Market Overlooks Danone's Prospects for Margin Expansion

Danone possesses a narrow economic moat derived from strong competitive positions in its dairy and infant formula businesses. These competitive advantages should preserve Danone’s market shares as strong economic, demographic, and consumer trends drive volume growth. On top of population growth in Danone’s geographic footprint, per capita consumption growth is likely to occur in almost all segments, thanks to urbanization, economic development, and an increasing consumer preference for healthier food and beverages.

Although medium-term growth looks likely to undershoot management’s 2020 guidance, we expect it to be profitable growth, and we see no reason Danone cannot sustain an operating margin closer to its peers of around 15%. The firm achieved 70 basis points of consolidated EBIT margin expansion in 2016 on just 2.9% organic sales growth, which is evidence of the profitability improvement opportunities ahead. We think investors are overlooking the margin opportunity in the early-life nutrition segment because of a lack of guidance and an assumption that margins will simply be maintained. But with secular 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 to the upside.

Competitive Positioning Keeps Moat Narrow We think Danone has a narrow economic moat, with intangible assets and a cost advantage at its heart. There is significant variation in Danone's brand equity and industry structure across its four product segments--bottled water, infant nutrition, dairy products, and medical nutrition--and we think the net effect is that, in terms of its competitive positioning, Danone is a middle-of-the-pack operator in the packaged food space.

In the aggregate, Danone’s economic moat is derived from its leadership and near leadership in multiple categories, which make it an important vendor to retailers. This intangible asset, coupled with economies of scale, allows Danone to generate significant cash flows, with a free cash flow to the firm run rate of around EUR 1.3 billion. In turn, this enables Danone to invest heavily in marketing and research and development (we estimate that the firm spends close to 25% of its sales on these activities) and provides the flexibility to react to the loss of shelf space to new entrants.

Danone falls short of a wide moat, however, because although its virtuous cycle of competitive advantages gives it some protection against new entrants, its competitive positioning against some of its large-cap competitors is less strong. Benchmarked against its packaged food peers, Danone scores in the middle of the group based on our cost analysis, which excludes discretionary costs not directly linked to production and distribution. Its cost structure appears bloated relative to its closest peers, including wide-moat firms Nestle NSRGY/NESN and Mead Johnson MJN.

Danone’s brand equity is highly variable across its segments but is generally quite weak. In the early-life nutrition segment, brand equity contributes somewhat to Danone’s strong franchise. Parents seek to limit risk when it comes to feeding their children, and brand recognition is a powerful force in the buying process. The global infant formula industry is characterized by low private-label penetration (less than 1%, according to consulting firm Zenith International), as brands are perceived to carry greater nutritional value. However, loyalty varies widely across markets. According to Nielsen, 72% of mothers globally switch formula brands, usually following a word-of-mouth recommendation, although this number appears to be lower in China, Danone’s largest market for formula sales. According to Bain estimates, consumers regularly purchasing the same brand account for 40% of formula sales in China.

Visibility into the sustainability of brand equity as a moat source is very limited, owing to the fragility of brand loyalty. This is particularly true in China, where there have been several instances of local brands becoming contaminated with toxins, most notably the 2008 melamine scandal in which 300,000 children were stricken with kidney stones and other health complications. As a result, international brands, perceived by consumers as being lower risk, now dominate the market. This is a double-edge sword, however, as consumers’ focus on product safety creates a heightened sensitivity to the operational mishaps and subsequent negative publicity to which Danone has been vulnerable in recent years. This was evident in the annihilation of its locally produced Dumex infant formula brand in China after a product recall in 2013. Sales of the brand have fallen 70% since the recall, and in 2015, Danone wrote down the asset by EUR 398 million and ultimately divested it for EUR 150 million. The company suffered another, albeit less dramatic, collapse in volume and brand equity in its dairy segment in Europe, when Danone voluntarily removed promotions based on health claims of its probiotic yogurt portfolio (Actimel and Activia). We estimate that since 2013, when the impact of these negative developments began to flow through to Danone’s financial performance, adjusted return on invested capital has fallen by around 140 basis points. Nevertheless, the breadth of the portfolio and the performance of other formula brands in China have ensured that Danone has sustained excess ROIC over its weighted average cost of capital. We think this supports our narrow moat rating.

Although we are cautious about the sustainability of the firm’s brand equity as a competitive advantage, we think brand strength, along with its cost advantage and relationships with customers, played a role in the firm’s recovery from the Dumex catastrophe. Danone’s remaining infant formula portfolio has driven company market share growth, with its value share in China rising from 5% at the depth of the crisis to 15% two years later. Danone was able to leverage its retailer relationships and cost advantage and quickly regain shelf space through replacement international brands (particularly Aptamil and Nutrilon), while its penetration of the emerging online and mother-and-baby store channels is a measure of the brand recognition of those products. It is now the number-two player in the category in China, and thanks to its leadership in the online channel, it is also the fastest-growing.

Brand Risk Is Present We think Danone faces heightened brand risk relative to the broader fast-moving consumer goods industry, owing to its exposure to infant formula. Safety scares have destroyed many brands, including Danone's own Dumex brand in China. Another source of brand risk lies in the dairy portfolio. Danone has been forced to adapt its products (primarily by fortifying Actimel and Activia with vitamins in some markets) as well as its marketing (by removing health claims) in response to the prohibition in the European Union regarding the promotion of probiotics' alleged health benefits. European regulations are more stringent than those in most of the rest of the world--the burden of proof for a health claim is 95% efficacy--but there is a risk that regulators in other markets could also prohibit Danone from marketing the health benefits of some of its dairy products.

If Danone were to be prevented from marketing the health benefits of probiotics, this would probably significantly weaken its brand strength in the category, soften its pricing power, and increase its exposure to its other significant business risk: volatile commodity costs. Farm-gate milk prices have been very volatile in recent years and have been on an upward trajectory since 2006. Danone has not always been able to pass through this inflation in its raw materials. The recent transition of European dairy farmers to a more liberalized production model should ease some of the supply-side pressure, although we expect the changes, which include the abolition of quotas, will cause some near-term volatility.

We forecast medium-term free cash flow of almost EUR 2 billion annually, so we think debt maturities are manageable, but it is noteworthy that in both 2019 and 2021, Danone faces debt maturities of more than EUR 1 billion, each of which represent around 20% of the firm’s debt and 2% of its market cap. The decision to offer scrip dividends will help alleviate our cash flow concerns, if the same option is offered to shareholders in future years. In the event of any excess cash, which we believe depends partially on dividend policy, we think small acquisitions are the most likely, and a fairly appropriate, use of cash. The firm has pursued bolt-on acquisitions in emerging markets, and we expect this strategy to continue.