Noncyclicals (Still) Rule

Call it the $7 billion penny. Late Monday, consumer-goods powerhouse Gillette announced late that it would miss Wall Street’s earnings estimates by one cent, and on Tuesday investors dumped the stock, sending it down 12 percent and shaving $7 billion off the company’s market cap.

On the one hand, that reaction simply reflected investors’ lack of patience with companies that fall short of expectations. With stock prices as high as they are–and even though Gillette’s stock hasn’t really moved in the past year, it’s still valued at a more-than-healthy price-to-earnings multiple–there’s no room for bad news. More substantively, the sell-off reflected a growing concern that blue-chip consumer companies like Gillette and Coca-Cola, the ones whose businesses were supposed to be noncyclical, aren’t really blue-chips at all, and that their hefty p/e multiples are no longer justified.

You might call Gillette and Coke (with Disney and McDonald’s added into the mix) the Buffett stocks, since in the last decade they became the prototypical “buy and never look at them again” companies. The combination of powerful brands, distinctive product lines, and unequaled distribution networks was seen as a guarantee that these companies would never really be challenged, and that their earnings would continue to grow steadily for as far as the eye can see.

With the exception of McDonald’s, though, all of these companies have endured a very difficult year and a half. Disney’s earnings in the latest quarter are projected to fall compared with a year ago. Coke recently announced that its sales and earnings growth have been slower than expected. And Gillette’s shortfall is just the latest in a series of disappointments. So, has the reign of the supposed noncyclicals (they’re called that because most consumer companies’ businesses are cyclical, which is to say they rise and fall as the economy does) really ended?

Unfashionable as it now is to say, the answer is no. But there are sources of real concern, especially in the case of Coke. It has significant problems in North America, where the number of cases sold volume rose just 2 percent in the most recent quarter and where it apparently can’t raise prices without eating into sales. And it has been hit hard, as all these companies have, by continued economic weakness in Asia and Latin America. Gillette’s core razor business, on the other hand, remains as dominant as ever in the United States, and is able both to charge premium prices and increase market share. But its other divisions are weaker, and softness in Asia and Latin America are hurting it.

When the Asian crisis hit more than a year and a half ago, everyone quickly pointed out that the Asian and Latin American markets accounted for only a small percentage of the U.S. economy, and that fact does help explain why the United States has weathered the global storm so well. But those markets accounted for a very high percentage of the earnings and revenue growth that multinational companies such as Coke and Gillette were expecting, and as those markets have evaporated, so too have the steady profits investors have come to rely on.

Still, the return on invested capital (ROIC) of Coke and Gillette remains high relative to their peers, which means that the dollars they’re putting into their businesses are not going to waste. And the fact that Gillette’s Mach 3 razor is now the best-selling razor in the United States, despite its hefty price tag, suggests that the fundamentals of that company’s business have not changed. (I do have a personal stake in this question, since I wrote an article last summer talking about the Mach 3 as proof of the success of Gillette’s business model.) In the end, it’s hard to see what has happened in the last two years–other than Asia and Latin America–that could have changed people’s appetites either for Coca-Cola or for Gillette razors. Assuming the rest of the world eventually does snap back into prosperity, the consumer noncyclicals will snap back, too. Of course, it is taking a little longer than everyone expected. But I guess that’s why you buy them and never look at them again.