Thursday, August 16, 2012

Five Sectors Set to Benefit From Lower Commodity Costs

The downgrades to China’s growth expectations have hit commodities hard and I think this is creating potential for some upside surprise to certain sectors in the developed world. The good news is that analysts rarely make big macro calls in their estimates, so I think there is a good possibility that their forecasts will prove too low.

It’s time to have a look at some stocks that could be set to benefit. Ultimately, I’m looking for stocks with substantial commodity input costs but, whose end demand will not be affected by the cyclical factors that are causing commodities to fall.

To put this argument into context, let’s have a look that the US ISM manufacturing prices paid data.

May saw a dramatic drop off but might this be a one-off event -- similar to the data in the fall of 2011? I doubt it. Here is the Thomson/Reuters Jefferies CRB Index.

The decline is clear and both graphs correlate, so which sectors are set to benefit?

Consumer Packaging

Investors like the consumer staples sector for its defensive characteristics, but why not look at the companies that package the goods?  For example, Ball Corp (NYSE: BLL) is a major manufacturer of beverage, food and aerosol cans.

What makes this sector attractive is that the likes of Ball and UK rival Rexam tend to build their plants near their customers in order to capture long-term manufacturing contracts. Given that their end customers have relatively stable end demand, this gives the packaging companies a lot of revenue visibility. However, it does leave them exposed to any major slowdown as they would have already committed to capital expenditures. Also, they are exposed to commodity costs, which in this case, is the good news!

Now I know, these companies all argue that they hedge their input costs. They also argue that they are not exposed because they pass on costs in the contracts to the customer. Both of which are worthy arguments. However, I have never seen a company of this type effectively hedge commodity costs. Hedging costs money and as it gets more expensive, the more the commodity goes up. Moreover, when commodity prices rise, even if the input cost is passed on to the client, his customers will cut back on volumes because of raised prices. This is a negative cycle when input costs rise, but a virtuous cycle when they fall.

Since we are hoping for the latter, I think consumer packaging is worth a look. With regards to Ball Corp, investors may want to investigate its emerging market growth prospects. China’s housing market may be in trouble but I doubt the growth in soft drink consumption is going away anytime soon.

Food Companies

Investors should be looking at a traditionally safe haven of food. The sector has been hit with rising prices over the last few years and with changing consumer trends that have seen established brands losing share to private label. Kraft is worth a look because I think the split will create synergies that will allow snacks to generate growth.

For a purer play on this theme, I think General Mills (NYSE: GIS) is attractive. The company reported 10-11% input cost inflation in the last quarter and margins were under pressure. This suggests that when costs fall, it can expand profitability significantly. Whilst the cereal market is difficult, much of this is due to sharply increased corn prices, which are now moderating. In addition, it has made the right move in diversifying with the Yoplait yogurt acquisition. The dividend will attract income seekers and its management has a good track record of execution.

Consumer Goods

This is an obvious port of call for this theme. Not only is this sector exposed to raw material input prices but also to energy prices within production line costs. The usual suspects are well known. Kimberly-Clark, Procter & Gamble, Unilever etc.

I like Colgate-Palmolive (NYSE: CL). It is not the sexiest of stocks, but it has single digit earnings growth forecast and generates very strong cash flows. It offers security given a protracted slowdown in the global economy and has upside potential if commodity prices keep falling. Moreover, Colgate has growth initiatives with products like ‘Optic White’ toothpaste and is increasingly exposed to emerging market consumer demand.

Big Box Retailers and Transportation

The last two sectors are volume based retailers and transportation companies. I don’t want to dwell too long on the big box retailers because they were covered in an earlier article. Suffice to mention that recent sales figures from companies like Wal-Mart and Target (NYSE: TGT) have been at the high end of expected ranges. Target reported strong comparable sales numbers for May. Moreover, as fuel costs decline, more discretionary income will be in the hands of consumers. Revenues should then shift to higher margin sales and, the warehouse retailers should see some margin expansion from lower costs as well as cheaper input prices.

Similarly, with regards to transportation companies like UPS (NYSE: UPS) or FedEx, a major part of their cost base will be in fuel costs. Granted, the slowdown in the economy will create downward pressure on their revenues, but UPS has a growing ecommerce exposure. This is a trend that appears to be accelerating in a tough economic environment as customers value the cost savings in buying online. Also, the dividend is attractive for income seekers that want GDP style growth, but more yield than a Treasury.

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