Our Outlook for Consumer Defensive Stocks
The usual suspects of cost inflation and soft consumer spending have yet to move out of the spotlight, but rather than sitting still, consumer product firms are pursuing different tactics to drive value.
Commodity Cost Pressures Reappear, but Volume and Profits at Moaty Consumer Defensive Firms Should Hold Up
Just when consumer product firms were thinking the operating environment was improving, unfavorable weather conditions in much of the United States combined with record flooding and drought conditions in Russia started placing more pressure on commodity costs. Although it's difficult to determine the impact this will ultimately have on final crop yields this year, especially against a backdrop of macroeconomic and political uncertainty, we generally remain cautious that elevated grain prices (September corn futures are up almost 60% since June and trade at nearly double the five-year historical average corn price received) could put additional pressure on margins at a time when many consumers remain vigilant about maximizing their limited income. We recognize that there is only so much that today's fragile consumer is going to be able to absorb--particularly in operating environments where unemployment levels remain stubbornly high and austerity measures are constraining discretionary spending. However, consumers in emerging markets may also feel some pain over the short term, given that food costs represent a larger portion of household budgets than in the developed world. For instance, 10%-15% of a family's income is spent on food in the U.S. versus nearly 40% in Egypt. Emerging-market consumers have enabled consumer staple companies to offset more sluggish growth in mature, developed markets, but this could be tempered if food costs continue to increase.
However, there is a lag between the time when costs go up and when firms ultimately incur raw material inflation (particularly as they tend to hedge commodity needs by locking in prices in advance), and as a result, we don't expect higher prices to show up on grocery store shelves for at least a couple of quarters. In addition, consumer staple companies possess other levers beyond just raising prices--including adjusting packaging sizes or product composition as well as driving additional cost efficiencies--to offset these higher costs. For instance, General Mills (GIS) is currently 50% hedged with regards to its raw material exposure for this fiscal year, and grain makes up just 5%-10% of its overall purchases. Further, the packaged food firm has announced that it is eliminating 850 positions from its global workforce (roughly 2% of its total employee base) in an effort to improve its cost structure.
From our perspective, higher input prices will affect firms throughout the consumer defensive sector to varying degrees. For example, we think meat prices (which have been increasing at double-digit rates for quite some time) could continue to rise. More specifically, the total supply of cattle is shrinking due to recent drought conditions (which have resulted in smaller cows and higher feed costs), and demand has failed to meaningfully subside (particularly in the export market). Less supply should help producers charge higher prices and partially offset input cost inflation, but the significant rise in corn and soybean prices will probably hinder gross margins in the coming quarters at Tyson (TSN) and Hormel (HRL) and are likely to overshadow any benefits from increased efficiency over the near term.
Conversely, while we tend to regard confectionery purchases as an affordable luxury, even Hershey's (HSY) volume has continued to slip. Hershey announced a 10% price increase in March 2011, but Easter was the first holiday during which consumers saw these higher prices at the shelf. Management doesn't seem to be concerned about these trends and expects more balanced sales growth (between price and volume) throughout the remainder of fiscal 2012, although we are slightly skeptical (given that volume has been softer than management was anticipating). That said, we still believe firms that possess a solid brand portfolio, like Hershey, are best positioned to charge higher prices without a significant risk to material downward volume pressure.
Given its dominant position, McCormick (MKC) also fits the bill, as higher prices, favorable mix, and increased volume have contributed to the recent uptick in sales. Management's decision to raise prices during the fourth quarter of fiscal 2011 (which historically has accounted for one third of the firm's consolidated sales) pressured higher-margin branded volume at the same time as consumers opted for lower-priced value offerings, but it now seems that consumers are adjusting to these higher prices as volume trended up. From our perspective, the strength of McCormick's brand portfolio, combined with investments behind product innovation that resonates with consumers, will continue to prop up volume.
