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Julian Close's Insights

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Julian Close
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April 22, 2013 - Consumer Product Sales Safe Despite Rising Food Costs

Food prices in the U.S. are expected to rise 3% to 4% in 2013, due in large part to the serious drought that struck America's breadbasket in 2012. Despite a small dip in the CPI in March, the producer price index showed food prices rose 0.8%. Even small increases in the price of food are worrisome, as food is not something consumers can easily scale back on. Unless consumers change their habits, they will have less money in their pockets. Some, at least, are likely to do just that.

The trick, however, is not in determining what consumers will and what they will not choose to do without, but in determining which companies are, and which are not, in a position to weather, and perhaps even profit from, an environment of higher food costs.

Smart money knows that when the cost of doing business rises, companies with narrow profit margins have no choice but to pass the extra cost along to the consumer and hope their competitors do the same. This creates an opportunity for companies with higher profit margins than their competitors; while they have the option of raising their prices and continuing with business as usual, they may choose to keep prices flat, thereby making lower profits in the short term, but likely gaining market share, and possibly putting the financial screws to their rivals.

Such opportunities are not as likely to appear in industries where profit margins are universally thin, as is the case for grocery store chains. At 4.28%, Whole Foods (WFM) has the highest profit margin of any grocery chain. It might make them appear vulnerable when faced with a 3% to 4% increase in costs, but not compared to the competition. Safeway (SWY) has a profit margin of 1.35%, Kroger's (KR) is not much better at 1.55%, and SuperValu (SVU), with a profit margin of -2.65%, already has a gruesome amount of red in its ledger. Keep in mind that a negative profit margin is considerably worse than negative earnings; the more business SVU does, the more money it loses.

Of course not everything on the grocery store shelves is food, and as it is only the price of food that is rising, this provides an opportunity for the companies that stock the non-food related shelves, and no company does more of that than consumer colossus and DOW 30 stock Proctor & Gamble (PG). With its $218 billion market cap, PG owns many of the most recognizable brand names in the world, including Gillette, Crest, Vicks, Dawn, Duracell, Bounty, Charmin and Pampers. If you need it, chances are pretty good that PG makes it.

Of particular note is PG's profit margin of 15.5%, which seems astonishing for a company so big, and which means that PG will be one of the last companies to feel the squeeze if consumers feel they have less cash in their pockets than they would like. Though the share price has climbed from around $70 per share at the beginning of the year to near $80 today, it has done so in an orderly fashion. Even after this rise of nearly 15%, the stock trades at a reasonable PE of 18.16 and is buoyed by its dividend yield of 2.8%.

We believe the timing is excellent to take advantage of PG's strength with a bull-put credit spread. Make this trade by buying a July PG 67.5 put and selling a July PG 70 put for a net credit of 22 cents. This target return for this trade is 9.6%, which is an annualized return of 36.9% (for comparison purposes only). The stock needs to fall 9.5% before the trade is threatened. This is an aggressive trade, best undertaken by investors with diverse portfolios and high tolerance for risk.

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