Consumer Defensive: A Handful of Values in an Overheated Sector

• The consumer defensive sector remains overvalued, trading at roughly a 6% premium to our fair value estimate. Macroeconomic uncertainty, low prevailing interest rates, and continued near-term cost-cutting opportunities have drawn investment in recent quarters, and we don't see a sizable margin of safety in the sector's current stock prices.
• Investors looking for better growth prospects--without sacrificing solid fundamentals--should give ingredient suppliers a look. Despite the absence of branding or pricing power, ingredients companies often have just as good margins and returns on capital as branded consumer companies. They also provide protection from channel shifts that impinge on branded consumer companies by capturing growth from a variety of angles.

Valuations in the consumer defensive sector remain lofty, trading at about a 6% premium to our fair value estimate (up from about 4% at the end of May). We attribute this continued investor over-optimism to macroeconomic uncertainty, low interest rates, and further near-term cost-cutting opportunities that exist among many of the companies in the space.

We acknowledge that the prevalence of economic moats in the consumer defensive universe, the companies' generally solid dividend yields, and internal profit-enhancing opportunities in a low-rate, slow-revenue-growth environment may calm investors' short-term fears (helping to explain the continued overvaluation). That said, we remain focused on the long-term fundamental valuations of these stocks. In particular, we expect the need to reinvest a sizable portion of cost savings into product and marketing expenses will lead to unfavorable risk-adjusted returns over the next several years, on average.

Kraft Heinz is a good example of this phenomenon. From the time the tie-up between the two consumer defensive behemoths was announced in March 2015, much attention has been given to the pronounced cost-efficiency target the combined firm seeks to realize, with plans to cut $1.5 billion in costs from its operations (which equates to more than 7% of cost of goods sold and operating expenses excluding depreciation and amortization) over a three-year period. Despite what appears to be a large magnitude of savings on the surface, we've never perceived this as an unreachable goal (we actually anticipate the firm will exceed these initial targets by about $250 million).

But we don't think the well from which the firm will extract cost savings is limitless, a stance that seems to differ from the market. For instance, we maintain that increased investment behind its brands as a means by which to withstand intense competitive pressures, the potential for more pronounced commodity cost inflation, and the challenges resulting from its portfolio mix stand to constrain margins in the longer term. Kraft Heinz could opt for lower levels of brand spending in the longer term in order to further bolster its profitability, but such a decision could ultimately impede its competitive position. From our vantage point, Kraft Heinz faces impending headwinds that are likely to stall its margin expansion potential in the longer term.

Conversely, we believe the ingredients industry is one area of the consumer defensive complex that's often overlooked. With healthy sector dynamics and strong company fundamentals, this is an interesting space with competitively advantaged names for long-term investors. In particular, within the industry, flavors and fragrances companies offer among the highest margins and healthy returns on invested capital. These good returns on capital are the result of low capital intensity coupled with good operating margins. Organic growth rates are also respectable, and this segment of ingredients also has the highest exposure to developing markets (close to 50% of sales).

Lastly, as the space is still quite fragmented (the top four flavors and fragrances players account for two thirds of industry sales), there are many opportunities to engage in external growth and further build scale. We think European firm

(

) looks particularly attractive at current valuations, but we also recommend investors keep an eye on other narrow-moat names such as

In other sector news, ABI InBev is scheduled to complete its merger with fellow global brewer SABMiller in a few short weeks, and given the relatively slow global growth environment for consumer defensive companies, we wouldn't be surprised to see continued acquisition activity across the sector. For these brewers in particular, we believe the deal is ultimately only very modestly value-enhancing for ABI, but it should nonetheless provide a boost to the wide-moat firm's secular organic growth and cost advantages.

Top Picks

Symrise

(

)

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: EUR 76.00

Fair Value Uncertainty: Low

Consider Buying: EUR 60.80

In our view, the market hasn't adequately priced in the strength of Symrise's narrow economic moat; rather, we suspect that it has been too focused on short-term considerations, such as the firm's need to integrate its recent acquisitions and the dilutive short-term impact on returns on invested capital. Despite the distracting effect of integrating a major acquisition, Symrise is clearly gaining market share, as underlying volume growth remains impressive and well ahead of peers. With long-term trends supported by health & wellness and positive demographic trends (including increased urbanization, more processed foods being eaten, and more women working), we believe the narrow-moat company's stock offers a decent margin of safety.

Pilgrim's Pride

PPC

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $29.00

Fair Value Uncertainty: High

Consider Buying: $17.40

With shares trading at an attractive discount to our valuation, we believe no-moat Pilgrim's Pride allows investors to capitalize on strong protein and fresh food demand and rising meat consumption in Mexico (which makes up an estimated 16% of forecasted 2016 sales). Pilgrim's is exposed to commodities, but we expect its balanced portfolio and growth in Mexico to act as a counterweight even as inputs again rise. Moreover, we think the company is generally now more insulated from commodity swings, given increased use of variable-price contracts, a buy/grow strategy that limits cut mismatches, and a broad portfolio that includes steady but lower-margin small birds and more volatile and lucrative large chickens. Even with ground beef prices falling, Pilgrim's should benefit from rising U.S. chicken consumption because of the meat's price advantage and health perception. We see poultry taking share from beef in the long run, though short-term sales should be pressured as some consumers return to red meat and prices fall in step with beef.

Woolworths

(

)

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: AUD 28.00

Fair Value Uncertainty: Medium

Consider Buying: AUD 19.60

Woolworths is seeing early signs of progress following the implementation of its strategy to strengthen its supermarket business. On a number of metrics, the Australian food business showed improvement in the fourth quarter of fiscal 2016, and the trend has seemingly continued into the first eight weeks of fiscal 2017. This is mirrored in a jump in overall customer satisfaction from a consistent reading of around 69% to 75% in the fourth quarter and 77% for the month of June. So far, comparable sales have increased 0.3% in fiscal 2017. Despite these encouraging results, the supermarkets business is still in the very early stages of its turnaround process, with only one year of the three- to five-year process behind it. That said, we believe the stock is undervalued, as the issues facing the company are not terminal. Although it will take time, operating performance will improve with good management and better daily execution.

More Quarter-End Insights

Stock Market Outlook: A Little Too Buoyant?

Credit Market Insights: Leaving Brexit Behind

Basic Materials: China-Dependent Producers Largely Overvalued

Consumer Cyclical: Poised to Perform in the Second Half

Energy: Rally in the Works, but It Won't Last Long

Financial Services: Berkshire Is Bigger Than Buffett

Healthcare: We See Value in the Drug and Biotech Industries

Industrials: Weak Commodity Prices Weigh

Real Estate: Expect Some Choppy Waters Ahead

Tech & Telecom: Opportunities in Smartphones and IT Services

Utilities: How Long Can the Yield Paradox Survive?