Our Outlook for Consumer Defensive Stocks
Headwinds surrounding raw material inflation and regulatory oversight fail to stem strategic actions, as consumer defensive firms look to enhance the value proposition for shareholders.
Commodity Cost Pressures Unlikely to Derail Profitability of Most Consumer Product Firms, but Buying Opportunity Could Emerge
The drought across much of the Midwestern United States this past summer has driven prices for many agricultural commodities well above historical averages, and we expect these elevated prices will continue to challenge the cost structures of many packaged food companies over the near term (particularly since the impact of the drought is now taking a toll on waterway transportation of raw materials). Most companies routinely focus on reducing supply chain inefficiencies, but cost-cutting has its limits, and many firms have been unable to completely offset higher commodity prices through cost reductions alone.
Given that commodity pressures are unlikely to abate during the first half of 2013 (as there is a lag between when costs go up and when firms ultimately incur raw material inflation, given that firms tend to hedge commodity needs by locking in prices in advance), we expect volume could remain lackluster if companies take additional pricing. However, as we've discussed in the past, "moaty" consumer product firms that possess significant brand equity ( Hershey (HSY), McCormick (MKC), Coca-Cola (KO), Diageo (DEO)) are likely to be relatively unscathed by such pressures. Conversely, for firms that operate with a more commodified portfolio ( Tyson (TSN), Dean Foods ) the impact could be more sizable. Despite this, all is not lost, as we think any downward pressure could create a buying opportunity in the shares if the market overemphasizes the quarterly impact the drought may have on near-term profits while ignoring the potential boost in profitability that could occur with a bountiful 2013 crop.
The challenge for meat processors reflects the fact that grains represent a disproportionately large percentage of their production costs, at more than 40% of the total cost for chickens and about 80% of the costs of producing feed, versus just 5%-10% of the costs for a packaged food firm like General Mills (GIS). For instance, Hormel (HRL) indicated during its fourth-quarter earnings report that roughly $100 million in higher grain costs could flow through results in fiscal 2013 (ending October), which represents a 120-basis-point hit to gross margins, all else equal. We estimate that Tyson's chicken segment margins will be hardest hit by elevated grain prices over the near term, compared with its beef and pork businesses, as the segment's vertical integration requires that the company directly purchase grains used to feed broilers (birds used for chicken consumption).
We believe that coordinated decreases in industry supply would help to stabilize prices and potentially provide some buffer to falling margins, but this depends on whether other industry participants are rational in reducing supply. Hormel is decreasing production in the 1%-2% range, in line with meat processors, which we think should help to reduce costs. However, we expect the company will look to drive innovation and may take selective pricing to completely cover elevated grain prices. We also think Tyson should be able to take pricing; by our calculations, a 10% increase in prices could result in 1%-2% of volume reduction, as cash-strapped U.S. consumers will continue to focus on maximizing limited income. However, declines in chicken volume (which accounts for more than one third of Tyson's sales) may be more muted than declines in other proteins, primarily because chicken products are often perceived to offer relatively good value.
Despite these headwinds, we think long-term industry fundamentals are relatively unchanged. Meat processors' shares have proved volatile, reflecting concerns that profitability could be challenged in the short term, but we believe the fundamental trends affecting total demand for proteins should lead to long-term upside. Although the risk/reward opportunity is less compelling than it was in the late summer and early fall, we still see an opportunity for patient fundamental investors as the market extrapolates lackluster earnings.
Looming Fiscal Cliff Prompts Strategic Actions From Consumer Defensive Firms
Even before the threat of the fiscal cliff, the flurry of activity from consumer staples firms looking to wring additional value out of their businesses was in high gear. Earlier this quarter, Kraft separated its North American grocery business ( Kraft Foods ) from its global snack operations (named Mondelez (MDLZ))--a move that it first announced in August 2011. In our opinion, Kraft's motivation was to unlock a higher multiple for its faster-growing snack business that had been unappreciated when combined with the more mature North American grocery brands. We think investors looking for sweeter growth prospects from a packaged food firm may want to consider the Mondelez global snacks business, while income investors will likely find the new Kraft Foods shares appetizing because paying a top-tier dividend is to be the firm's main use of cash.
