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updated 11/11/2005 4:58:58 PM ET 2005-11-11T21:58:58

With sales growth among U.S. consumer-products companies expected to lag behind last year's big gains, this holiday season may prove to be a double whammy for those outfits with already weakened financial profiles. On the heels of one of the worst hurricane seasons on record, in which Katrina and Rita helped drive up already steep energy and commodity prices, U.S. consumers are being forced to rejigger their usual spending habits this holiday shopping season.

Even though energy prices have retreated some in recent weeks, they remain at historically high levels. Lofty prices for gasoline and home heating fuels combined with rising interest rates may force consumers to reconsider big-ticket purchasing decisions.

At the same time, elevated energy expenses are fueling higher operating costs throughout the manufacturing supply chain, including raw materials, factory overhead costs, and transportation. The result: A further squeeze on the profit margins of consumer-products outfits.

'Adverse effect'
"Because holiday sales commitments are already in place for most consumer-products makers, perhaps the biggest impact of a ho-hum holiday season will come from retail price markdowns and excess inventory," says Standard & Poor's credit analyst Kenneth Drucker. "This could certainly have an adverse effect on the sector's financial results in the near future as manufacturers step up to protect retailers' margins. Moreover, 2006 replenishment orders could negatively be affected if the pull-through during the holidays is weak."

Rising raw materials and operating costs are expected to largely offset moderately positive volume trends and any benefits of restructuring initiatives undertaken over the past several years. "Because we've been in such a long period of rising raw materials and energy prices already, many consumer-products companies aren't in a position to raise prices this holiday season and run the risk of reduced demand and lower sales volumes," adds Drucker.

The extent to which consumer-products makers will have jolly sales will indeed depend on how consumers react to high energy costs. A prolonged softening in consumer confidence could weaken demand for more discretionary products such as home decor and furnishings, and limit travel and related purchases. Demand is likely to hold up for nondiscretionary goods — personal items and food — but those manufacturers won't necessarily escape unscathed.

Waning confidence
"The food and nondurable sectors face not only high costs but there's added uncertainty about whether or not they can raise prices to maintain margins," says S&P credit analyst Nicole Delz Lynch. "Large retailers will continue to use their leverage to limit price increases, and in some instances, consumer-goods makers may find it hard to pass through rising energy costs."

The prospects for a bright holiday shopping season were dimmed a bit by the October consumer confidence survey, which fell to a two-year low. The index now stands at 85, compared with a post-Katrina 18-point drop to 87.5 in September. The Consumer Conference Board, which conducts the survey, attributed the decline over the past two months to the recent hurricanes, higher energy prices, and a weakening labor market. This will undoubtedly negatively affect the purchasing of nondiscretionary and high-end consumer products.

"There's no disputing that pricier energy will crimp the spending patterns of consumers, who have been living on the brink," says S&P economist Beth Ann Bovino. Higher energy costs have been absorbed by a reduced saving rate, permitted in part by borrowing against the rise in house prices, though S&P expects sales should slow once households get their first heating bills.

"The saving rate has now been in negative territory for the past several consecutive months," says Bovino. "However, higher energy prices, by themselves, will only cause consumer spending to slow, not stop. And assuming that oil has peaked for a while, both the damage to growth and the increase in inflation should remain manageable." Despite low sentiment, October retail sales were upbeat.

In such a challenging environment, how will key consumer segments hold up this holiday season? Here is the view from S&P credit analysts:

Personal care products
Consumers will undoubtedly continue to buy soap, toothpaste, and cleaning products in a tough economy, and the business and financial profiles of companies that sell these items are fairly stable compared with those in other consumer-product sectors. Nevertheless, achieving sales growth has been challenging for many issuers given the maturity of the U.S. market and the resulting intense competition in many household-products and personal-care categories.

Fragrances, which typically has significant holiday sales, could be hurt by more restrained consumer spending. Elizabeth Arden recently lowered its second-quarter and full-year 2006 earnings guidance in part because of a weaker-than-expected projection for the holiday season in Western Europe.

The mass-market cosmetics channel will remain highly competitive with tough growth prospects. "While mass retailers are expected to remain committed to the cosmetics category, the ability for cosmetics companies to maintain market share is expected to remain challenging," says S&P credit analyst Patrick Jeffrey. "As there's less in-store service compared with the prestige segment in department stores, product presentation and promotional activities are key factors in maintaining market share and shelf space at retailers."

The mass segment's focus on middle-income customers also makes it more vulnerable to economic slowdowns. While Revlon Consumer Products doesn't have significant fragrance sales, it does generate a significant amount of cash flow in its fourth quarter ending in December. The company expects its EBITDA for fiscal 2005 will be below 2004 levels due in part to more cautious retailer inventory management given weakened consumer sentiment.

