Consumer Staples SPDR XLP
August 21, 2006 - 10:08pm EST by
2006 2007
Price: 25.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,444 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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The XLP is an exchange traded fund with 39 holdings in the consumer staples sector. The objective of the ETF is to provide a market-capitalization weighted assortment of companies in cosmetic and personal care, beverages, tobacco, food products, and drug and discount stores. With a 2% dividend yield and a payout ratio that will fluctuate between 35% and 40% over time, the XLP is trading at approximately 17x-18x FY2007 earnings. The absolute valuation of the XLP is just as attractive today as it was during the bear market in July 2002, October 2002, and March 2003. In addition, the relative valuation of the XLP compared to the 10-Year Treasury is similar to the 1982 and 1990 bear markets and more attractive than the 1994 period before Goldilocks and almost any period over the last 25 years.
The XLP is an excellent opportunity for investors like us who have traditionally focused on micro-cap, small-cap, and mid-cap stocks and have very little experience with companies this large to gain exposure to a very stable, attractive part of the market in an unbiased manner. The median market capitalization of the top 10 positions of the XLP is $102 billion. As a result, we believe these companies are too big for most investors to have much of an edge analyzing the prospects of each business. Generating alpha is very challenging given the immense sell-side coverage. The remaining 29 positions are not as large and we recommend shorting out the small weighting in Whole Foods and Estee Lauder and some of the other borderline consumer discretionary names as they do not serve a purpose as part of this investment thesis.
This report will argue that the XLP’s low valuation is due to several reasons. 1) The mega-cap consumer staples companies such as Coca-Cola, P&G, and Wal-Mart, traded at peak valuations of approximately 39x forward earnings during the bubble period from 1998-2000 and many of these companies disappointed unrealistic growth expectations. They became even more overvalued once speculators plowed into these names in 2000 as a defensive play before the looming recession. 2) Operating margins for the consumer staples companies were never cyclically inflated in 2000 so they did not contract and then rebound off a depressed base. This is unlike many companies in the rest of the economy.  This is a very important point that many investors are missing. 3) As a result, the relative earnings growth of the consumer staples sector has been terrible since 2003. Eight-to-ten percent consistent growth in earnings and dividends is amazing over the long-run. However, it does not entice hot money investors who have been enamored by companies in energy, financial services, real estate, industrials, materials, infrastructure, consumer discretionary, etc. that have grown like gangbusters in recent years. This is a time tested recipe for any sector to under-perform major market indices in the short-run regardless of fundamentals. 4) Review the July 3, 2006 write-up on GE for the other reasons.
With clear evidence that the economy has moved out of its rapid growth phase as indicated by the recent Fed pause and national slowdown in housing, we believe that the XLP is likely to perform very well over the foreseeable future given its historically low valuation and tendency to attract catalytic investors when the economy is decelerating or contracting. For example, in August 2000 after the last Fed pause, the XLP appreciated 18% in only a four month timeframe—even when the valuations were unreasonably high. Now with valuations that are actually cheap in addition to a good catalyst, we believe performance could be much better. Finally, most of positions in the XLP have reported strong earnings recently as well and the XLP just reached a four year high today in a challenging market.
Index: Approximately 68% of the XLP is made of the following 10 positions. For more information on the XLP, visit index.cfm?story=charting&symbol=XLP.
Important Observations: Many investors may not realize that the valuation of the consumer staples mega-cap companies of 17.5x FY2007 earnings today is the same opportunity that investors had in July 2002, October 2002, March 2003 to purchase the XLP. Since the March 2003 bottom, the XLP has increased in value approximately 10% a year excluding dividends without any multiple expansion contributing to the return. Again, all of the increase is due to earnings growth. We believe this earnings growth is sustainable and real since consumer staples companies are not cyclical businesses by definition.
Median Forward Year P/E Chart
                                     1994        1998-2000  Bear Market  Today   Current        Payout   5 Growth           Implied             
                                   Trough         Bubble        Bottom                      Dividend       Ratio          Rate              Return
Median                          13.4x            38.8x          17.8x          17.8x       1.9%          35%         10.9%           12.8%         
Mean                             13.2x            39.9x          17.4x          16.8x       2.0%          40%         10.5%           12.5%         
Median Discount to          0%             167%          -38%           -15%
P&G                              14.0x           37.8x           18.1x          18.7x       2.0%           40%         11.0%           13.1%         
Altria Group                     7.3x           17.6x             6.0x          14.2x       4.0%           60%           8.0%           12.0%           
Wal-Mart                       17.5x           50.0x           25.2x          13.5x       1.5%           23%         13.0%           14.5%         
Coca Cola                      16.6x           63.0x           18.0x          17.5x       2.8%           53%           8.0%           10.8%           
Pepsi                              13.8x           30.1x           17.0x          19.3x       1.9%           40%         11.0%           12.9%        
Walgreen                        13.0x           49.7x           23.7x          23.6x       0.6%           18%         15.5%           16.1%          
Anheuser-Busch             12.4x           26.5x           17.7x          17.1x        2.5%           46%          8.4%            10.9%          
Colgate Palmolive           14.1x           37.1x           17.9x          18.2x        2.2%           44%         10.0%           12.2%        
Archer Daniels Midland  10.3x           47.2x           14.2x          13.3x        1.0%           15%          9.4%            10.4%        
CVS Corp                      12.9x          39.7x           10.6x          18.1x        0.5%           10%         15.0%           15.5%    
10 Year Treasury / TIPS
The discount relative to the 10-Year Treasuries is greater than the 1994 period. This proved to be an unbelievable buying opportunity as many positions in the XLP appreciated over 50% annually over the next 4 years. We are not predicting this will happen again given valuations got out of control, growth is probably going to be lower, and the 10-Year Treasury does not appear to have as much room to decline. However, we would not be surprised if 15%-25% annualized gains were achievable due to earnings growth and moderate multiple expansion. If interest rates go significantly lower, multiple expansion could end up surprising a lot of people to the upside.
