Our Outlook for Consumer Defensive Stocks
While emerging markets remain a key growth driver, we're noticing a growing dichotomy among consumer defensive firms with regard to pricing and profitability.
Quarter-End Insights
- Emerging-markets hype appears likely to persist over the near term, but competition is mounting.
- Consumer product firms put cash to use for emerging-markets land grab.
- While further price increases from sin stocks could prop up margins, packaged food firms may be more challenged, as low- to middle-income consumers prove they aren't afraid to hunt for value.
Emerging-Markets Hype Likely to Persist Near-Term, Competition Mounting
Deteriorating economic conditions in Europe, combined with sluggish growth in North America, are challenging consumer product firms. Our expectation is that the competitive landscape in more mature, developed markets, including Europe, will remain intense for the foreseeable future, as consumer product firms battle to garner a larger slice of consumers' reduced discretionary spending. As a result, we think that emerging markets will remain a top growth prospect for consumer staple companies for an extended period, particularly due to their consumers' added wealth and spending power, which is propelling per capita consumption.
Within the global beverage arena, firms such as Coca-Cola (KO), PepsiCo (PEP), Diageo (DEO), SABMiller , and Heineken (HEIA) are steadily adding capacity and distribution scale in emerging markets such as Asia, Africa, South America, and Eastern Europe. This trend should plant the seeds for future earnings growth. More specifically, we believe that Asia and Africa present the greatest future growth opportunity for Coca-Cola. Whereas the average American consumes over 400 eight-ounce servings of Coca-Cola products (including carbonated soft drinks and still beverages) per year, the average Chinese citizen consumes less than 40 servings, the average Indian just over 10 servings, and the average Nigerian about 30 servings. Globally, the average person consumes about 90 Coca-Cola beverages per year. We believe that Coca-Cola's global volumes are bound to increase, as consumer purchasing power in emerging economies increases over the coming decade.
Even though we expect the growth trajectory of these faster-growing regions to remain head-and-shoulders above developed markets, some softening may be in store. For instance, Estee Lauder's(EL) management took a cautious stance toward macroeconomic conditions in China during its fiscal third-quarter conference call in May, which could indicate that sales growth in one of the firm's fastest-growing regions is likely to slow. We contend that emerging markets will face increased competition as consumer product manufacturers seek the same pockets of opportunity in regions where product categories are growing. As a result, it's possible for growth rates to trend down slightly from the lofty levels of the past few years.
Consumer Product Firms Put Cash to Use for Emerging-Markets Land Grab
With a greater share of the spending shifting to premium brands in emerging markets, consumer product firms have also looked to acquisitions to build out their presence. From our perspective, gaining entry into these regions by acquiring local firms that are familiar with local tastes and preferences is a wise investment. We expect that consumer product firms will continue efforts to further expand in these regions through bolt-on deals. However, with several companies looking to developing markets for expansion opportunities, we caution that valuation multiples could spike to nosebleed levels, making such deals less beneficial.
One of the more notable deals this past quarter was Nestle's (NSRGY) decision to acquire Pfizer's (PFE) infant nutrition business for $11.85 billion in an all-cash deal, which was valued at 5 times fiscal 2012 sales and 19.8 times fiscal 2012 EBITDA. Although the deal makes strategic sense, in our view, the price seems rich, likely reflecting the fact that Nestle wanted to keep this valuable asset out of the hands of competitors such as Danone (BN) and Mead Johnson .
Nestle's appetite for Pfizer's baby food business makes sense to us. The infant nutrition business is high growth (with Pfizer's unit generating about 85% of sales from faster-growing emerging markets like China) and high margin (with EBITDA margins in the mid-20s). This comes on the heels of Nestle's purchase of a 60% stake in Chinese confectionery manufacturer Hsu Fu Chi, the producer of the popular breakfast bar Sachima, last summer. China--along with other growing Asian economies--is an attractive market for Western manufacturers, whose domestic markets offer very few growth opportunities. This particular growth opportunity is reflected in the rich multiple Nestle is paying. When Nestle sold its stake in Alcon to Novartis (NVS) for $28 billion pretax, we argued that it should invest the cash in extending its footprint in emerging markets.
