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When stock markets falter, shares in household product and personal care companies can usually be counted on to produce superior performance. This is often considered one of the ultimate defensive sectors, thanks to its record of achieving modest but consistent earnings growth through the sale of consumer necessities, such as soap and washing machine powder - after all, these products are among the last to be dropped from even the most cash-strapped consumer's shopping list.
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Lately, however, the sector has not produced gleaming returns. Shares in personal care and household products companies may not be the best investments in this particular bear market. One of the peculiarities of the downturn to date is that oil prices have remained stubbornly high. And this is putting serious pressure on the sector's cost base, as spending on oil-based raw materials is among its highest input cost. The impact of rising raw material prices has been felt particularly hard by McBride, the manufacturer of detergents, shampoos and soaps for supermarkets across Europe. As a producer of supermarket own-brand products, McBride has far less control over pricing than competitors that sell their own brands, so the company has struggled to pass on additional costs to customers.
Nevertheless, it tried to reassure the market with its interim results by stressing that price increases have and will continue to be implemented following negotiations with retailers. This announcement has been welcomed by analysts, although broker Dresdner Kleinwort notes that "actions already taken should improve margins, but unfortunately not in time to save the second half." And, despite a lowly valuation and healthy dividend yield of 6 per cent, the broker believes the shares may mark time until the market receives greater visibility on the extent of margin recovery.
By contrast, the performance of some of McBride's larger competitors have been untarnished by rising costs. Both Unilever, which derives 45 per cent of its revenue from home and personal care products, and Reckitt Benckiser, the star of the sector, have managed to mitigate the impact of raw material cost increases by charging higher prices and making cost savings elsewhere. But while these groups' defensive qualities appear intact, their shares trade on lofty multiples of 2008 earnings of 15 and 19 times, respectively. Arguably these valuations are in line with their European peer group, but there's no escaping the fact that they remain high for a manufacturer of consumer staples.
Sector analysts have cautioned against fostering a false sense of security about prospects. Deutsche Bank analyst Harold Thompson warns that the sector's earnings Europe-wide could fall by 3 to 4 per cent if the global economy slows faster than expected. "This may not sound much, but history suggests that these modest downgrades could lead to share price drops of 15 per cent as a de-rating takes place," he says.
Mr Thompson is more bearish on Continental companies than UK ones, which he expects to benefit from currency movements. "Sterling is expected to depreciate against both the US dollar and the euro." he explains. "Consequently, UK-based companies are in a win-win situation if they have large American and eurozone exposure, which is the case for Reckitt Benckiser."
Other analysts also point out that self-help initiatives, such as restructuring, could also help support earnings growth. Unilever, for example, has benefited from the restructuring implemented by chief executive Patrick Cescau, in particular in its home care division, which used to be a drag on the group's overall profitability. Over the past two years, the group has refocused on its core market and these efforts, combined with product innovations, have helped to revive the growth of products such as Cif and Domestos. And further restructuring is under way as the group is contemplating the disposal of its US laundry business.
However, the upside to earnings in this cash-rich sector is most likely to come from acquisitions. While McBride had a tough first half, it benefited from the integration of the Datsy and Henkel private label businesses. In much the same way, there is potential for an earnings boost at Reckitt Benckiser following acquisitions in over-the-counter medicines, while PZ Cussons, owner of the Imperial Leather and Carex brands, could lift its earnings with the recent acquisition of the Sanctuary Spa, the Covent Garden-based spa that generates 70 per cent of its revenue from branded products. That said, it is not cheap to make acquisitions in this sector at the moment, which leaves little room for error.
Whether these initiatives will be sufficient to support the sector's high valuation in a bear market has yet to be seen, and for the time being little in the way of risk appears to be getting priced in.
Gone with a bang? - why management at Reckitt Benckiser will have to work harder than ever to maintain its decade-long record of outperformance.
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-IC-1.9.0c-prod - 15/05/2009 11:00:33 - stuart.turner
