Consumer staples and consumer discretionary: brands, margins and demand

What you will learn

• Why demand for staples and discretionary goods reacts differently to income and prices
• How to split sales growth into price, volume, mix, currency and acquisitions
• How input costs and pricing power move gross margins, often with a delay
• Which retail metrics (like-for-like sales, inventory turnover) reveal real demand

Explanation

The difference between cyclical and defensive sectors was introduced in lesson 2. Here we look inside the two consumer sectors and ask: what exactly should you measure?

Two kinds of demand

Consumer staples are everyday products: food, drinks, household and personal-care goods, and the supermarkets that sell them. Consumer discretionary covers goods and services people can postpone: cars, clothing, travel, restaurants, furniture and many online retailers.

The key concept is income elasticity of demand: the percentage change in quantity demanded divided by the percentage change in income. It is usually low for staples (people still buy toothpaste in a recession) and high for discretionary goods (a new car can wait). A second concept is price elasticity of demand: how much quantity falls when the price rises. A brand with low price elasticity has pricing power, the ability to raise prices without losing many customers.

Splitting sales growth

Reported sales growth mixes several effects. Consumer companies usually report:

• Price: the effect of changing prices for the same products.
• Volume: the change in the number of units sold.
• Mix: the effect of selling more expensive or cheaper products within the range.
• Organic growth: price, volume and mix together, excluding currency effects and acquisitions or disposals.

Combine the effects by multiplying growth factors: (1 + price) × (1 + volume) × (1 + mix) − 1. Simply adding them is a close approximation for small numbers.

Growth driven only by price, with falling volume, is weaker than it looks. Customers may be switching to private label products (the retailer's own cheaper brands) or simply buying less. Several quarters of negative volume are a warning sign.

Margins and input costs

Gross margin (sales minus cost of goods sold, divided by sales) shows whether price increases cover rising input costs such as raw materials, packaging, energy and transport. Price increases often follow cost increases with a delay of a few quarters, because contracts with retailers are renegotiated only periodically and companies hedge some inputs. So margins often fall first when costs jump and recover later when prices catch up.

Brands also spend heavily on advertising and promotion; cutting it to protect this year's margin can weaken the brand later.

Discretionary and retail metrics

• Like-for-like sales (also called same-store sales): sales growth only from stores or websites that were open in both periods. It removes the effect of new store openings.
• Inventory turnover: cost of goods sold divided by average inventory. Falling turnover means goods sit longer in warehouses, which often leads to discounts and lower margins later.
• Operating leverage: many discretionary businesses have high fixed costs (rent, staff), so a small fall in sales can cause a much larger fall in profit.

Worked example

Hypothetical example: a food company had sales of €10,000 million and cost of goods sold (COGS) of €5,500 million last year, so the gross margin was 45.0%. This year: price +6%, volume −2%, mix +0.5%. Raw materials make up 60% of COGS and rose 8% per unit. Assumptions: COGS move in line with volume; mix does not change unit costs; no currency effects or acquisitions. Taxes, hedging gains and promotions are excluded.

1. Organic growth factor: 1.06 × 0.98 × 1.005 = 1.04399, so organic growth is about +4.4%.
2. New sales: €10,000m × 1.04399 = €10,439.9m.
3. Unit cost factor: 1 + (0.60 × 0.08) = 1.048, so unit costs rise 4.8%.
4. New COGS: €5,500m × 0.98 × 1.048 = €5,648.7m.
5. Gross profit: €10,439.9m − €5,648.7m = €4,791.2m; gross margin = 4,791.2 ÷ 10,439.9 = 45.9%.

Price increases more than covered cost inflation. Alternative: if the company could raise prices only 3%, sales would be €10,000m × 1.03 × 0.98 × 1.005 = €10,144.5m and the gross margin would fall to about 44.3%. The 3-percentage-point difference in pricing decides whether the margin rises or falls. Note also that volume fell 2%: the growth is price-led, so you should watch whether volumes stabilise.

If reported growth also included −1.5% currency and +1% from an acquisition, reported growth would be 1.04399 × 0.985 × 1.01 − 1 = about +3.9%. Look at organic growth first.

Common mistake

Practice activity

Hypothetical retailer: last year it had 100 stores with total sales of €200 million. This year the same 100 stores sold €206 million, and 10 new stores, open for about half the year, added €10 million. On paper, calculate (a) total sales growth and (b) like-for-like growth. Then write one sentence on what the difference tells you.

Key takeaways

• Staples have low income elasticity; discretionary demand reacts strongly to income and confidence.
• Split growth into price, volume and mix, and focus on organic growth.
• Gross margins show whether pricing power keeps up with input costs, often with a delay of a few quarters.
• Like-for-like sales and inventory turnover reveal real demand in retail.

Next step

In the next lesson you will apply similar thinking to industrials and materials, where order intake, capacity and the capital-spending cycle drive results.