Relative to these moaty packaged food firms, ConAgra's (CAG) portfolio includes many second- and third-tier brands, which has left it struggling to convince retailers that its brands deserve shelf space in this particularly competitive market. With several lackluster brands, we believe ConAgra will continue to grapple with stiff competition from other branded players and lower-priced private-label offerings, particularly as it competes in some categories where consumers tend to consider price rather than brand when making purchase decisions, such as cooking spray. Subsequently, we anticipate that volume and profitability will remain constrained at ConAgra.
We believe global beverage makers are more resilient and likely to continue to experience overall volume growth in the coming year, but this growth will remain bifurcated. While we think all beverage makers should be able to generate volume growth in emerging markets, we expect that various categories, including carbonated soft drinks and mainstream beers, will see flat to falling demand in many developed nations. Despite this, beverage firms (like Monster Beverage (MNST), Boston Beer (SAM), and Brown-Forman (BF.B)) with exposure to on-trend categories such as energy drinks, craft beer, and spirits should buck the trend and realize volume growth in North America and Western Europe. Rising input costs have resulted in gross margin headwinds for most beverage makers, but we believe that firms such as Coca-Cola (KO), PepsiCo (PEP), SABMiller (SBMRY), and Diageo (DEO), will be able to steadily raise prices in order to increase revenue and maintain profit margins over the long term.
Pace of Emerging-Markets M&A Has Yet to Slow, but Deals in Mature Markets Also Picking Up Steam
Similar to last quarter, acquisition momentum in faster-growing emerging regions persisted throughout the third quarter. We believe gaining entry into these regions by acquiring local companies that are familiar with tastes and preferences in their home markets is a wise investment, but given that firms throughout the industry are looking to developing markets for expansion opportunities, valuation multiples could trend to insanely high levels, making such deals less beneficial.
One sector that was rife with activity in the quarter was the global beer market. In late June, Anheuser-Busch InBev (BUD) agreed to purchase the equity stake of Grupo Modelo that it does not already own. Grupo Modelo is the leader in the Mexican beer market with 59% share, and its Corona brand sells almost twice the volume of the second-largest brand. Following the acquisition, ABInBev will own 5 of the top 6 and 7 of the top 10 beer brands in the world. While Corona is already distributed in 180 countries and is the number-one import brand in 38 of them, it will benefit from ABInBev's global distribution platform and lead to further growth. Separately, Grupo Modelo will sell its 50% joint venture interest in Crown Imports (the joint venture that distributes Corona in the U.S.) to Constellation Brands (STZ). After adjusting for the sale of the Crown joint venture and pro forma for expected synergies, it appears that ABInBev is paying about 11 times enterprise value/EBITDA, which seems reasonable to us.
Further, in August, Heineken (HINKY) agreed to buy Fraser and Neave's entire stake in Asia Pacific Breweries for SGD 53 per share, or a total consideration of SGD 5.4 billion. The deal, which must still be approved by a simple majority of F&N's shareholders and is expected to close before Dec. 15, values APB at roughly 35 times the firm's trailing-four-quarter earnings. Beer making is a scale business, and while we believe that these brewing behemoths will benefit from increased control of their operations in Latin America and Asia, we believe the APB deal could be dilutive to Heineken's near-term earnings.
Consumer staple firms, including alcoholic beverage operators, also showed an increasing desire to put their cash to use in mature developed markets. During Diageo's most recent earnings call CEO Paul Walsh noted that while Diageo currently distributes Cuervo in the U.S., it is in discussions to deepen its relationship with the tequila maker. We believe it would make strategic sense for Diageo to obtain some sort of ownership position in Cuervo, but it must be done at a reasonable price. Owning this premium tequila maker would add yet another heavyweight product to Diageo's already robust portfolio of brands.
Campbell Soup (CPB) also announced its intentions recently to acquire Bolthouse Farms (a domestic seller of fresh carrots and superpremium beverages) from Madison Dearborn Partners for $1.55 billion in cash. At first blush, the deal strikes us as slightly rich, as Campbell has agreed to pay 2.2 times trailing-12-month sales and 16.8 times trailing-12-month EBIT. While we applaud the firm's efforts to build out its faster-growing healthy beverage business (this deal will double the size of this segment to account for around 15% of consolidated sales), the addition of Bolthouse doesn't address the challenges that Campbell faces in its domestic soup operations.
