portfolios toward higher-margin products and it shows; gross margins at both firms increased 400 basis points over the past five years.
These firms are the exception, however, not the rule. From 2005 to 2009, gross profits for the companies Morningstar covers increased 6.9% and operating profits increased 8.3% annually. Based on these metrics it would seem that most of the margin expansion is coming from overhead cost savings. During this period numerous firms reduced staff and eliminated manufacturing facilities, among them Avon, Colgate, Church & Dwight, and Estee Lauder. Additionally, in the last year dramatically lower advertising rates allowed many firms to maintain or increase advertising levels while lowering total costs. With advertising rates increasing again, savings from this line item will be harder to come by. As opportunities to reduce overhead costs lessen and input costs tick up, we expect minimal margin expansion across our coverage list over the next five years.
Deploying Capital, Generating Returns, and Our Outlook for the Industry
Because of the breadth of the products that they carry and the broad distribution of products, household product firms have higher inventory levels and lower asset turns compared to packaged food or grocery/general merchandise retailers. Annual capital expenditures in the industry typically run about 4.0% of total sales, in line with depreciation.
Overall, the household products firms that Morningstar covers operate with manageable capital structures. For the most part the companies are not dependent on the capital markets to fund their operations. As an example, we expect Kimberly-Clark's free cash flow will approximate the 10.0% of sales generated over the past five years throughout our five-year forecast period. This impressive cash flow should enable the firm to comfortably meet future debt maturities. Industry firms typically reinvest excess cash into the business or return it to shareholders in the form of higher dividends or share repurchases. P&G is reinvesting more than $1 billion in savings into its business, while Estee Lauder repurchased 3.0% of shares outstanding on average over the past five years. We think Estee Lauder, P&G, and Kimberly-Clark will continue to raise their dividends annually, with increases ranging from the mid-single digits to as much as 10.0% annually, over the next five years, and we also expect share repurchases to continue.
We estimate that the firms Morningstar covers have a median weighted average cost of capital of 9.0%. The median return on invested capital over the past five years for this same group of firms is approximately 18.0%, but we expect returns to compress to a median of 14.5% over the next five years as revenue and earnings growth slow.
Household product firms have weathered the worst of the economic downturn, in our opinion, but as the US begins to pull out of a recession, a sovereign debt crisis in Europe still looms. We've already seen the negative impact of increased commodity costs and a strong dollar on top-line results and earnings power, and in all likelihood the industry is heading into a similar cycle again.
We believe growth in mature markets will remain relatively stagnant, and growth in emerging economies such as China, Brazil, and India will be insufficient to offset declines in developed countries. Total sales in the global household and personal products industry are expected to reach $424.1 billion by 2013, reflecting an annual growth rate of 3.3%.1 We think Morningstar's household and personal product firms will achieve slightly better results or median sales growth of 4.9% annually.
1. Source: Datamonitor Industry Profiles, Personal Products, Dec. 15, 2009 (http://www.datamonitor.com/).
