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A Defensive Ride

Consumer defensive stocks, though fairly valued, still offer opportunities for investors concerned about safety. 

Philip Guziec, 04/12/2013

In the face of commodity cost pressures and weak economies worldwide, consumer defensive companies continue to press on through the ups and downs of the business cycle. Investors, searching for yield and safety, have rotated into the sector, pushing up values. Still, Morningstar’s equity analysts think that the long-term fundamentals of the sector are strong and that opportunities exist for patient investors. To learn more about consumer defensive stocks, I sat down with R.J. Hottovy, Thomas Mullarkey, Erin Lash, and Ken Perkins, who Morningstar equity analysts who cover the sector. Our discussion took place Feb. 25.

Philip Guziec: The consumer defensive sector is supposed to hold some value through an entire business cycle. How well did these stocks hold up through the our latest cycle?

R.J. Hottovy: Through 2008 and 2009, consumer defensive stocks outperformed the broader market. What we saw was a lot of rotation into high-quality names. Consumer defensive is one of the more-concentrated categories in terms of economic moats. Roughly two thirds of the 100 consumer defensive companies that we cover have either a wide or narrow Morningstar Economic Moat Rating. That makes them attractive in times of difficulties. These are the brands that people buy, regardless of the economic backdrop. And while shoppers may trade down to private-label and lower-priced items, these products are still produced by consumer defensive firms.

Now, as we started to see a bit more recovery, the bounce back among the consumer defensive stocks wasn’t as pronounced as it was in the higher-risk consumer cyclical space. Still, over the past six to nine months, consumer defensive stocks outperformed cyclical stocks. A lot of that had to do with investors’ preference for higher-yielding stocks. That’s another feature of the consumer defensive sector. It is full of dividend-payers. The average consumer defensive stocks pays a dividend yield of 3.5%. So, it’s a good category for investors chasing yield.

Guziec: In terms of operating performance, did they exhibit stable earnings as expected?

Hottovy: For the most part. There was more stability on the revenue line than anything else. You’re always going to have low-single digit volume growth with these companies, but pricing was a wild card. We did see a spike in commodity costs, particularly in the latter part of 2011, early part of 2012, which had a lot of consumer companies rethinking things. As a result, we saw more margin pressure than we had seen in past economic downturns, particularly in terms of food-related commodity costs, which were so severe that it ate away at profitability for a lot of these companies.

Another thing we see in the retail side of the sector is a lot of consolidation. Big players such as Wal-Mart WMT and Costco COST are now commanding a lot more bargaining power with consumer staples companies. But all things considered, consumer defensive stocks were able to better preserve their margins when things were getting worse than what consumer cyclicals were able to do. But they may not bounce back as quickly as some of the other categories once we get higher revenue growth.

Guziec: Where are things valuation-wise? What looks interesting?

Hottovy: As a result of investors’ rotation into these stocks, the space is 5% to 10% overvalued. Again, for income investors, we do think there are a lot of attractive names that are paying healthy dividends. But just on a purely fundamental basis, we are reaching multiyear highs in terms of forward-looking multiples, both on price/earnings and enterprise value/EBITDA. We haven’t seen these types of levels in several decades for a lot of the consumer defensive names. That said, there are some opportunities here and there.

Thomas Mullarkey: One opportunity is in the beverages category; values exist in the nonalcoholic industry. Coca-Cola KO and PepsiCo PEP both trade around our fair value estimates. That means we think long-term investors should be rewarded as these companies leverage their strong brands and scale in emerging markets to grow per capita servings. And both of these firms have around a 3% dividend yield.

But the other categories I cover are overvalued, including most spirit companies, such as Brown-Forman BF.B, Diageo DEO, Beam BEAM, and Pernod Ricard. In tobacco, U.S. companies such as Altria MO and Reynolds American RAI are also overvalued. The U.S. cigarette market is in a state of steady secular decline—losing 3% to 4% per year as consumers quit smoking cigarettes.

Growing are cigarette alternatives, such as smokeless tobacco products and even e-cigarettes. Lorillard LO, a domestic cigarette company trading at our fair value estimate right now, recently acquired a company called blu, which makes e-cigarettes. Additionally, we like international cigarette companies such as Philip Morris International PM, trading slightly below our fair value estimate. Philip Morris has strong brands, an addictive product, and terrific emerging-markets exposure. As consumers in emerging markets get more money, they smoke more cigarettes. Philip Morris is able to steadily increase prices year after year, and with a 3.7% dividend yield, it should be a good long-term holding for investors in a diversified portfolio.

Guziec: How about in household products and packaged foods?

Erin Lash: We don’t see a ton of value right now in the household and personal-care sector or in the consumer packaged goods sector overall, for that matter. A lot of these companies have been in favor of late, so they are trading at a premium to our fair value estimates.

