Consumer Staples Sector

1. Consumer Staples Sector Laura Fillman Mary Kanet

2. Recommendation • Under-weight Consumer Staples • Interim period between Federal Reserve action • Under-weight .50%, S&P 500 is at 9.46% • Consider under-weighting more when the economy gains momentum • Although there is uncertainty, the economy is expected to rebound, which would have a relatively negative effect on the consumer staples sector

3. Outline • Sector Overview • Business Analysis • Financial Analysis • Valuation Analysis • Recommendation

4. Sector Overview

5. S&P 500 Composition Source: www.standardandpoors.com, as of 01/31/03

6. Consumer Staples Composition Source: Business Week Online, 01/31/03.

7. Consumer Staples Composition Largest Companies • Procter & Gamble, 15.20% (Household Products) • Coca-Cola, 13.65% (Soft Drinks) • Altria Group, Inc., 10.84% (Tobacco)

8. Business Analysis

9. Demand • Growth/Mature Life Cycle • Growth • More Competition • High Cash Flow • Defensive Business Cycle • Stable performer • Performs better when market falls

10. Users and Geography • High Foreign Exposure • Global Franchises for Coca-Cola and Procter & Gamble • Declining dollar since the beginning of 2002 • Emerging markets in Asia and Latin America

11. Trend line analysis • Given that consumer staples is a stable/defensive sector, we predict future demand to be consistent with past demand

12. Supply • New capacity additions increase linearly with demand

13. Profitability and Pricing • Ease of Entry • Difficult • Established companies • High brand recognition • Global presence • High initial investment

14. Strength of Customers • Widespread demand • Loyal to brand recognition • Increasing with global expansion • Strength of Suppliers • Lower • Trying to maintain current customers

15. Competition • High • Pepsi vs. Coca-Cola • Very split • Substitution • Moderate • Lower cost items • Not as much because of brand recognition • Inelastic demand for tobacco and alcohol

16. Financial Analysis

17. Current Revenues are $34,566 Growth rate is 4.1%

18. Revenues have a growth rate of 14.5% • Current growth rate estimate is 16.0% • Total returns have a growth rate of 19.7%

19. -Revenues have a growth rate of 3.9% -Current growth rate estimate is 12.0% -Total returns have a growth rate of 13.6%

20. -Revenues have a growth rate of 3.0% -Current growth rate estimate is 10.0% -Total returns have a growth rate of 8.1%

21. -Revenues have a growth rate of 4.1% -Current growth rate estimate of 11.0% -Total Returns growth rate of 8.1%

22. Profit margins have risen from 6.7% in December 2000 to 7.9% in September 2002. • Profit margins have risen as revenues have fallen, indicating cost-cutting activity within the sector. • Long-term estimated median growth rate is 10.8%.

23. -Margins (EBIT/Sales) have fluctuated between 8.5% and 13.2% over the last decade. Margins for 2001 were 10.97%. -Asset turnover (Sales/Assets) has fluctuated between 1.37 and 1.66 over the past decade. Turnover for 2001 was 1.41. -Reported ROE has fluctuated between 20.6% and 34.0% over the last decade. ROE for 2001 was 29.4%.

24. -Margins for the S&P 500 have been greater than those for consumer staples, however, the ROE has been less. Recall, ROE in 2001 for CS was 29.41%. For the S&P 500, ROE was 7.52% in 2001.

25. -Free cash flow after dividends has been positive during the past 5 years -The sector had a positive change in free cash flow during four of the past five years.

26. Price of consumer staples has generally been less relative to the S&P 500. It declines in expansion and grows in recession.

27. Valuation Analysis

28. Trends

29. Dividends (+) Dividends are providing a higher yield than the S&P 500

30. Earnings (-) Earnings are starting to dip as the economy starts to look promising

31. Earnings Estimates

32. Value relative to S&P 500 (-) P/E ratio is moving in the same direction as price and earnings. Earnings are starting to dip as well as the price, indicating that P/E will not be expanding in the future

33. Value relative to S&P 500 Net profit margin is decreasing as the P/S ratio decreases. Trend toward poor future performance

34. Momentum More selling activity than buying activity

35. Total Return Estimates

36. Valuation Summary • + Dividends, Dividend yield is higher than S&P 500 and trends toward remaining that way • - Earnings, Earnings growth is not as high as S&P 500 and is slowing • - P/E ratios are declining, it is a signal of bad things to come, not more value • Overall, the total return is too low, and will be worse with a strengthening economy

37. Growth rate estimate has decreased to 10.9%. The estimate has not fallen as much as the rest of the market, causing the upward trend line.

38. -Analysts have been recommending holding less consumer staples over the past year.

39. Recommendation • Business • Cycle indicates that the sector will under perform due to the state of the economy • Financial • Profit margins are increasing, revenues are decreasing, bad mix • Valuation • Poor returns for Consumer Staples expected

40. Recommendation (cont’d.) • Keep Consumer Staples under-weighted • Economy is still trying to rebound from recession • Consumer staples do not perform well coming out of recession • Prices, earnings and net profit margins are trending downwards • Estimate revisions and selling activity indicate skepticism about consumer staples’ future performance