Packaged foods
This segment has even demand characteristics, and 16 of the 26 rated companies in this category currently have stable outlooks. However, S&P is closely monitoring margin contraction from rising raw commodity costs and the sector's limited pricing flexibility due to the highly competitive operating environment and consolidated retail landscape. High energy costs and above-average raw material prices will continue to heighten the need for sector members to institute sustainable price increases and profit margins.

Many outfits in the sector have recently introduced new products in an attempt to gain pricing momentum and secure preferential product placements as consumer traffic increases with the coming holidays. Moreover, new products mitigate the momentum toward private labels, especially in a rising-cost environment. The success of these new products along with the adequate returns on expected step-ups in marketing dollars will be key to sustaining the sector's historically high margins.

Distilled spirits and wine
The outlook for suppliers in this category is stable, excluding merger-and-acquisition activity. Distilled spirits and wine should remain favorite holiday gifts, and their availability in a wide range of price points is expected to sustain demand. For domestic beer producers, volume has been declining. In particular, higher gasoline prices may preclude the purchase of discretionary beverage and other "pay at the pump" store items.

S&P believes beer companies will continue to be challenged by a very competitive operating environment, including continued interest by consumers in both wine and distilled spirits as an alternative to beer. Price increases are unlikely in the second half due to an ongoing heavy promotional environment.

Small-appliance makers
The outlook here is less than robust. Lackluster demand from cash-strapped consumers, pricing pressure from retailers, or margin pressure from rising raw material and fuel prices may lead to weak operating performance and further downgrades in the sector.

"Consumers will certainly have less discretionary income to spend on small-appliance purchases," says S&P credit analyst David Kang. "They might wait until the last minute for markdowns or postpone purchases altogether, making for a difficult holiday season," he adds. "Furthermore, retailer consolidation has led to greater purchasing clout with the manufacturers, and the retailers' focus on improving operating performance has led to tighter inventory controls, both of which may impact the manufacturers' price and volume."

With respect to demand and sales, products in this category tend to be discretionary in nature and are generally seasonal, with the bulk of the manufacturers' sales occurring from August through November as their products are sold to retailers. Manufacturers are highly vulnerable to rising steel and oil prices, which may negatively impact profitability and margins. Key raw materials used in the manufacturing of small appliances include steel and plastic resin. And since more products are being made by lower-cost Asian manufacturers, shipping costs may also reflect rising fuel prices.

Large-appliance makers

For lots of people, buying a large appliance will be a tough call this holiday season. "Many consumers -- spooked by steep prices at the pump and the expectation of enormous heating bills this winter -- will likely scale back on discretionary purchases, including large appliances this holiday season," says S&P credit analyst Jean Stout. "I think that decisions will be made in light of what people need vs. what they can live without," adds Stout.

Industry shipments of major home appliances are influenced by several factors, including sales of new and existing homes, consumer confidence, innovative technologies, and replacement needs. About three-quarters of industry volume is replacement business, which lends some stability to demand. Although the mix of products sold is highly dependent on consumer sentiment, shipments historically have grown at a compound annual growth rate in the low-single digits.

"Still, the mix of products sold may become adversely impacted or pricing flexibility become more limited as a result of significant inroads by low-cost Asian competitors in the U.S. market," notes Stout. "Consumers may also opt to repair rather than replace home appliances," she adds. "On the other hand, current economic conditions could fuel demand for energy-efficient appliances."

Of the rated stand-alone major appliance manufacturers, Whirlpool has done a good job of managing costs in this inflated raw-material environment through a combination of product innovation, productivity initiatives, and selective pricing increases. On the other hand, Maytag continues to struggle with its high cost structure, limited pricing flexibility, and ongoing unfavorable product pricing and mix, primarily in floor care.

Apparel makers
S&Ps believes the outlook for apparel companies will be one of caution. Rising fuel and energy costs are also expected to take a bite out of consumers' disposable income for apparel purchases. Small consumer electronics will continue to take share from apparel as well. Retailers are maintaining leaner inventories and taking markdowns earlier. This will pressure already shrinking margins, while the expected cost benefits from removal of quotas won't be offset by this trend.

"We expect the higher-end premium brands will continue to do well for the holiday season, such as Polo Ralph Lauren, and specialty niche brands, such as Juicy Couture (a Liz Claiborne brand," says S&P credit analyst Susan Ding. "However, if the holiday sales are disappointing, this may translate into higher markdown allowances for the apparel companies, and negatively impact retail orders for the following year."

Copyright © 2012 Bloomberg L.P. All rights reserved.

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