My Favorite 3rd Quarter Turnaround Story

Joseph Hogue's picture

Monday, August 27, 2018 - 2:30pm

by Joseph Hogue

It’s no secret that value and the traditional safety sectors have underperformed lately as the market reaches new highs. Besides investor sentiment to growth, macro headwinds seem to have conspired against a few sectors.


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That could be about to change.

Many expect earnings out in the first half of the year to be a peak in the cycle, meaning growth stocks could lose their appeal. Economic data also seems to point to a 180-degree turn in the fortune of some stocks hit by high producer prices.

This could be the headline when third-quarter earnings start coming out in October and now could be the time to start building a position.

Strong Consumers But Weak Consumer Staples
Companies in the consumer staples space have been the second-worst performers over the last year with a 2.1% decline, beaten only by the 2.3% decline in the utilities sector.

A litany of headwinds has built against the sector from higher rates, making yields less attractive to increased commodity prices and stagnant wage growth for consumers.

With wage growth going nowhere since the end of the recession, companies have had a difficult time passing higher prices on to consumers. At its narrowest in August 2017, the spread between wage growth, increasing at just 2.6% a year, and producer prices for food manufacturers increasing at 2.1% annually left the sector facing weakened prospects for profitability.

Expectations for third-quarter earnings have crumbled with profits just 6% higher compared to last year’s quarter. That’s against estimates for 9.8% growth at the end of June. Revenue growth for the quarter is expected at just 2.9% on a year-over-year basis which would mean sales haven’t budged when accounting for inflation.

Consumer Staples Could Be The Turnaround Story Of The Year
Despite the bleak macro environment, management has been able to use cost-cutting to produce greater profitability. The sector reported second-quarter earnings that largely topped expectations with 88% of S&P 500 companies beating earnings estimates even as only 58% beat estimates for revenue.

As a sector, the group reported an average upside surprise of 5.3% on earnings, according to FactSet Research. Net profit margins have doubled from a sector-wide 3.5% to 7% from the second quarter 2017.

There’s also evidence that the price environment might be shifting to the sector’s favor. The producer price index for food manufacturers has plunged from a 1.3% year-over-year increase in April to a decline of 0.7% in July. Wage growth remains around 2.7% annually and this widening spread could help companies in the sector surprise to the upside when third-quarter earnings are reported.

The weakness in share prices has left the sector more attractive on a yield basis. The sector began the year paying an average 2.5% dividend yield which has now grown to a 2.7% yield, matching the increase in yield on long-term bond rates.

Greater profitability could enable management to boost cash payouts while rates on the long-end of the yield curve are seen constrained by low global rates and fears around economic growth. That could bring investor sentiment back to the group and push prices higher into 2019.

The last year’s misfortunes and improving environment have started to attract activist attention with Jana Partners taking a 10% stake in Pinnacle Foods (NYSE: PF) and Trian Partners’ push for reorganization of Procter & Gamble (NYSE: PG). Consolidation has been a persistent rumor in the space this year with a speculated merger of Kraft-Heinz and Campbell Soup and upside call-buying in the sector seems to point to hopes of increased deal flow in the second half of the year.

3 Best-of-Breed Consumer Stocks In Value Territory
Even if the third quarter doesn’t mark a turning point for the sector, companies should find some support from here. The very definition of these companies is products that consumers need on an almost daily basis. That provides top-line support and investors would do well to take advantage of opportunities to pick up best-of-breed companies when discounts appear.

The Hershey Company (NYSE: HSY) dominates the U.S. market for chocolate with nearly half (45%) of sales. A new CEO took the helm early last year and initiated a strategic program to sell off non-performing lines, especially internationally, and focus on profitability. That plan is now starting to show results with the operating margin in the international division jumping 4.2% in the second quarter, its most profitable on record.


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Hershey’s brand recognition and low relative price for products gives it more pricing power than other consumer companies. Combine the ability to raise prices along with inflation and up to $175 million in cost savings management believes it can attain from the strategic program, means both top-line and earnings growth could outperform.

Shares, down 5.3% in the last year, trade for 20 times trailing earnings and pay a 2.9% dividend yield. Earnings are expected higher by 12% to $5.50 per share over the next four quarters.

The Hain Celestial Group (Nasdaq: HAIN) is a leading manufacturer of natural foods but management inefficiencies and an acquisition strategy left the company weak at a time of slower U.S. sales growth. The recent announcement that the CEO would step down could create opportunity as activist investor Engaged Capital looks at options on its 10% stake.

The trend to healthier foods makes the company a valuable brand and it’s started increasing distribution to traditional grocery stores versus a prior model of specialty-store focus. The organic and natural food segment is growing faster than overall grocery and consumers are not as price conscious, giving the company more pricing power.

Shares are down 30% over the past year but could attract a takeover buyer or interest from other activist investors.

Pilgrim’s Pride (Nasdaq: PPC) is the second-largest poultry foods producer in the U.S. with market share in the mid-teens versus industry leader Tyson. The company has also built a strong position in Mexico with 35% of the prepared foods market with the Moy Park acquisition.

Rising global demand for higher-protein foods and solid international expansion should support growth in the highly competitive and volatile industry. Weak demand for chicken in the U.S. and tariff fears have hit the shares, down 34% over the last year, but the company has a strong balance sheet to withstand short-term weakness.

The company has diversified across poultry sizes as well as adding organic and antibiotic-free products to spread its risk. Brazilian beef producer JBS owns 79% of the company and could eventually acquire the remaining shares.

Risks To Consider: Weak wage growth against faster growth in producer prices mean top-line revenue could be constrained for the next couple of quarters even as companies have found a way to eke out greater profitability.

Action To Take: Take advantage of an ebb in investor sentiment to pick up best-of-breed consumer staple companies at a discount.

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Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.