Consumer Defensive: Not a Lot to Feast On

• Consumer defensive valuations have continued to trend higher over the past several months, leaving the sector slightly overvalued at a price/fair value ratio of about 1.04.
• In light of slowing growth prospects around the world, expectations for sluggish revenue growth appear reasonable.
• We expect cost-cutting and brand-building to remain key areas of focus over the coming quarters, but think that the market is overly optimistic in terms of the profit gains that are likely to be realized in some cases.
• From our vantage point, a handful of consumer defensive firms look attractive, with overly pessimistic margin assumptions baked into their shares.

Valuations within the consumer defensive sector have remained elevated, trading at around a 4% premium to our fair value estimate. From our vantage point, this premium reflects a rotation into higher-quality names amid the uncertainty within the global macroeconomic landscape, along with investors' appetite for yield, the strong shareholder returns that characterize the sector, and continued optimism for merger-and-acquisition activity in the space.

The first quarter of 2016 was challenging for many consumer companies; as expected, however, defensive firms delivered more stable results than many firms on the consumer cyclical side (especially apparel retailers). In general, organic revenue growth remains positive but relatively uninspiring across the consumer defensive landscape.

Although the consumer staples space tends to be fairly defensive in a more challenging market climate, global consumer spending, particularly in emerging markets, remains tepid. But beyond these pressures, we expect the pace of emerging-markets growth to exceed more developed markets in the longer term, given favorable demographic and disposable income trends. Given that most competitively advantaged firms in the sector are relatively mature (although some are benefiting from increasing exposure to emerging markets), we think market expectations for low- to mid-single-digit revenue growth are reasonable. We don't see many firms mispriced based on unrealistic revenue growth assumptions.

In light of the persistent pressure to accelerate top-line growth, cost-cutting remains a key area of focus for consumer defensive firms looking to drive bottom-line growth. But in this ultracompetitive environment, we don't believe the bulk of the savings derived from cost-cutting activities will merely drop to the bottom line; rather, we contend that these initiatives offer an effective means by which to free up funds to support brand investments and, ultimately, a firm's competitive positioning.

But this take hasn't always aligned with the market. We still believe that the market's overly optimistic outlook regarding the long-term market expansion trajectory for

For instance, we think that the potential for more-pronounced commodity-cost inflation, increased investment behind its brands in an effort to withstand intense competitive pressures, and a shifting mix toward the lower-margin natural and organic channel (which accounts for more than 10% of its consolidated sales) and away from the highly profitable soup category are poised to hinder material margin gains off of recent levels. Campbell's shares trade more than 20% above our fair value estimate, and we've failed to warm to its valuation.

However, while few moaty firms in the consumer-defensive space are screaming bargains, we see value in a handful of competitively advantaged firms that have more muted margin assumptions baked into their shares. For example, we think the market is overlooking the margin opportunity for

We also see long-term upside to owning higher-risk European grocers, such as

) (no moat) and

) (narrow moat), although near-term results could be volatile. These firms still face intense price competition from discounters, alongside general market deflation (driven by lower commodity prices). These dynamics have resulted in declining sales and margins for several quarters, prompting many investors to give up hope that these firms will recover. However, traditional U.K. grocers such as Tesco are progressing toward competitive price architectures, more sustainable margins, and healthy volume increases, giving us confidence that conditions could normalize over the medium term.

Top Picks

Carrefour

(

)

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: EUR 32.00

Fair Value Uncertainty: High

Consider Buying: EUR 19.20

As the largest retailer in Europe and the second-largest on the planet, Carrefour boasts economies of scale and attractive properties that are worthy of a narrow economic moat. Further, we believe its recent initiatives--including efforts to drive higher private-brand penetration, incremental price investments, and more decentralized merchandise decisions--are poised to stabilize sales and margins in France. From our vantage point, investors remain understandably concerned about evolving competitive dynamics between formats, as well as macroeconomic and currency headwinds in Asia and Latin America. Nevertheless, we view Carrefour as a strong operator with the scale to defend its turf in multiple channels at home and lead industry consolidation in emerging markets. Over the long term, we think the firm should generate healthy cash flows; as such, we believe Carrefour could be a good way for long-term investors to gain exposure to the European, Latin American, and Asian grocery retail markets.

Sainsbury

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Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: GBX 280.00

Fair Value Uncertainty: Medium

Consider Buying: GBX 196.00

As one of the largest grocers with a well-known history in the United Kingdom, Sainsbury has enough scale to compete with other large rivals on price while also touting its areas of differentiation. Sainsbury has been one of the few traditional firms to increase market share over the past few years, and its solid online and convenience-store presence should continue to fuel growth. In addition, the firm's above-average private-label penetration, Nectar loyalty program, and consumer banking services could bolster customer loyalty and drive solid like-for-like sales growth. However, switching costs are virtually nonexistent in the grocery industry, and it's not clear that no-moat Sainsbury's points of differentiation are strong enough to ensure that excess returns on capital can be sustained over the long term. Despite numerous challenges, Sainsbury is well positioned to capture incremental share in the faster-growing convenience store channel, in our view, and we view shares as attractive at current levels.

Tesco

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Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: GBX 235.00

Fair Value Uncertainty: High

Consider Buying: GBX 141.00

Given its standing as the largest food retailer in the U.K., we portend that Tesco's scale should allow the company to invest in its value proposition and ultimately maintain its leading U.K. market share position. Price cuts remain a headwind, though, as Tesco attempts to improve the competitiveness of its products relative to those of discounters. While these price cuts could continue to weigh on profits, we see signs that Tesco's shift to more everyday low prices is having a positive effect. With Tesco's challenges so clear for all to see, we believe the market's forecast--which projects declines in like-for-like sales to persist for a decade and operating margins around 2.5%--is a bit dire. As such, we contend that Tesco's positive traffic trends, sharper prices, and solid online and convenience-store businesses are getting less credit than they deserve.

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