Consumer Defensive: Attractive Companies, Top-Shelf Valuations

• Most names in the consumer defensive sector trade above our estimates of intrinsic value, and while some decent growth opportunities exist, we think that investor returns could suffer if growth slows and valuation multiples contract from lofty levels.
• Defensive retailers could bolster competitive advantages in the organic/natural food space, but robust organic food growth could detract from consumer product firms' moats.

Many consumer defensive companies have economic moats because of pricing power and cost advantages, which give their management teams different levers to pull when challenges arise. These characteristics result in stable cash flow generation, which can be used to support dividend payments regardless of the economic backdrop. However, while these qualities are attractive, we do not believe that current valuations are as compelling. Most consumer defensive names trade at a premium to fair value; many firms are valued at peak multiples on peak margins, leaving more downside than upside in many cases, in our opinion.

We're generally cautious about consumer spending growth in many markets, although we believe that lower gas prices and improving consumer confidence could bolster spending in some regions over the near term. We also see pockets of value in the names we highlight below--

Moreover, we see solid long-term growth prospects in the organic and natural food space. The organics sector has been growing by about 10% annually over the past 10 years, around three times the level realized by the overall consumer packaged goods space; we estimate that organic food sales could increase by around 6% annually over the next couple of decades, as we anticipate growth can continue because of consumers' penchant for health and wellness offerings combined with favorable demographic trends.

Some firms are better-positioned than others to exploit these higher-growth opportunities. For example, some niche and traditional grocery retailers are directly exposed to organic/natural food trends, whereas organic products represent less than 10% of sales for many major consumer packaged goods firms. By focusing on the organic space and targeting a niche consumer, defensive retailers stand to amass a brand intangible asset, which could in turn drive a cost advantage. However, consumer product firms are unlikely to yield an advantaged competitive position by expanding in organics, and may even realize erosion in the brand intangible asset and cost source of a moat if products fail to win with consumers and leverage remains elusive.

Leading organic manufacturers, including Boulder Brands, Hain Celestial, and WhiteWave Foods, strike us as likely targets for packaged food firms looking to consolidate the space. Based on recent transactions in the industry--including

Aside from focusing on acquisition candidates, we recommend focusing on companies with narrow or wide moats that enjoy strong brand intangible assets or sustainable cost advantages, even if growth prospects aren't quite as compelling. Although it doesn't play in organics currently,

Philip Morris International

PM

Powerful intangible assets are at the core of Philip Morris International's wide economic moat. In addition, the company's platform of total tobacco products and e-cigarettes gives it economies of scope and scale that make it difficult for new entrants to gain the critical mass of volume necessary to compete. Finally, the addictive nature of tobacco products makes demand fairly price-inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.

Ambev

ABEV

Ambev still has opportunities to increase volume in its core markets of Latin America, but we believe its medium-term revenue growth trajectory will fade from the double-digit compound annual growth rate achieved over the past four years to a mid- to high-single-digit rate. However, even as volume slows, we believe an opportunity for revenue growth lies in the premiumization of the market. Currently, the premium beer segment makes up just 5% of volume in Brazil, versus almost 15% in Argentina and Chile, and we expect a strong mix effect to become a key driver of revenue growth for Ambev in the medium term; premium now represents 8% of volumes, indicating that continued premiumization should provide a long-term tailwind to the top line, even if volume growth undershoots its historical run rate.

Procter & Gamble

PG

P&G's announcement that it intends to shed 90-100 brands--more than half of its portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates that it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer products arena. We view this as a particularly important trait given the stagnant growth emanating from developed markets and the slowing prospects from emerging regions. Undervalued names are few and far between in the consumer defense space, and with Procter & Gamble's shares trading about 10% below our fair value estimate, we think investors should consider owning this wide-moat name.

More Quarter-End Insights

• Stock Market Outlook: Proceed With Caution
• Economic Outlook: More Slow Growth but Labor Scarcity
• Credit Outlook: Demand Rises for Higher-Yielding U.S. Dollar-Denominated Debt
• Basic Materials: China Will Keep a Lid on Most Commodities
• Consumer Cyclical Investors: Shop Carefully in 2015
• Energy: Coping With Lower Oil and Gas Prices
• Financial Services: Bank Worries Are Overdone
• Health Care: 3 Picks in a More Expensive Sector
• Industrials: A Few Bargains Still Remaining
• Real Estate: REITs That Can Weather a Rising Rate Environment
• Tech and Telecom Sectors: Time to Be Selective
• Utilities: Bloody February Brings Valuations Back In Line