In addition, Church & Dwight (CHD) announced last month that it had jumped back into the acquisition ring, acquiring privately held Avid Health, a leading player in the gummy vitamin and supplement category with brands such as Vitafusion and L'il Critters, for $650 million (2.8 times trailing-12-month sales and 11.2 times EBITDA). We weren't surprised to see the consumer product firm look to build up its personal-care business, which tends to generate much better margins than household products but has been lagging the former segment for the past few quarters. With the inclusion of Avid, Church & Dwight gains a new platform, which is inherently risky, but the company has proved to be a prudent acquirer, so we aren't overly concerned.
Finally, over the past year, ConAgra has made five acquisitions, which we think should enable it to leverage its existing operations. Most recently, ConAgra announced intentions to buy Unilever's (UN) North American frozen meal business (which includes the Bertolli and P.F. Chang's brands) for $265 million in cash, about 0.9 times fiscal 2011 sales--a good price, in our view. With free cash flow amounting to more than 5% of sales in fiscal 2012 ($715 million), we doubt the firm's appetite for new deals has been satisfied and anticipate that ConAgra will remain an active acquirer this fiscal year, with a particular emphasis on expanding its private-label presence as well as building out its international footprint.
Investors Attempt to Drive Change, Wring More Value From Consumer Defensive Firms
Amid a challenging landscape that has troubled several consumer product firms, activist investors worked over the summer to unlock value. In July, Bill Ackman disclosed he had accumulated a sizable position (about $2 billion, or 1% of shares outstanding) in Procter & Gamble's (PG) shares. While Ackman has yet to show his cards, we have little doubt that he would like to push for change to unlock additional value from this household and personal-care behemoth (whether through a management shakeup, further cost efficiency efforts, or strategic alternatives such as selling noncore brands or splitting up the business). However, management appears to be working to return additional cash to shareholders and keep activist investors (like Ackman) at bay. For instance, the firm announced during its fourth-quarter earnings call that it would repurchase about $4 billion in shares (about 2% of shares at the current market price) this fiscal year, which is contrary to earlier comments whereby management said it would suspend share repurchases to ensure that its AA credit rating remains intact.
From our perspective, splitting P&G into beauty- and health-care businesses (which also includes the grooming segment) and home care (which for the purposes of our analysis includes the fabric-, baby-, and family-care operations) would be a value-enhancing endeavor. Each of these businesses would generate more than $40 billion in annual sales and subsequently would possess significant scale benefits in its own right. Assuming an EV/EBITDA multiple of 13 times for the beauty business and 12 times for the home-care segment (each of which is in line with major competitors like L'Oreal (OR) and Reckitt Benckiser (RB.)) results in a sum-of-the-parts valuation of $70 per share--above our $64 discounted cash flow fair value. If the valuation multiples are increased to 15 times and 14 times, respectively, the fair value would jump to $82. Despite this, we still think the probability the board will opt for this course of action is small at this point.
In addition, Dean Foods (DF) announced in August that it intends to sell 20% of its high-growth, high-margin WhiteWave-Alpro business via an initial public offering. We're not surprised the company--whose chairman and CEO, Gregg Engles, owns around 4% of the outstanding shares--is pursuing this course of action, but we hadn't thought this would occur until leverage meaningfully declined; at $3.6 billion, or about 4 times EBITDA, we'd argue it hasn't. From our perspective, this valuable asset (which includes the Silk, Horizon Organic, and Land O'Lakes brands) could be scooped up by another packaged food firm before too long. We think interested buyers may include Danone (BN), Nestle (NSRGY), and potentially even General Mills(which acquired Dean's domestic yogurt business last year). At first blush, and assuming 12 times forward EBIT (the average for Morningstar's packaged food coverage universe), we think WhiteWave-Alpro could garner a price tag of $2.4 billion-$2.8 billion.