Dean Foods was also fast at work in the quarter, as the dairy processor spun-off 12% of its high-growth, high-margin WhiteWave-Alpro business (the intentions of which were first disclosed in August) as a means of unlocking value. In addition, Dean announced plans to sell its Morningstar segment (with a portfolio that includes creamers, ice cream mix, value-added milks, sour cream, and cottage cheese) to Saputo for $1.45 billion. (This segment is unrelated to Morningstar Inc., the publisher of this note.) Dean intends to direct the $300 million of proceeds from the IPO, the funds from a new $870 million credit facility (which will reside on WhiteWave-Alpro's balance sheet but ultimately will be consolidated because of Dean's majority ownership), and the nearly $900 million in proceeds from the sale of Morningstar toward the reduction of debt, which would effectively reduce leverage to 3.0 times by the end of the year from 3.7 times at the end of the third quarter, according to the company. While we've been encouraged that the dairy processor hasn't merely paid lip service to the need for debt paydown, we are concerned that Dean's ability to service its debt could be challenged following the IPO of WhiteWave-Alpro and the sale of the Morningstar business, given our expectations for continued volatility in the operating income of the fluid milk business.
Further, despite its repeated rebukes just a year ago, Ralcorp ) is now set to be acquired by ConAgra (CAG). The deal, which values the private-label manufacturer at 12 times its fiscal 2012 adjusted EBITDA on an enterprise value basis, strikes us a great strategic fit for ConAgra (even in light of the lofty price tag) and a very good deal for Ralcorp shareholders. This caps a year over which ConAgra has announced five other deals, and given that the private-label segment (which ConAgra management has identified as a priority for expansion) still remains highly fragmented, with hundreds of companies that generate revenue of less than $75 million annually, further consolidation could be in the cards. We suspect that Ralcorp management was more open to a deal this time around due to pressure from activist investor Corvex Management, which disclosed in August that it had amassed a 5% ownership stake in the private-label food manufacturer.
Beyond the flurry of deals, consumer staples firms (including Campbell Soup (CPB) and Brown-Forman (BF.B)) have also been declaring special dividends in rapid succession, which is a prudent use of cash and reflects the uncertainty surrounding future tax rates on dividends. If current negotiations in Washington ultimately lead to increased taxes for dividends, we think that slower dividend growth could be in the cards next year, and share buybacks may take precedence. However, if shares trade at a premium to our fair value estimate, other uses of cash (such as reinvesting in the business) may be more appropriate. While we think it's possible that other CPG firms could look to return additional cash to shareholders, we expect the pace of other strategic actions (i.e. acquisitions) could be on hold until more clarity is garnered surrounding the potential tax implications.
Increased Energy Drink Oversight Probably Won't Prompt Significant Change, Similar to Recent Push for Modifications to Tobacco Packaging Abroad
Heightened government regulations and taxation can have drastic impacts on any company's bottom line, and hence valuation. In the past, increased tax rates and marketing restrictions have negatively impacted the growth rates for brewers, distillers, and cigarette companies. However, recently shares of Monster Beverage (MNST) have been on a roller coaster ride following the receipt of a subpoena from the New York Attorney General and plenty of pressure on the FDA from Senator Durbin and Senator Blumenthal, regarding investigations into whether excessive energy drink consumption is linked to death. We continue to believe the outcome of the FDA's efforts will be benign and the impact on Monster Beverage will be minimal.
Although the FDA is willing to work with the Senators, it must make science-based decisions within the bounds of its statutory authority and mandate. While we believe it is unlikely that Monster's ingredient list will be drastically altered, we would not be surprised to see new labeling requirements (such as disclosure of caffeine levels). Overall, we believe that the bulk of the FDA's letter supports our overall positive thesis on Monster, but the situation still carries some risk. As the FDA further digs into the adverse event reports and likely brings in outside experts (such as the Institute of Medicine) to conduct more studies, additional labeling and marketing restrictions could pop up. Consequently we are maintaining our high uncertainty rating on Monster Beverage, but aren't making any changes to our fair value and view the shares as fairly valued. However, if concerns surrounding heightened regulation weigh on the stock, long-term investors may find value in Monster.
