Consumer Staples Seek Juicier Profits

Food makers sell healthier foods in smaller packages, beverage makers dive into vitamin water, and personal-care companies push natural products

by Barney Brodie From Standard & Poor's Equity Research

Companies often talk about emphasizing their higher-margin products in the hope of beefing up their earnings. The consumer staples group is no exception; in fact, it seems to be a universal theme for the sector in 2008.

S&P equity analyst Tom Graves sees food companies improving their profit margins through a shift toward newer products with features and brands that can carry higher prices. He notes food and beverage companies are adjusting to changing consumer preferences, many of which relate to a desire for healthier consumption.

This includes a focus on what are sometimes called functional foods, or nutraceuticals. "Such products are often associated with providing added health benefits, such as lowering cholesterol, replacing vitamin deficiencies, or combating disease," Graves says. "If consumers perceive and want a higher value from a food item, it should, on balance, allow the manufacturer to charge a higher price."

Also, with consumers concerned about being overweight or obese, Graves expects that the introduction of "portion control" products (e.g. 100-calorie snacks), will provide opportunities for food companies to boost profit margins, as smaller, individually packaged servings are likely to be priced higher per ounce than the same item in a larger package.

New Products Boost Kellogg

In the past few years, packaged food companies have faced sharply rising costs for ingredients such as corn, wheat, and dairy products. "In our view, rising ingredient costs have placed additional pressure on packaged food companies to operate their businesses efficiently, a focus that we see reflected in restructuring programs that include activities such as the consolidation of manufacturing facilities and reductions in the workforce," says Graves.

He views Kellogg (K; recent price: $50; ranked hold) as a company that's continuously refreshing its product pipeline and creating opportunities to bolster profits with new products. Kellogg says that in 2006, almost $2 billion of its sales (out of $10.9 billion total) came from products that had been launched in the past three years.

"Like other food companies, Kellogg has been facing pressure from higher commodity costs, which contributed to a small decline in its gross margin percentage in the first nine months of 2007," Graves notes. "However, with higher sales, Kellogg's gross margin dollars were up nearly $280 million in the first nine months of 2007, which helped to provide funds for spending on innovation and advertising."

Graves says new products from Kellogg include extensions of the Kashi cereal brand to include frozen entrees and brand extensions involving new flavors or ingredients, such as Special K Chocolatey Delight.

"We expect that Kellogg will be among various food companies looking to introduce new or enhanced products that appeal to consumers' interest in seeking healthier foods," Graves says. "We see offerings already including portion-controlled 100-calorie snack packs and All-Bran products with dietary fiber."

Beverage Companies' Energized Moves

S&P equity analyst Esther Kwon notes that for the beverage companies she follows, it's not so much a move to higher-margin products as it is a move to higher-growth areas. "Beverage companies already make pretty good operating margins," she says. "The real growth area is in energy drinks and enhanced water, which are growing 20%-plus."

One example would be Coca-Cola's (KO; $64; strong buy) purchase of Energy Brands for its vitaminwater and smartwater drinks. "I believe vitaminwater and smartwater have a great deal of brand equity and think consumers will still pay a healthy premium over competitors' products," Kwon says.

Tobacco companies are also searching for growth, says Kwon, whether it's international, or smokeless areas like chewing tobacco and snuff, or higher-margin products such as cigars.