In addition, General Mills (GIS) is to acquire Yoki Alimentos, a privately held Brazilian food maker whose portfolio of products spans the snack, seasoning, and convenient-meal aisles. The packaged food firm is paying around $850 million for the deal (about 1.6 times sales). That said, because General Mills' business in Brazil only includes the sale of Haagen-Dazs ice cream and Nature Valley snacks currently, we think this deal provides a platform over which it should be able to extend the distribution of its existing brands. Beyond enhancing shareholders' return (through increased dividends and share repurchases), we expect that acquisitions will remain a top priority use of cash for General Mills.
In May, Diageo agreed to purchase Brazil's leading premium cachaca, Ypioca, from Ypioca Agroindustrial Limitada for GBP 300 million. We believe that the deal is a smart move, providing Diageo with a foothold in the premium segment of a local premium spirit and increasing the size of its distribution system in Brazil. Additionally, premium spirit companies such as Beam and Brown-Forman (BF.B) have ample opportunity to continue growing their businesses in emerging markets, as consumers increasingly choose to imbibe premium international spirits.
Price Hikes Could Prop Up Sin-Stock Margins, but Value-Conscious Consumers May Pose Challenges for Packaged Food Firms
During 2011, many consumer product companies experienced margin compression as pricing failed to keep up with input cost inflation. However, we're now noticing a dichotomy among consumer defensive firms with regard to pricing and profitability. For one, we think that tobacco and alcoholic beverage firms will realize margin expansion as additional price increases should outpace input cost inflation. Conversely, it is likely--in our view--that margins at packaged food and household and personal care firms will remain under pressure, given that consumers have shown a willingness to trade down or out of categories in order to garner the best value for their constrained spending dollars.
For example, Brown-Formanis about to roll out a price increase on its various spirits, including Jack Daniel's, which should help the company expand gross margins and grow earnings per share over the next several quarters. We doubt volumes will be negatively impacted. Spirits companies also benefit from the shift in consumer tastes toward premium brands. Firms such as Diageo, Pernod-Ricard (RI),and Beamare rolling out premium brand extensions carrying higher price points, and heftier margins.
During 2012, we believe tobacco companies will continue to benefit from the pricing power they enjoy, which admittedly stems from a potent mix of powerful brands and an addictive product. However, international tobacco firms Philip Morris International (PM) and British American Tobacco (BTI) have better opportunities for long-term growth, in our view--versus Altria (MO), which markets cigarettes only in the United States--given their substantial exposure to emerging markets. Consequently, we believe that Philip Morris and British American should be able to steadily grow margins and EPS over the medium term, as they continue to gain scale in emerging markets and sell a richer mix of premium tobacco products. For example, during 2011, Philip Morris' cigarette volumes in Asia grew by 11%. This was partially bolstered by increased Japanese demand following the earthquake and tsunami, which negatively impacted Japan Tobacco's capabilities. A 12% increase in average revenue per pack and an improving mix of premium products--combined with a weakening U.S. dollar--contributed to improving the company's top line.
That said, consumers have responded differently to the higher prices that packaged food and household product firms are charging in the grocery store aisle. For instance, similar to other firms throughout the industry, Ralcorp has increased prices in order to offset elevated raw-material prices (such as durum wheat and snack nuts), but volume in the most recent quarter was negatively affected, as private-label price increases exceeded branded pricing (particularly in the peanut butter and snack nut categories). In addition, management commented that price realization lagged its expectations, as retailers were reluctant to raise prices on the shelf in light of their view that raw material costs are trending lower.
Additionally, while J.M. Smucker (SJM) has taken significant pricing over the past year to offset commodity costs, it recently announced a 6% reduction in its coffee prices in May. We think this is the right move. Coffee commodities have receded from their highs, and competitive pricing from branded rivals and private labels has challenged Smucker's brands in recent quarters. Still, Smucker's announced price decrease was quickly followed by Kraft's (KFT) decision to lower the price for its Maxwell House coffee brands. The operating environment remains difficult, and competition remains fierce. This will make innovation, acquisitions, and international expansion important growth drivers for firms throughout the space over the short and long term. Even if these costs subside, we further question how well these firms will be able to maintain the significant price increases that they implemented as raw material prices skyrocketed.