But within packaged food, we see some value in a couple of names. Kraft Foods Group KRFT is the North American grocery operations of the former Kraft business. The Kraft Foods Group is a spin-off of the consolidated business as of October. We think that the market right now is underestimating the substantial cash flows that the North American grocery business generates, which we estimate at about 10% in terms of free cash flow to sales over the next five years. In addition, we think that the North American grocery business was being used as a cash cow to fund growth in the global snacks business. By reinvesting in these more-mature brands, Kraft is going to be able to realize decent levels of growth, despite the fact that it competes in the more mature domestic market. For example, Kraft has talked about the fact that it increased the advertising investment behind Kraft Mayo by about 50% and realized a 9% jump in sales. We were at the Consumer Analyst Group of New York conference last week, and the company’s presentation further solidified our take. Management seems committed to improving Kraft’s innovation pipeline and investing in those brands to drive sales growth, which we think is a positive. Finally, for income investors, the company is committed to returning cash to shareholders. The dividend yield is 4% to 4.5%, which is obviously significant.

Beyond Kraft, Sysco SYY, the North American food-service distributor, is also trading at a slight discount to our fair value estimate. The company is investing to expand its platform in the North American food-service distribution market, but it still maintains substantial scale, with control of nearly 18% of this $235 billion market. In addition, the company has been focused on driving additional costs out of the business. Volatile food costs, lumpy restaurant traffic, and the fact that the restructuring effort is taking longer and costing slightly more than anticipated are all issues weighing on the stock. But we think management is appropriately investing for the long term. In addition, the dividend is yielding around 3.5%, making it attractive for income investors.

Ken Perkins: I cover meat processors. The smaller-cap companies, such as Hormel Foods HRL, Hillshire Brands HSH, and Tyson Foods TSN, are slightly overvalued. They’re facing some pretty significant commodity cost headwinds as a result of the drought. But we think that of the three, Hormel is probably the most attractively priced. They’re a good manager of brands, and that’s allowed them to manage some of the commodity-cost pressures better than their peers have. They’ve also just acquired the Skippy brand, which opens the doors to China and should allow the company to leverage its Spam distribution in the region. So even though these companies have lower dividend yields than their larger counterparts, their international growth opportunities could allow them to increase their dividends at an above-average rate.

Hottovy: That raises an important point, which Thomas also alluded to earlier. One of the key themes at the analyst conference was the idea of innovation in emerging markets. An attractive feature of the consumer defensive space is that it offers emerging-markets exposure. A lot of these companies have been in emerging markets for decades. They have built up established operations.

Mullarkey: If you look at a company such as Coca-Cola, emerging markets are going to be the driver of growth. In the United States, the average person consumes 400 8-ounce servings of Coca-Cola beverages each year. This compares with just approximately 40 servings per capita in China and less than 15 servings per capita in India. As consumers in emerging markets get more money in their pockets through GDP growth, they will buy more and more packaged beverages and packaged foods. We expect that the emerging regions of Latin America, Africa, and Asia will be a major driver of not just Coca-Cola’s growth but also Pepsi’s for its snacks business, and Philip Morris’ for its cigarette and tobacco business.

Lash: Within the household and personal-care and packaged-food firms, we have two different setups. There are consumer product companies that are almost exclusively focused on the U.S. market. Church & Dwight CHD, Clorox CLX, and ConAgra CAG come to mind. But several of the packaged-food and household and personal-care names that we cover maintain a sizeable presence in emerging markets. Colgate-Palmolive CL and Unilever UL both derive more than 50% of their sales from faster-growing emerging markets. They have been in those markets for a significant period of time, which gives them the benefit of understanding the local consumer and the routes to market—the sales and distribution platforms that are necessary in those markets. These are huge advantages.

We’ve also seen several companies in the space look to expand their footprint in emerging markets of late, primarily through acquisitions and joint ventures. For example, two years ago General Mills GIS acquired Yoki Alimentos, a Brazilian consumer products firm. HJ Heinz HNZ has made deals in China and Brazil over the past couple of years. We expect this trend to continue, because tastes and preferences vary around the world.

Guziec: What could derail this emerging markets story? What are the risks there?

Hottovy: At the end of the day, emerging markets are still heavily dependent on developed markets. They’re typically trade partners. If we continue to see pressure in the European markets, or if we see a retrenchment in the U.S. economy and a decrease in demand in developed markets, it could have a trickle-down effect on emerging markets.

These countries are the producers of a lot of these products, and a lack of demand would weigh on the spending power there. It’s one critical risk as we look at 2013 and beyond, although we’re comfortable saying now that we’ll see growth in the mid-single digits, and possibly see high-single-digit operating-income growth for a lot of consumer staples companies this year.

Mullarkey: Emerging markets also are more subject to political instability. For example, during the Arab Spring, consumer-packaged goods companies saw their sales decline for beverages and tobacco in parts of North Africa. When countries such as Syria fall into turmoil or when hyper-inflation occurs in countries such as Venezuela, consumers’ purse strings shrink, as do whole distribution channels. So, it’s a risk that these companies face to a much greater extent in emerging parts of the world than in the developed markets.

Hottovy: As a side note to that point, a lot of the infrastructure build in emerging markets has been footed by the governments themselves. But a lot of governments are under budgetary pressure. As a result, the responsibility for building infrastructure, whether it is for transportation or water, is falling on the shoulders of the companies themselves. This spending could depress results over the next couple years as companies construct their own infrastructures in emerging markets. Lash: I would also add that food-cost inflation has a much more substantial impact on the emerging-markets consumer than it does in developed markets. For example, 10% to 15% of a family’s income in the United States is spent on food annually. In a country like Egypt, it’s 40% or more. As we see the commodity-cost environment become more favorable, it could have an adverse impact on emerging-markets consumers.

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