Higher Costs Are Climbing Up The Value Chain

By Stephen D. Simpson, CFA | March 23, 2011 AAA

How much should investors worry about some of the details of Nike's (NYSE:NKE) guidance? More to the point, if this champion of brand value is seeing costs bite into its margin, that cannot be good news for branded consumer product companies in general. After all, if the lions are having to tighten their belts a bit, it stands to reason that those lower on the food chain might be left starving.

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Brand Versus Value
As long as there have been premium brands, there have been companies willing to undercut those prices with products that may sacrifice a little quality (or sometimes only the cachet) but still offer good value. However, because these white label/private label companies typically have lower margins, it is not so surprising that they are very sensitive to input costs.

In other words, it is largely a given that companies like TreeHouse Foods (NYSE:THS) and Cott (NYSE:COT) are going to see some challenges to their gross margins. These companies produce products that do not carry the same labels or brand loyalty of competing products from Unilever (NYSE:UL), Kraft (NYSE:KFT) and Coca-Cola (NYSE:KO). That means that they cannot charge as much for their products and they can really only raise prices if the market leaders do so first. If they close the gap in price between their products and the brand names too much, they lose their business.

Savings Through the SG&A Line?
What is interesting, though, is that despite the well-publicized challenges that companies like Kraft, Unilever and Kellogg (NYSE:K) are having with input costs, the private-label companies really are not suffering. Cott and TreeHouse, for instance, are both close to 52-week highs.

And why not? Both companies are showing solid growth right now and beating analyst estimates. On top of that, employment and wage conditions have not really changed all that much for the better and there are still millions of shoppers willing to trade down (in brand value if not quality) to save money and shrink their monthly grocery bill.

Moreover, these companies do not have the high advertising and marketing burden that goes into supporting brands. To wit, Coca-Cola has incredible brand value, and still spent 8% of its revenue (nearly $3 billion) on advertising (and the real number may be higher, as a variety of promotional expenses can be run through other income statement lines. For a company like TreeHouse or Richelieu, though, most of the advertising and product promotion is handled by the stores themselves.

Will High-Value Brands Come to the Rescue?
An old school of thought is going to be put to the test once again in the consumer goods space. For a long time the thought has been that high-value brands can protect their owners and allow them to sail through rougher seas more or less unscathed.

Right now, though, the data is mixed. Nike seems likely to sell off on management's own worries that the cost of materials and labor will impinge margins. On the other hand, apparel makers like Hanesbrands (NYSE:HBI) and Polo Ralph Lauren (NYSE:PL) are going to take a stab at raising prices and hoping that customers do not abandon their goods for those made by companies willing to take lower margins.

Looking at food companies, the data is also mixed. Companies like Unilever, General Mills (NYSE:GIS) and Kellogg all have premium brands like Ben & Jerry's, Haagen-Dazs, and Kashi in-house, but they also have huge businesses in mass-market products and even some private-label exposure.

In other words, there just isn't enough profitability in the high-value brands to offset the pressures across the business. So while companies that focus almost exclusively on higher end goods and sell-through retailers like Whole Foods (Nasdaq:WFMI), companies like Bob's Red Mill and King Arthur Flour, may be able to use their brands to offset at least some of the input cost pressure, this does not seem to be the case for the bigger corporations.

The Bottom Line
All things considered, it is still better to invest in companies with solid brands. Brand value often translates into superior returns on capital and superior long-term returns to shareholders. That said, investors should not just assume that brand value is an impenetrable shield against the realities of the business cycle. Prices are going up across the board and even the best companies with the best brands are going to have to get clever to maintain margins in this environment. (For more, see Top 5 Global Brands.)

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