We could not deny the importance of brand investments (related to both advertising as well as product innovation) following L'Oreal's (OR) recent analyst day. New products represent 15% to 20% of U.S. revenue annually, and 80% of the productslaunched in North America are specifically developed for the local consumer. Twice a year, L'Oreal's CEO, Jean-Paul Agon, allocates the latest technology to specific brands for use in its products, enabling the firm to differentiate its offerings from competitors while also enhancing the value of its products in the eyes of consumers. In our view, the success of these investments is evident in that L'Oreal has moved away from deep discounting, but has not realized a subsequent decline in sales, as North American revenue increased a healthy 5.5% in fiscal 2011 and 6.6% on a like-for-like basis during the first quarter of 2012. In addition, L'Oreal is realizing measurable share gains, as Maybelline New York now controls 20.5% of the domestic cosmetics market (which is up from 18.1% in 2009), exceeding Cover Girl's 16.8% share.
Our Top Consumer Defensive Picks
Following the recent market volatility, we peg the average price to fair value for our consumer defensive universe at 0.99 (implying the category is essentially fairly valued). There are few outright bargains, though we continue to focus on later-cycle categories such as home improvement, which may strengthen as the recession cycles through. We would become more interested if the market were to trade down another 5% or so, but we are quick to gravitate toward firms with established economic moats, which may be in a better relative position to withstand near-term revenue and operating margin volatility.
In general, we like companies possessing a combination of scale, pricing power in categories where perceived differentiation matters, exposure to emerging markets (particularly China), resources to extend brand reach, and strong dividend growth potential.
| Top Consumer Defensive Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ Fair Value | |
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| Kroger |  | $30.00 | None | Medium | 0.76 |
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| Sysco | | $36.00 | Wide | Medium | 0.81 |
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| Heineken | | EUR 44.00 | Narrow | Medium | 0.87 |
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| Campbell Soup | | $36.00 | Wide | Low | 0.89 |
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| Kraft Foods | | $44.00 | Narrow | Medium | 0.89 |
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| Data as of 06-18-12. |
Kroger (KR)
Despite trading at higher valuations on a P/E basis than Safeway and Supervalu , we believe Kroger offers investors the best risk/reward profile in the grocery store category, because we see the least relative downside risk to sales, earnings, and cash flows. Kroger continues to not only defend but gain market share, while Supervalu and Safeway have not posted positive identical-store sales (excluding fuel) since 2008. Because of the ability to consistently drive share, Kroger has the best chance among its peers to be left standing to reap the rewards of margin expansion inherent after the industry moves beyond the consolidation phase.
Sysco (SYY)
In our view, the market's concerns regarding sluggish restaurant traffic and food cost inflation are overdone and are unjustly weighing on Sysco's shares. We continue to believe that Sysco's expansive distribution network will enable it to remain the dominant player in the North American foodservice distribution space, generating strong cash flows and outsize returns for shareholders longer-term. In addition, we think the firm's business transformation offers the potential for higher customer retention, the ability to better serve customers, and improved reporting, the combination of which should sustain revenue and limit unnecessary expenses.
Heineken (HEIA)
Over the past five years, Heineken has been expanding its exposure--both organically, and via acquisitions--in the faster-growing emerging markets of Latin America, Africa, and India. The company's acquisitions typically include strong local brands and solid distribution systems that help to drive increased sales for the company's iconic Heineken beer. Additionally, the company’s TCM 2 cost efficiency program should generate EUR 500 million of savings through 2014. Given the company's emerging-markets potential and narrow economic moat, we believe the shares are currently undervalued.
Campbell Soup (CPB)
Although Campbell Soup has been challenged by rampant cost inflation and intense competitive pressures, we contend that the firm is appropriately investing behind its brand. We don't anticipate that these efforts will yield measurable improvements overnight, but overall we believe that the unrivaled scale in its business enables the firm to generate operating margins in the domestic soup segment that far exceed other areas of the consumer products space. While the shares are modestly undervalued, we believe there is limited downside risk for this wide-moat packaged food firm, even with more aggressive competition and rising input costs.
Kraft Foods (KFT)
We believe that a move to break up Kraft is a value-enhancer, motivated by management's desire to realize a higher multiple for the faster-growing snack business that was being unappreciated when combined with the more mature North American grocery brands. Following the spin-off, investors with an appetite for growth in the packaged-food sector may be interested in the global snack business, while income-seeking investors may want to consider the North American grocery business, as management has said that dividend payments would be a priority for cash. Overall, we contend that the firm's dual focus of 1) investing in its brands, and 2) introducing products that resonate with consumers should ensure that Kraft continues to win at the shelf.
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