Macro Factors: Most consumer staples companies have active, sizable and expanding buyback programs and good acquisition prospects due to healthy balance sheets and strong, predictable free cash flow. They also have attractive dividend yields compared to the S&P 500 that have historically been maintained and grown during all types of economic and political environments. The benign tax environment for equities with 15% long-term capital gains taxes at the highest bracket and 15% dividend taxes has never been more favorable relative to Treasuries, TIPS, CDs, and money market funds which are taxed at the marginal rate of 35%. This will matter a lot during a low-return environment that is likely going forward in many asset classes.
Growth and Return Targets: We believe earnings and dividends per share could grow 8%-to-10% a year over the next decade which is consistent with sell-side estimates, historical results from 2000-2006, and many management estimates but lower than growth rates over the past several decades.  
This could provide a return of approximately 10%-to-12% a year with no multiple expansion. On an after-tax basis, a long-term investor in the XLP could receive up to a 9% premium above the risk-free rate of return assuming no multiple expansion in a conservative scenario. More likely, we believe the discount to intrinsic value will be arbitraged. The premium over the 10-Year Treasury is too rich right now given the high earnings quality, low transaction costs, and information transparency. The market should eventually be willing to accept a lower risk premium of anywhere from 2%-to-3% over Treasuries for large, stable blue-chip companies in non-cyclical industries such as consumer staples.
With a cost of capital approximately 200 bps-300 bps above Treasuries at 4.8% and a 17.5x terminal multiple consistent with today’s valuation, the XLP deserves a 21x-to-26x multiple at fair value. In 2 years, the XLP could have approximately 50% upside including dividends.
A big opportunity exists for the XLP once the market starts to respect the risks of the sustainability of US pre-tax corporate profit margins relative to GDP. Due to low interest rates, a strong economy off a depressed base, and other factors, US pre-tax corporate profit margins are at a 40-year high and are approximately 20%-to-30% above the average since World War II. Since 2003, margins have expanded by over 50%. Consumer staples companies have not had margins expand at all. If anything, margins have been under pressure because of soaring commodity costs.
At some point, this trend will reverse and the effects will be ugly on smaller companies with a weak balance sheet that have a strong correlation to the economy and have experienced significant margin expansion even if the multiple seems cheap on the surface. The earnings for smaller companies in the Russell 2000 and Nasdaq and to a lesser extent the smaller S&P 500 companies have benefited the most from this margin expansion and they will be the first to collapse as well. This overhang is penalizing valuation multiples for a lot of companies for understandable reasons.
The risk of revenue declines or margin contraction is very low over the next several years. It may happen over a long period time because of exogenous factors specific to the industry but a housing bubble bursting, decline in business or infrastructure spending, higher interest rates, hard landing in China, or global domestic or recession, etc. will not cause margins to decline materially for such a diversified, proven group of businesses.
Many investors believe that 17.5x earnings is not cheap without having done much in-depth analysis about sustainability of earnings and macro risks and opportunities. We believe many investors got burned by paying high multiples for businesses in the bubble days and as a result are reluctant to pay up a little bit more than they are used to for quality and moderate, dependable growth.
Options: Many investors cannot imagine the XLP getting multiple expansion because it has not happened for a long time. For example, the January 2009 LEAP call options at $25 are $3.10, which is a very low options premium. In addition, the January 2009 options have only strikes available of $23 through $27 in one dollar increments—hardly a wide range in either direction. Consequently, the call options are a good way to capture the upside in the stock price because of the tight trading range, low business risk, and low interest rate environment.
1) The strength in the economy continues. There is no housing bubble. The consumer holds up just fine. The XLP continues to grow but experiences multiple contraction or stagnation. Investors prefer riskier assets for longer than we think. 
2) Although the Fed has already paused and the most liquid interest rate futures market predict a decline in the Fed funds rate by 2007, the Fed continues to raise interest rates to 10% or higher and the earnings and dividend yield are not as attractive to TIPS. Commodity prices soar out of control causing stagflation and profit margins decrease.



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