Consumer Stocks: Losing Their Sparkle?

High commodity prices have taken their toll on Procter & Gamble and other makers of household items, dampening their appeal as defensive plays

Companies such as Procter & Gamble (PG) and Colgate-Palmolive (CL) are supposed to be great places for investors to hide out in recessions. Even if the economy slows down, consumers need to eat, wash their clothes, and clean their bathrooms.

But with the notable exception of discount retailers like Wal-Mart (WMT), consumer-staples stocks have let investors down this year. The reason? This year's economic slowdown has been accompanied by massive commodity price increases.

Even as the economy has slowed, energy and raw material costs have skyrocketed at household products companies such as Procter & Gamble and Colgate-Palmolive, as well as big food companies like Kellogg (K) and Kraft (KFT). All four of those consumer icons reported first-quarter earnings on Apr. 30, giving important clues as to how well the consumer-staples sector will perform during this economic slowdown.

Passing the Costs Along

Companies in the sector are indeed seeing higher costs, but they're finding ways to post solid profits anyway. One tried and true method: Make up for the skyrocketing cost of grain, oil, and other materials by boosting prices. At Kraft Foods' U.S. cheese division, dairy costs were about up 30%, for example. "We have been pricing quite aggressively to recover those costs," Chairman and Chief Executive Irene Rosenfeld told analysts Apr. 30.

Procter & Gamble announced more price increases Apr. 30—for example: a 7% increase in hand dishwashing products such as Dawn and an 11% increase in the price of its Oral-B power brush products.

Will U.S. consumers pay more? In many cases, they have no choice. Despite higher price tags, executives at big consumer outfits said they're holding onto market share, as competitors and other private label brands are also being forced to raise prices. Still, most assume there are limits to the price increases consumers will accept, and consumer staples manufacturers have tried to maintain profits in other ways.

A Better Product For a Bigger Price

Industry players have been restructuring and finding other ways to cut costs, says Standard & Poor's equity analyst Loran Braverman, They're also bringing out innovative products. These new products have to be good enough to sell for higher prices, giving companies wider profit margins. "People have to feel they're getting something for [their money]," Braverman says. (S&P, like BusinessWeek is a unit of the McGraw-Hill Companies (MHP).)

Procter & Gamble beat expectations for its most recent quarter, with earnings of 82¢ per share vs. 74¢ a year ago, as sales rose 9%. By the early afternoon of Apr. 30, P&G shares were up 3.4%, to 68.13. Most of P&G's wide range of brands sold well despite the weak economy and higher costs. The one exception was beauty products in the U.S., especially its Pantene line.

Colgate-Palmolive's earnings were 86¢ per share vs. 89¢ a year ago, as sales rose 16%. That largely met expectations, but investors were disturbed by a drop in the firm's profit margins. "In the past, the company has been able to offset [raw material cost increases] through pricing and cost savings," said Oppenheimer (OPY) analyst Joseph Altobello. But this quarter, profit margins were squeezed, and the stock suffered, falling 5.5%, to 71.61 after the company released first-quarter results.

Kraft's Aggressive Price Hikes

Colgate Chief Executive Ian Cook said in a statement that price increases and cost savings should allow the company to widen profit margins again in 2009, "even if oil and commodity prices increase moderately above current record levels."

Investors seemed to like Kraft's aggressive price hikes as well as strong sales in developing markets, where revenues showed organic growth of 21.7%. Kraft posted earnings of 44¢ per share, vs. 44¢ a year ago. Revenue rose 21%. By early afternoon Apr. 30, shares were up 3.6%, to 31.87.

Kellogg reported earnings of 81¢ per share, which Wachovia (WB) analyst Jonathan Feeney called "a big beat on solid performance across all segments." The stock was down 0.46%, to 51.74 in afternoon trading Apr. 30. That might reflect worries that Kellogg will have trouble keeping up its performance "with the price increases piling on quarter after quarter," Feeney says.

Recovery Doesn't Mean Cleaner Teeth

So are consumer staples companies a good investment? In a slow-growth, high-commodity-price environment like this, the stock market clearly prefers a company such as Wal-Mart, which has seen its shares go up 22% so far this year. Shopping at Wal-Mart is still a necessity for many Americans, but the giant retailer can easily pass on higher commodity prices from its suppliers. "Wal-Mart is insulated from the commodity swings," says Georges Yared of Yared Investment Research.

However other consumer staples stocks also have advantages for investors. Consistent and predictable, they pay out dividends reliably. And they're likely to outperform in a terrible stock market.

"[But] investors abandon them"—in favor of faster-growing sectors—"when they begin to sense strength in the market," Yared says. Even in a strong economy, they tend to grow slowly and steadily. After all, Braverman says, "People aren't going to brush their teeth more because the economy is recovering."

So for many consumer staples stocks, the best case scenario may be the economy stays weak, but signs arrive of some relief for commodity prices. A drop in raw material prices would provide a big boost in profits, attracting investors' attention even if other sectors are dragged down by recession.