* Fundamentals remain challenged in Q3, but it’s still all about the macro: After a disappointing Q2, the much hoped for H2 sales recovery in Staples is failing to materialise. In recent weeks Unilever, L'Oréal and a number of other Staples companies speaking at various investor events/conferences have highlighted deteriorating trends
in both Emerging (volume) and Developed (price) markets for Q3 and into the yearend. We cut our FY1E organic sales growth (OSG) estimates by -34bps in this report and Q3 14E European Staples OSG by -84bps to +3.4%. Despite this further reduction in top-line growth, recent FX moves, particularly for euro reporting stocks, mean earnings
revisions are negligible, with FX tailwinds a 1-2% offset. With the challenging Q3 now well-flagged, we believe near-term Staples relative share price performance is likely to be driven by wider market trends rather than sector fundamentals themselves.
* Spirits, Cosmetics and mid-cap food our preferred sub-sectors: We reiterate our OW ratings on Pernod Ricard, L'Oréal, Kerry and Glanbia. Pernod Ricard is our top-pick in spirits. With de-stocking complete some signs of improvement in Cognac in China and the prospect of cost savings/Euro support underpinning F15E EPS. At L’Oréal,
disappointment around Nestlé's decision to only partially sell its stake in L'Oréal has led to a considerable de-rating of the stock, which is now at the very bottom end of its 5 year relative trading range. Although Q3 will remain tough, L'Oréal’s first class product and operating footprint bodes well for the medium/long term.
* Beverages – No respite as weather and US spirits deteriorate: In Beverages, the absence of Easter, the World Cup and a tough weather comp means beer sales growth is forecast to have slowed sequentially to +2.6% in Q3. Soft drinks sales are also suffering a weather impact, with the slowing rate of growth exacerbated by recent increased promotional intensity in Northern European markets. In spirits, destocking will be less of a drag on quarterly performance, and despite a still mixed message on China (Remy still cautious and Pernod slightly more benign) we expect sales declines to have moderated. The US spirits market is still tough and we expect cautious shipments trends ahead of the important Christmas holiday period. Moreover, with one-time issues such as beer tax changes in Kenya still impacting Diageo's beer business, we expect overall spirits organic sales growth rates to have remained lacklustre.
* Food and HPC – Deflation and EM price elasticity pressure: The deflationary environment in Europe is pressuring pricing, while rising price elasticity means incremental pricing is becoming more difficult to implement in Emerging markets. This will be an issue for those names with exposure to still-rising inputs costs, such as cocoa and coffee. In cosmetics, the North American mass market is not showing the Q3 rebound many hoped for back in July,
while Western Europe’s muted trends may be exacerbated by bad weather and lacklustre sun-care sales. We have lowered our OSG expectations for 2014 for both Food and HPC accordingly. At the EBIT level, due to the nature of their cost structures (lower gross margins/more operational gearing), we expect Food and Home Care margins to be less
resilient to pricing pressures and lower volumes growth than Cosmetics. However, self-help (SKU pruning, operational efficiencies), a favourable commodity environment, and a weaker euro may allow most to maintain FY guidance.