Consumer Defensive: Still Thirsty for Growth

• Consumer defensive sector valuations have edged higher, with shares trading about 5% above our fair value estimates, reversing the approximately 4% discount we saw in the last quarter.
• Top-line growth is hard to come by, with prices relatively stable and commodity costs still reasonably low; we expect the environment to persist short term before reverting to more normal patterns of inflation.
• Cost-cutting and share buybacks have dominated as firms try to preserve EPS growth in a soft revenue environment; while much of the efficiency benefit should prove durable as conditions normalize, firms run the risk of underinvesting in their brands and growth infrastructure.

While opportunities still exist, sector valuations currently outpace our fair value estimates by about 6%, reversing a 4% discount last quarter and returning to the premiums we had seen about a year ago. Although we believe margins of safety have compressed after the recent runup (in part due to M&A speculation, in our view), we continue to see opportunities in certain parts of the consumer landscape where idiosyncratic factors have obscured firms' long-term potential. Broadly, however, investors are looking for firms with a competitive edge that are likely to be able to fend off rivals amid volatile, slowing growth around the world.

Unimpressive top-line outlooks across the industry are driven by intense competition and low input costs,

. However, the input cost environment has generally failed to translate into higher margins, with the competitive picture often leading firms to use savings to reduce list prices (as a means by which to take share) or increase trade spending. The most competitive, commodity-linked industries have seen the greatest pressure, such as meat processors (including

With top-line growth muted and creating associated cost deleverage pressure, firms have looked to reduce expenditures as a means to protect earnings. While we generally have a favorable view of efforts to improve operational efficiency, firms risk cutting too far and underinvesting in advertising, innovation, and other brand-building activities. As a result, we have paid special attention to the source of savings in this recent round of corporate austerity.

The prevalence of intangible asset-based moats among the firms we cover in the sector means much of companies' value depends on the degree to which they can use their brands to ward off competition, either by gaining consumers' esteem or by building deep relationships with retailers. Maintaining these advantages amid intense competition requires investment, and so we look at current cost reductions with a long-term lens to determine whether management teams are mortgaging the future to meet investor demand for near-term earnings growth.

Similarly, we are skeptical that the margin expansion that firms like Kraft Heinz and

While we anticipate that elevated valuations across the space reflect the consistent cash flows and returns that consumer product firms boast combined with the income streams offered to shareholders, we also surmise that speculation surrounding further industry consolidation has placed upward pressure on stock prices. In that vein, Kraft Heinz's $143 billion attempt to take over Unilever failed, but speculation that the firm's appetite for consolidation is undeterred has led potential targets to rebound from levels seen when the proposed deal was first announced.

We anticipate acquisitions will remain an avenue for growth in the sector as firms attempt to use synergies to boost efficiency amid a slow sales growth environment, and suspect the packaged food industry could be particularly active, with firms like

Top Picks

Symrise

(

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Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: EUR 78.00

Fair Value Uncertainty: Low

5-Star Price: EUR 62.40

As the world's fourth-largest supplier of flavors and fragrances, with an 11% market share, we believe Symrise stands to benefit as emerging-markets populations grow, urbanize, and increase processed food consumption as female workforce mobilization rises. With developing economies accounting for 43% of sales, Symrise is poised to augment developed-market demand drivers stemming from an increased focus on health and wellness issues and clean labeling. While pricing power is limited, we assign Symrise a narrow moat rating on the basis of the switching costs clients face, as the firm's customers hesitate to take risks with other suppliers that would face the daunting task of replicating proven tastes or fragrances (around 95% of sales are customized). Shares trade at an attractive price/fair value ratio of 0.8, which we believe offers a favorable risk/reward profile.

Pilgrims Pride

PPC

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $28

Fair Value Uncertainty: High

5-Star Price: $16.80

While its shares have risen about 15% thus far in 2017, we believe market sentiment still modestly underestimates Pilgrims' ability to use its balanced portfolio, premium products, and Mexican operations to generate 3%-4% average annual top-line growth even as the industry benefits from contracting changes that have reduced risk.

Pilgrims' no-moat rating is consistent with industry peers, but we believe the company can use its diverse mix of bird sizes to benefit from increased protein and poultry consumption across all parts of the retail and foodservice spectrum. With corn and soybean meal prices still attractive, we believe the company should be able to weather price deflation spurred by falling ground beef prices.

Recent avian influenza outbreaks remain a concern, but we are encouraged that regulators globally are increasingly taking a regionalized approach to import bans from affected areas, rather than the country-wide restrictions seen in years past.

We also do not see recent pricing scandals in the chicken industry (in particular, concerns regarding the composition of a price benchmark and potential indirect collusion) as likely to affect leading producers such as Pilgrims. As the stock still trades at about a 20% discount to our valuation, we would suggest that long-term investors looking to gain exposure to the industry should consider building a position in Pilgrims Pride shares.

Danone

DANOY

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $16

Fair Value Uncertainty: Medium

5-Star Price: $11.20

We see Danone at a crossroads and believe the painful ride investors have seen over the past several years should yield to strengthening prospects as a new management team centralizes the firm's structure and refocuses on profitability.

Although medium-term growth looks likely to undershoot management's 2020 guidance (though our 4%-5% annual organic growth estimate for the next five years still outpaces most packaged food competitors), we expect it to be high-quality, helping to drive 280 basis points of margin improvement in the medium term. We contend there is little reason Danone cannot sustain an operating margin closer to its peers of around 15%.

In our view, the firm's early-life nutrition unit should drive improvement beyond market expectations that seem to assume that segment margins will simply be maintained. While we see the firm's competitive positioning, derived from its leadership and near leadership in multiple categories, as middle-of-the-pack (and worthy of a narrow, rather than wide, moat rating) due to its vulnerability against some of its large-cap competitors, we view the shares' current trading level, which correspond to about a 10%-15% discount to our valuation, as an attractive entry point for investors looking to build a position.

More Quarter-End Insights

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Video Report: Few Values Left in the Global Stock Market

Economic Outlook: First-Quarter Underscores Slow Growth Expectations

Credit Market Insights: Bond Indexes Perform Well as Spreads Tighten Further

Basic Materials: The Most Expensive Sector We Cover

Consumer Cyclical: Still Opportunity in a High-Confidence Environment

Energy: Coming Shale Growth a Major Threat to Oil Prices

Financial Services: Weighing the Strategic Tradeoffs of the Fiduciary Rule

Healthcare: Stock-Picking Increasingly Important as Valuations Rise

Industrials: Solid Fundamentals, but Few Screaming Buys

REITs: Playing Defense in an Uncertain Market

Tech: Overvalued Overall, but Opportunities Remain

Telecom: Firms Strive to Be More Than 'Dumb Pipes'

Utilities: Is There Enough Growth to Offset Higher Interest Rates?