This follows increased regulation in Australia related to the introduction of plain olive-green packaging with graphic health warnings for tobacco products--a law that has been challenged by Philip Morris International (PM), British American Tobacco (BTI), and Imperial Tobacco Group (IMT). These tobacco titans believe that plain packaging will encourage illicit trade by making it easier for knock-off (and excise-tax free) cigarettes to enter the supply chain; usurp their intellectual property rights; and will neither prevent anybody from starting nor compel anyone to stop smoking. We believe that plain packaging will ultimately backfire for governments. Uniform packages would make it easier for tobacco bootleggers to enter the market. These scofflaws don't pay excise taxes, so governmental tax receipts will likely fall faster than the rate of smoking cessation.
We believe this is a case of "better the devil you know," meaning, tobacco bootleggers are frequently associated with organized crime. Plain packaging initiatives could help these mobsters fund their other criminal enterprises, whereas the large tobacco companies are heavily regulated, follow the rules, and pay billions in excise taxes. The biggest risk for the tobacco companies would be if other countries follow suit. In the past, countries such as the United Kingdom, Canada, New Zealand, and Lithuania have considered plain packaging; depending on how the Australian decision pans out, politicians in these countries may once again consider plain packaging initiatives. Although we view it as unlikely, if the plain packaging movement gains global momentum our bear-case scenarios for the tobacco companies could come to fruition.
Our Top Consumer Defensive Picks
Consumer staple firms continue to be viewed as safe havens in this uncertain economic landscape, and shares subsequently have trended 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 space as fairly valued to slightly overvalued at this point in time. However, we think that long-term investors looking for exposure to the consumer staples industry should still keep an eye on the moaty names in this space. While outsized growth is unlikely, 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 stocks within the consumer products industry 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.
|Under- and Overvalued Consumer Defensive Sector Stocks
| Fair Value
| Fair Value
|Church & Dwight
|Data as of 12-13-12.
Molson Coors (TAP)
Although a recovery could be more than a year away, we still think the market is currently undervaluing Molson Coors' intrinsic value. Our $55 fair value estimate assumes 3%-4% annual revenue growth and 27% operating margins by the end of the decade. With Molson Coors' shares trading at just 10.5 times 2013 earnings and delivering a 3% dividend yield, we view the stock as attractive. The ongoing economic malaise has resulted in elevated levels of unemployment for young men who are key beer drinkers, and we believe that a rebound in the economic conditions in North America and the United Kingdom will serve as a catalyst for Molson Coors' stock price.
Following its split from the global snacks business earlier this year, Kraft Foods still possess sizable competitive advantages, including a solid brand portfolio (Kraft, Oscar Mayer, and Maxwell House each generate more than $1 billion in annual sales and another 20-plus brands produce more than $100 million in sales each year) and substantial economies of scale in the North American market (with more than $19 billion in annual sales). One of the opportunities for the domestic grocery business, in our view, lies in the fact that as a part of the consolidated organization these brands had been underinvested in; we think it was more or less the cash cow that funded the growth of the global snack business. We think the market is overlooking the substantial cash flows that Kraft's grocery business generates (which we forecast at 10% of sales on average), and income investors likely will find Kraft appetizing as the firm's top priority for cash is to fund a highly competitive dividend, which at $2 per share is yielding around 4%.
We expect federal fiscal contraction causes a consumer pullback in 2013, which should pressure all of the stocks in our defensive sector, including Costco. However, over the long term the loss leader capabilities of Costco's narrow-moat business model should continue to drive disproportionate market-share gains. Consistent and steady market-share gains should deliver sustained double-digit EPS growth, potentially acting as a catalyst for relative outperformance.
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 20 times the midpoint of management's 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 investments in product innovation and marketing support behind core brands have resulted in sales growth and margin improvement, the firm faces intense competition from its significantly larger peers. In addition, the firm lacks the size and scale advantages of the dominant industry players (which possess more diversified product portfolios and deeper pockets), potentially making Church & Dwight's future expansion quite costly.
Coca-Cola FEMSA (KOF)
Coke FEMSA operates in a number of emerging-market countries with solid growth prospects, including Mexico, Brazil, and Argentina. However, these are regions in which geopolitical events could lead to volatile commodity and currency fluctuations and ultimately disrupt normal operations. 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. However, at a price/fair value of more than 1.6, we think the current market price appears rich after taking into account the number of risks facing the firm.
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