Most recently, activist investor Corvex disclosed that it had taken about a 5% stake in Ralcorp (RAH), as it has been unsatisfied with Ralcorp's lackluster performance, suggesting that the private-label packaged food firm sell the business, merge with a peer, or beef up its board in an attempt to improve execution, seek out acquisitions or more efficiently allocate capital. The irony of this news is that 12 months ago, ConAgra was offering $94 per share for Ralcorp (which is now trading near $70), but management thought it was in the best interest of shareholders to go it alone. We had been of the opinion that a deal with ConAgra would be a smart move and that spinning off the Post business would prove value destructive (and given that Ralcorp paid around $2.7 billion for a brand that now maintains a market cap of just around $1 billion, we'd say we were right). We doubt that strategic buyers (other than potentially ConAgra) would be interested in expanding in the lower-margin private-label market, but even ConAgra may not jump at the chance to pursue a tie-up with Ralcorp now, given the unfriendly reception it received last year.
Consumer Defensive Stocks for Your Radar
The uncertain economic climate has continued to drive the valuations of consumer staple firms higher, given the consistent cash flows and total shareholder returns (including dividend and share repurchases) that tend to characterize these firms. As such, we tend to view the sector as fairly valued to slightly overvalued at this point. However, we think that long-term investors looking for exposure to consumer staples should still keep an eye on the moaty names. Stellar growth is unlikely, but solid cash flow generation and a history of enhancing shareholder returns (with increased dividends and additional share repurchases) should appeal to income-seeking investors. If consumer product stocks trade down on concerns surrounding rising input costs or competitive pressures, we may look to recommend the shares. We have provided a summary of our most undervalued and overvalued names below.
|Consumer Defensive Sector Stocks for Your Radar|
|Star Rating|| Fair Value |
| Economic |
| Fair Value |
|Church & Dwight||$42.00||None||Medium||1.27|
|Data as of 09-17-12.|
We believe that shares of Molson Coors, which currently trade around 11 times our estimate for 2013 earnings, are attractively priced. We believe a rebound in economic conditions in North America and the United Kingdom will serve as a catalyst for Molson Coors' stock price. The ongoing economic malaise has resulted in elevated levels of unemployment for young men, who are key beer drinkers. We believe that once the job environment improves in Molson Coors' key developed markets, the company's beer volume should start increasing, spilling over into improved earnings per share.
In our view, the market's concerns regarding sluggish restaurant traffic and food cost inflation are overdone and unjustly weighing on Sysco's shares. We continue to believe that Sysco's expansive distribution network will enable the firm to remain the dominant player in North American food-service distribution, 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.
Although we think Brown-Forman has built an enviable wide-moat business, we believe that its shares (which are trading at more than 25 times our fiscal 2013 earnings estimate) are currently overvalued. During the past decade, Brown-Forman has been a disciplined allocator of capital, making just a few small strategic acquisitions, selling noncore/lower-margin businesses, and returning cash to shareholders via dividends and share repurchases. However, we believe the market's expectations are excessive, especially when considering potential economic headwinds looming in developed and emerging markets.
Church & Dwight (CHD)
We still think the market is too optimistic with regards to Church & Dwight's prospects, with the shares up around 20% year to date and trading at 19 times our updated fiscal 2013 earnings per share estimate--a lofty multiple for a firm that derives the bulk of its revenue from the mature U.S. market and faces significant competition from much larger peers. While we recognize that Church & Dwight's brand investments are gaining traction with consumers, we can't ignore the fact that the firm lacks the size and scale advantages of the dominant industry players. In addition, we doubt competitive pressures will subside and, given that the company's competitors tend to operate with more-diversified product portfolios and deeper pockets, Church & Dwight's future expansion should be quite costly.
Coca-Cola FEMSA (KOF)
We expect Coca-Cola FEMSA will continue to benefit from Coke's brand equity, which should help it to generate solid free cash flow over the long term. Nevertheless, the company has myriad near-term headwinds, and we think the market has overshot the company's longer-term revenue growth and margin expansion potential. Additionally, we believe market continues to underestimate the risk profile of the firm's key operating territories. Coca-Cola FEMSA operates in several emerging-market countries (such as Venezuela and Colombia), leaving it vulnerable to political instability, inflationary pressures, and volatile foreign exchange rates.
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Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.