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Quarter-End Insights

Consumer Defensive: Attractive Companies, Top-Shelf Valuations

Investor returns could suffer if growth slows and valuation multiples contract from lofty levels.

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  • Most names in the consumer defensive sector trade above our estimates of intrinsic value, and while some decent growth opportunities exist, we think that investor returns could suffer if growth slows and valuation multiples contract from lofty levels.
  • Defensive retailers could bolster competitive advantages in the organic/natural food space, but robust organic food growth could detract from consumer product firms' moats.
  • We think that firms with the most exposure to organic foods (such as  Kroger (KR) and  Whole Foods (WFM)) are overvalued at current levels, but we wouldn't be surprised to see more mergers and acquisitions among food manufacturers.

Many consumer defensive companies have economic moats because of pricing power and cost advantages, which give their management teams different levers to pull when challenges arise. These characteristics result in stable cash flow generation, which can be used to support dividend payments regardless of the economic backdrop. However, while these qualities are attractive, we do not believe that current valuations are as compelling. Most consumer defensive names trade at a premium to fair value; many firms are valued at peak multiples on peak margins, leaving more downside than upside in many cases, in our opinion.

We're generally cautious about consumer spending growth in many markets, although we believe that lower gas prices and improving consumer confidence could bolster spending in some regions over the near term. We also see pockets of value in the names we highlight below-- Philip Morris International (PM),  Ambev (ABEV), and  Procter & Gamble (PG).

Moreover, we see solid long-term growth prospects in the organic and natural food space. The organics sector has been growing by about 10% annually over the past 10 years, around three times the level realized by the overall consumer packaged goods space; we estimate that organic food sales could increase by around 6% annually over the next couple of decades, as we anticipate growth can continue because of consumers' penchant for health and wellness offerings combined with favorable demographic trends.

Some firms are better-positioned than others to exploit these higher-growth opportunities. For example, some niche and traditional grocery retailers are directly exposed to organic/natural food trends, whereas organic products represent less than 10% of sales for many major consumer packaged goods firms. By focusing on the organic space and targeting a niche consumer, defensive retailers stand to amass a brand intangible asset, which could in turn drive a cost advantage. However, consumer product firms are unlikely to yield an advantaged competitive position by expanding in organics, and may even realize erosion in the brand intangible asset and cost source of a moat if products fail to win with consumers and leverage remains elusive.

Leading organic manufacturers, including Boulder Brands, Hain Celestial, and WhiteWave Foods, strike us as likely targets for packaged food firms looking to consolidate the space. Based on recent transactions in the industry--including  General Mills' (GIS) purchase of Annie's in September 2014 for 4 times sales and 29 times on an enterprise value/trailing-12-month EBITDA--future takeover targets will almost certainly come with a lofty price tag. Each acquisition should be evaluated individually, but investors shouldn't assume that growth or channel diversification synergies will justify the purchase prices, especially as the organics category becomes more competitive.

Aside from focusing on acquisition candidates, we recommend focusing on companies with narrow or wide moats that enjoy strong brand intangible assets or sustainable cost advantages, even if growth prospects aren't quite as compelling. Although it doesn't play in organics currently,  Kraft (KRFT) could be poised to dive into the organic realm. The firm's new management seemed to indicate a desire to take more drastic actions with regards to its brand portfolio, which we think could include initiating a position in organics. Further, we don't believe funding a deal, while still maintaining an investment-grade rating, will prove a hurdle, given its manageable debt load.

Top Consumer Defensive Sector Picks
Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Philip Morris International $92 Wide Low $73.60
Ambev $6 Wide Medium $4.20
Procter & Gamble $90 Wide Low $72
Data as of 3-26-15

 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 (ABEV)
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)
P&G's announcement that it intends to shed 90-100 brands--more than half of its portfolio, which in aggregate posted a 3% sales decline and a 16% profit reduction the past three years--indicates that 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 estimate, we think investors should consider owning this wide-moat name.

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Ken Perkins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.