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Quarter-End Insights

Our Outlook for Consumer Stocks

How recovering consumer habits are playing out across the sector, and where opportunity still lies.

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Consumers may not feel like they have gained much during this recession, but one area where they are benefiting is in consumer products. In an effort to remain competitive, many grocers have slashed prices on everyday staples to drive traffic into their stores.

But where the consumer has gained, the grocers have lost. Because of their higher fixed cost structures, many grocers have seen their margins squeezed as lean heavy hitters like  Wal-Mart (WMT) become increasingly aggressive in cutting prices. Additionally, food deflation in certain categories like dairy and meat have added pressure on the top line. Although we expect food deflation to abate in future quarters, we believe the consumers' laser focus on price means grocers will have to adapt their cost structures to stay competitive.

It doesn't appear that consumers have begun to open their wallets to increased spending, but many consumer products companies have opened up theirs. Acquisition activity has definitely picked up again in recent months, from small bolt-on purchases, like  Alberto-Culver's  acquisition of the Simple brand in Europe, to large-scale transformational mergers like  Kraft's (KFT) pursuit of  Cadbury .

Companies that are flush with cash or have strong balance sheets are increasingly rumored to be on the prowl;  SABMiller (SAB) and  Heineken (HEIA) are said to be in talks over  FEMSA (FMX);  Hershey (HSY), and  Nestle (NSRGY) are supposedly interested in Cadbury as well; and  Diageo (DEO) is rumored to be wooing the spirits division of Moet and Hennessy. We view this as a sign that consumer products companies expect growth to be muted over the near term and so are taking advantage of potentially depressed prices to bulk up on brands. We wouldn't be surprised to see more acquisitions in the next quarter.

One industry that we certainly expect to remain weak for some time is travel and leisure. Consumers have significantly pulled back from big ticket purchases, like boats, motorcycles, and vacations. In Las Vegas, for example, the weak travel market has hurt hotel and casino traffic, and added capacity, like the opening of the City Center, will likely keep prices under pressure. Given the often high financial leverage of many of the casino operators, a pickup in the economy would be much-needed relief. However, we believe consumers will re-introduce other types of spending, like dining out more often or trading up in apparel, before making big-ticket purchases once the economy recovers.

The  Comcast -NBC Universal deal was the major headline in the media industry during the fourth quarter. Established cable networks like USA and CNBC are probably the assets that Comcast really coveted in this transaction, but it had no choice but to buy the whole company. We think the nation's largest pay television distributor paying up for a content company demonstrates that quality content is tough to build from scratch. This new media joint venture will generate a significant portion of its cash flow from cable networks, similar to several companies on our media coverage list such as  Disney (DIS),  Viacom , and  Time Warner .

We think the advertising outlook is improving for media sectors that don't face secular issues, like cable networks and online search. According to TNS Media Intelligence, cable TV advertising was down only 2.9% in the third quarter, a bit better than the 3.6% year-over-year decline in the second quarter. We expect the gradual improvement to continue and expect overall U.S. cable network advertising to turn positive and increase in the mid-single-digit range in 2010.

Internet search advertising seems to be improving as well.  Google's (GOOG) revenue growth improved in the third quarter, and we expect further improvements thanks to both a rebound in overall advertising and the continued shift in ad dollars from old media to the Internet. Google's executives also noted improvements in traffic growth across most verticals, which could be an indication of an improving economy. However, not all search engines are enjoying the benefits of an improving economy equally. While we estimate that overall search advertising continues to grow, Google is capturing most of that growth at the expense of smaller players such as  Yahoo  and  AOL  (which was spun off from Time Warner in December).

Spending on discretionary goods appears to be stabilizing, but consumers remain fixated on price and continue to favor value players like Wal-Mart,  Dollar General (DG), and  TJX (TJX). While some premium-priced chains such as  Tiffany  are showing signs of life as affluent consumers have benefited from recent stock market gains, we do not expect a big bounce in overall spending in the coming year, as we assume high unemployment levels and minimal wage growth will keep spending levels in check.

Going forward, we expect the performance of discretionary and value-oriented retailers to converge as the former benefits from easy comparisons and improved consumer spending, and the latter is hurt by tough comparisons and trading-up.

Tighter inventory levels and recent cost-cutting efforts have helped mitigate margin erosion from lower sales levels in recent quarters. However, top-line growth over the next couple of years is critical for operating margin preservation/expansion going forward. In general, inventory levels are already lean and pricing remains cutthroat, leaving minimal room for gross margin expansion in the coming year. Additionally, recent cost reduction initiatives have left little to no more fat to trim, putting a number of retailers like the department store chains and home improvement stores in a position where sales growth is necessary to prevent further margin contraction.

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Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.