Consumer Defensive: Only a Handful of Values Left

• The consumer defensive sector still trades above our fair value estimate, and we see only a handful of undervalued industries and companies.
• Premium alcoholic beverage manufacturers should enjoy further volume gains as emerging-markets consumers trade up into higher-priced drinks, driving additional cost savings.
•  Procter & Gamble (PG) continued to make strides to enhance its market position in the quarter, and we contend that it's worth keeping an eye on in a sector where discounts are few and far between.

 

The consumer defensive sector trades at a median price/fair value of 1.10, and only a handful of firms's shares trade below our median fair value estimate. Investment opportunities remain, but many of the stocks we see as most undervalued face threats to their business strategies (such as grocers in the United Kingdom from discount retailers) or are seeing severe foreign currency headwinds that could continue to challenge their revenue and earnings over the near term.

Overall, we remain cautious on global consumer spending (particularly in emerging and developing markets) and generally recommend focusing on companies with narrow or wide moats that enjoy strong brand intangible assets or sustainable cost advantages. However, lower gas prices and improving consumer confidence could bolster spending over the near term; we believe that market prices already reflect these short-term tailwinds.

That said, several global brewers and distillers with economic moats look undervalued, in our opinion. Across the global alcoholic beverage industry, "premiumization"--the trend of consumers trading up or switching to more expensive categories or brands--is driving a long-term tailwind for manufacturers. Despite its defensive qualities, the alcoholic beverage industry is subject to some cyclicality, and macroeconomic trends can accelerate premiumization or reverse it (economization) on a temporary basis. Although cyclical forces have temporarily weighed on alcoholic beverage companies' earnings in recent quarters, we think premiumization is a long-term trend that will transcend economic cycles.

Moreover, where this trend is leading to volume growth, there is an opportunity to create and extend cost advantages. We believe  Ambev (ABEV) and  Heineken (HEINY) are two of the best-positioned firms to increase volume, as their portfolio positioning in midtier and premium segments and heavy exposure to growth-phase markets should provide a medium-term volume growth trajectory of more than 2% per year. While Heineken trades near our fair value estimate, Ambev is currently rated 4 stars. Similarly, alcohol conglomerate  Diageo (DEO) was also recently 4 stars, suggesting a decent margin of safety.

Another name to keep on the watch list is wide-moat Procter & Gamble. The firm has faced its share of challenges over the past several years, many of which have been shared by other consumer defensive companies. But even beyond the tough macro environment, where consumer spending has been ratcheted back and the competitive landscape has intensified, lackluster innovation and an attempt to overextend its geographic reach plagued P&G's financial performance and subsequently its share price.

However, we now believe that recent investments behind new products, a more disciplined expansion plan, and efforts to rightsize the brand mix while improving the efficiency of operations (strategies that we've seen other firms in the industry employ to varying degrees in order to drive higher earnings growth) appear to be gaining traction. As such, we contend that P&G is poised to post accelerating top-line growth as well as improving profitability metrics over the next several years. 

Top Consumer Defensive Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Tesco		GBX 270	None	High	GBX 162
United Breweries		$27	Narrow	High	$16.20
Nestle		$86	Wide	Low	$68.80
Data as of 12-16-2014

 Philip Morris International PM
Powerful intangible assets are at the core of Philip Morris International's wide economic moat. In addition, the company's platform of total tobacco products and e-cigarettes gives it economies of scope and scale that make it difficult for new entrants to gain the critical mass of volume necessary to compete. Finally, the addictive nature of tobacco products makes demand fairly price inelastic, and with few substitute products outside the portfolios of the Big Tobacco firms, a favorable industry structure exists for the largest players in which pricing, for the most part, is rational.

 Ambev (CCU)
Ambev still has opportunities to increase volume in its core markets of Latin America, but we believe its medium-term revenue growth trajectory will fade from the double-digit compound annual growth rate achieved over the past four years to a mid- to high-single-digit rate. However, even as volume slows, we believe an opportunity for revenue growth lies in the premiumization of the market. Currently, the premium beer segment makes up just 5% of volume in Brazil, versus almost 15% in Argentina and Chile, and we expect a strong mix effect to become a key driver of revenue growth for Ambev in the medium term; premium now represents 8% of volumes, indicating that continued premiumization should provide a long-term tailwind to the top line, even if volume growth undershoots its historical run rate.

 Procter & Gamble PG
Procter & Gamble is working to right its ship. The firm previously entered too many new markets (particularly emerging markets, where competitors already have a leg up) too quickly, and new products failed to resonate with consumers, as evidenced by its languishing market share position, weighing on the shares. However, P&G's announcement that it intends to shed 90-100 brands--more than half of its existing brand portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates it is parting ways with its former self, looking to become a more nimble and responsive player in the global consumer products arena. We view this as a particularly important trait given the stagnant growth emanating from developed markets and the slowing prospects from emerging regions. Undervalued names are few and far between in the consumer defense space, and with Procter & Gamble's shares trading about 10% below our fair value, we think investors should consider owning this wide moat name.

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