Consumer Defensive: Cooking Up a Bit More Value

• Valuations in the consumer defensive sector have pulled back modestly and now trade about 4% below our fair value estimate, which is a reversal from the premium valuation we've seen over the recent past.
• Despite our expectation that growth prospects should prove more favorable in emerging markets longer term, we don't believe beverage manufacturers stand to benefit from the same tailwinds in China.
• Consumer defensive firms have looked to acquisitions as well as split-ups as a means to bolster value, but we don't believe that  ConAgra's (CAG) efforts to slim down stand to enhance its competitive position or drive outsize profit improvement.
• From our vantage point, a handful of meat processing firms look attractive, with heightened speculation around industry pricing dynamics leading to overly pessimistic top-line assumptions being baked into the shares.

 

Valuations within the consumer defensive sector have pulled back modestly, as the sector now trades around a 4% discount to our fair value estimate. However, despite being slightly more attractive from a valuation perspective, we still believe only pockets of value exist, as a number of names in the sector are still favored in light of the strong shareholder returns that characterize the sector, combined with continued optimism for merger-and-acquisition activity in the space.

Growth prospects remain tepid around the world, as evidenced by recent results and the sluggish top-line outlook several consumer product firms maintain. However, longer term, we still surmise emerging markets offer more favorable prospects, in line with our expectations for exponential population growth, disposable income tailwinds resulting from urbanization and private investment, and a younger consumer base that offers the potential for a lifetime of transactions ahead. 

And although China is often cited as the next great growth savior for the beverage market, based on prior growth rates and low per-capita consumption, we're less optimistic. More specifically, we expect slowing gross domestic product growth, worsening demographics, and embedded cultural practices to cause much more muted gains over the next five years than many investors hope, in line with our outlook for volume gains below real GDP growth and sharply trailing past rates. In all, we expect growth to be limited to the single digits for both the soft drink and beer industries. That said, we see pockets of opportunity, particularly for wide-moat international firms  Coca-Cola (KO) and  Anheuser-Busch InBev (BUD) given their strong brand and distribution positions.

Corporate actions persist as another means by which to unlock value. For one, speculation surrounding consolidation continues, particularly in the packaged food space, as Kraft Heinz (KHC) has expressed that it intends to remain a consolidator in the space. Conversely, others are still seeking opportunities to benefit from increased focus, most recently as ConAgra split its consumer (ConAgra Brands) and commercial food (Lamb Weston) enterprises.

From our vantage point, splits have proved advantageous for others (including Kraft, Sara Lee, Ralcorp, and Fortune Brands) in the past and have in some instances led to an improved competitive positioning and financial prospects. But we think ConAgra's outcome may vary from its predecessors. Despite management's contention that this will allow for more focused execution, we aren't convinced that this strategic step will enhance its competitive edge. For one, ConAgra Brands still operates with a portfolio of second- and third-tier brands that have failed to amass much pricing power. Further, profits in the consumer brands business materially lag its peers, and even with plans to extract $300 million in costs (at the low end of the 4%-7% of cost of goods sold and operating expenses its peers target shedding), we don't forecast it will entirely close the margin gap with other branded packaged-food firms. As such, our stance is more tempered than the market's with regard to the prospects for ConAgra Brands (our forecast calls for mid-teens operating margins versus consensus in the high-teens), and we suggest investors remain on the sidelines.

In contrast, we believe shares of firms in the meat processing space (particularly Pilgrims Pride (PPC) and  Sanderson Farms ) are relatively more attractive following recent speculation surrounding industry pricing practices--concerns we view as overblown. More specifically, Georgia Dock chicken prices (a common industry pricing index) are now at above-normal premiums to other commonly cited industry benchmark levels (recently around 50%, versus a 30% historical average). However, from our vantage point, the industry has changed since Pilgrims' 2008 bankruptcy; we believe a decrease in fixed-price contracts, greater use of grain-based and cost-plus pricing, and more value-added products have brought large producers' exposures to Georgia Dock prices to less than 5% of revenue. Further, we believe contracts would switch benchmarks such that effective pricing is virtually unchanged if Georgia Dock prices were to fall into disuse. And while not as top of mind in the market, we contend that beef retail prices have room to fall, potentially leading to substitution away from chicken, as grocers have held the line on pricing despite cheaper wholesale costs. Although this could impact top-line industry prospects and our valuations (to the tune of 5%-15%), we maintain that consumers' secular shift toward health and wellness ultimately stands to benefit chicken longer term, which limits the true downside.

Top Picks

Symrise (SY1)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: EUR 74.00
Fair Value Uncertainty: Low
Five-Star Price: EUR 59.20

Symrise is the world's fourth-largest supplier of flavors and fragrances, with a market share of 12%. Its narrow-moat rating is based on customer switching costs, which make the business stable and predictable as clients don't change ingredients providers easily due to the risk that they might suffer production disruption as a result or impair brand values through changed taste, flavor, or fragrance profiles. Long-term growth of ingredients is supported by positive demographic trends (including increased urbanization, more processed foods being eaten, more women working), and health and wellness trends. Further, there is upside potential to ROIC once Pinova, its recent acquisition, has been successfully integrated. Symrise has exposure to the high-margin fragrance business, strong market shares in oral care ingredients, and high exposure to strong growth in emerging markets, which account for 46% of sales. With shares trading at a price/fair value of 0.77, the risk/reward profile seems favorable.

Pilgrims Pride (PPC)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $28.50
Fair Value Uncertainty: High
Five-Star Price: $17.10

We believe that the market is modestly underestimating Pilgrims Pride's prospects, as shares trade at a 35% discount to our valuation. Our forecast calls for Pilgrims' sales growth of about 3%-4% annually in the longer term. In our estimation, the no-moat chicken producer should capitalize on rising fresh food and meat demand in North America. Further, low corn and soybean meal prices have coincided with strong demand for chicken, conditions that we believe will benefit Pilgrims' balanced portfolio while providing investors with a steadier near- to midterm outlook than large bird-focused producers if commodity tailwinds abate. As such, we'd suggest long-term investors looking to gain exposure to the industry should consider building a position Pilgrims' shares.

 Danone (DANOY)
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $16.00
Fair Value Uncertainty: Medium
Five-Star Price: $11.20

From our vantage point, Danone possesses strong secular growth drivers that should allow it to grow organically at a rate above packaged food competitors. Although medium-term growth looks likely to undershoot management's 2020 guidance, we expect it to be profitable growth and forecast 280 basis points of margin improvement in the medium term. We see little reason Danone cannot sustain an operating margin closer to its peers of around 15%. In our view, investors are overlooking the margin opportunity in the early-life nutrition segment because of a lack of guidance combined with an assumption that margins will simply be maintained. But with volume growth drivers in place, strong pricing power in infant nutrition, and some near-term tailwinds from tepid cost inflation, we see an opportunity for Danone's margins and free cash flow growth to surprise on the upside.

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