These Wide-Moat Firms Are as Strong as Ever

Consumer-products companies have always faced change, but the intensity of change seems to have ratcheted up over the past few years. Perhaps the single largest switch has been the transformation of the U.S. consumer landscape from a "push" to a "pull" economy, in which consumers take greater control of their purchasing decisions. Word of mouth (greatly amplified by the Internet) and retailers' need to create a differentiated, consumer-centric shopping experience have changed merchandising strategies, which now align with the products that consumers "pull" rather than the traditional "push."

While these changes have forced a reallocation of marketing funds and will likely lead to continued acquisition activity, we think that traditional wide-moat consumer-products firms such as  Coca-Cola (KO),  PepsiCo (PEP),  Procter & Gamble (PG),  Anheuser-Busch (BUD),  Campbell Soup (CPB),  McCormick (MKC), Wrigley ,and  Hershey (HSY) will retain their long-term competitive advantages. This will be due in part to legacy brand equity built in the golden age of the push economy, but much more importantly it will come from distribution and scale advantages that remain as strong as ever. With the landscape and rules of the game in constant flux, we think that Morningstar's moat ratings are particularly valuable to consumers when considering the competitive threats to a consumer-products manufacturer.

Advertising: The Game Has Changed
Since the advent of advertising early in the 20th century, consumer-products companies have aggressively "pushed" their brands and products to consumers, moving from print to radio to TV and to the Internet, inundating programming with their messages. But the interactive age has marked an important shift: Consumers have taken a greater degree of control of their media. Consumers are being bombarded with more ads than ever, but the rise of technology and fee-based services has enabled them to avoid more and more ads, whether through Tivo and digital video recorders, renting a television series through  Netflix (NFLX), paying for a commercial-free  XM  radio feed, or simply enabling their Web browser's pop-up blocker. The use of technological gadgetry and pay services is currently much more prevalent in developed nations (especially in the United States) than in emerging markets. We think push brands in several overseas markets are still enjoying a golden age, as advertising avoidance mechanisms are less prevalent and will likely take several years to reach a meaningful mass--with the obvious exception being the Internet.

We believe that media fragmentation and the reduced impact of push advertising is a secular trend, however, and companies are now challenged to deliver a unified marketing message over disparate media outlets. In most cases, we think companies are lucky to be reaching consumers at all. Consumers are saying that their time is too valuable to spend watching ads--they will pay a premium to be constantly entertained and not pitched products. This presents a tricky dilemma to companies wanting to advertise--how to reach consumers that are paying premiums to not be reached.

One way to solve this problem is to spend more money on ads that consumers can't avoid. Someone might be able to skip a 30-second Budweiser commercial during a baseball game, but it will be hard to avoid the Budweiser sign painted on the centerfield fence (though some networks do in fact superimpose their own ads over those at the actual ballpark). Billboards are also difficult to ignore, as is in-store advertising in places such as the  Wal-Mart (WMT) network. The sponsorship of college football bowl games and TV and movie product placement have already become thriving businesses, and we shouldn't underestimate the use of new media to push brands. The dollars you spend on consumer products will be hunted relentlessly by companies looking for an edge.

Can Push Brands Roll with the Punches?
Retail consolidation and media fragmentation have put the power back into the hands of consumers, who are demanding more brands, flavors, and package sizes than ever. Retailers have been forced to acquiesce to differentiate themselves and drive sales in an intensely competitive marketplace. Subscale, regional players tout the breadth of their product offerings and unique items because they simply cannot compete on price with Wal Mart. 

Wal Mart has also changed the way traditional grocers compete by eliminating most slotting fees, which are traditionally paid by consumer-products companies to guarantee a place for their products on retail shelves. These fees created a barrier for smaller producers looking to break into stores, and they also created a less consumer-centric shopping experience because product selection was being at least in part dictated by the consumer-products companies rather than customers.

Despite fragmentation in the media landscape and the declining use of slotting fees to guarantee shelf space, we think that many of the old-fashioned push brand companies will retain wide moats well into the future. Their combination of scale, distributional advantages, established brands, and raw financial firepower will enable them to pull off acquisitions of niche brands and nurture them by using the parent company's multinational infrastructure--a powerful synergy story. Today's pull brands will thus very likely morph into tomorrow's push brands, funneled through a multinational infrastructure.

Coca-Cola's Growth by Acquisition
Coca-Cola's main competitive advantage used to stem from its strong brands. However, we now view its true strength as an ubiquitous distribution and marketing force of sufficient scale that can popularize brands on a global scale, whatever those brands may be. The days of manipulating consumer tastes through the perfect ad are dwindling, and consume-products companies are now truly in the business of satisfying, rather than controlling, consumer desires. 

A perfect example is Coca-Cola's recent purchase of Glaceau, a pull brand that had grown with little traditional media spending. Given Coke's distribution infrastructure both nationally and internationally, the company's payment of 8 times trailing 12 months revenue (our rough estimate) for Glaceau is not as ridiculous as it might appear at first glance. We think Coke can enhance the long-term growth prospects of brands that are already seeing strong growth , and consumer acceptance of vitaminwater points to a better payoff than spending $4 billion trying to introduce new products that may or may not succeed.

Coke's financial muscle and its distribution should allow it to continue to acquire up-and-coming pull brands, and we see that as a viable path to growth. Companies with dominant distribution and control of desirable points of sale can outsource some innovation to third parties, which they will have the opportunity to later acquire. Though the acquisitors will likely pay a premium, they will also likely have a much better grip on the prospects of the products they are buying. We have seen similar acquisition strategies employed by PepsiCo with acquisitions of brands such as Izze and Stacy's Pita Chips, as well as Anheuser-Busch through ownership stakes in regional craft brewers such as Goose Island. An acquisition strategy could be especially potent on an international level and could potentially create a sustainable avenue of earnings and total return growth. However, the specter of overpaying for acquisitions will always hang in the air, and each deal must be evaluated closely.

Final Thoughts
The pull economy is a clear indication that power has returned to consumers, and retailer consolidation is a strong force in consumers' favor. We think companies that have strong brands and distribution advantages are likely to thrive despite the migration to a pull economy. While the propensity for niche brands to grow in this environment has increased, the ability of larger firms to buy or at least imitate these niche brands helps to manage this threat, and the moats for large consumer-products firms remain wide. These firms can also make a compelling case for better brand growth prospects because of superior distribution and brand availability at attractive points of sale, especially internationally. The transformation from a push to a pull economy does not mean the end of the advantages that push brand companies have developed, but rather a redeployment of resources to become the pull brand of choice for consumers.

Mitchell P. Corwin, CFA, CPA, contributed to this article.