Consumer Defensive: Retailer Consolidation Sparks Concerns, but Opportunities Exist

• Consumer defensive valuations generally remain inflated, with the sector trading at about a 6% premium to our fair value estimates, generally in line with the 5% premium in the previous quarter.
• However, we fail to see how the pending deal will constrain consumer product operators, and we believe the combination could actually prove advantageous for manufacturers.
• Although firms throughout the space remain laser-focused on driving further efficiencies, these efforts to extract costs have failed to offset languishing top-line trends, prompting management teams to pursue more sweeping changes.

Valuations across the consumer defensive sector fail to present a compelling risk/reward opportunity at current levels, trading 6% above our fair value estimates. While the reaction to Amazon's acquisition of Whole Foods drove a broad-based retreat in the shares of firms across the landscape, creating pockets of value, we tend to still view valuations as a bit elevated even after accounting for recent declines.

In our view, a portion of the market's favor for firms throughout the sector reflects speculation about the potential for additional consolidation (particularly given the expressed hunger by

The news in the consumer defensive space this quarter was without a doubt Amazon's decision to acquire Whole Foods in a $14 billion all-cash transaction. Although the timing of the announcement caught us by surprise, we recognize the strategic benefit--affording Amazon the opportunity to gain a larger brick-and-mortar presence, as well as access to higher-quality fresh food (which stands to benefit its ambitions to expand its fresh grocery offerings).

The longer-term sector implications resulting from the tie-up, however, are more far-reaching. For one, competitive pressure across the retail defensive industry will undoubtedly intensify. Before this deal, we had already been concerned about a tough competitive environment as deflation and the entrance of Aldi and Lidl could hurt margins (factors that were baked into our assumptions). We now think that a Whole Foods/Amazon tie-up could exacerbate the pressure, as we expect Amazon to reposition Whole Foods more aggressively at lower average price points, leading to additional margin degradation across the space.

And while we believe this heightened competition will take a toll on most established operators, we think wide-moat

Further, within the online grocery business, we acknowledge that Amazon Fresh and Instacart (which is used in Whole Foods' online delivery offering and represents around 3% of total sales) should now be able to leverage Amazon's infrastructure to improve the speed and cost of delivery. However, Wal-Mart has also been working to bolster its exposure to the e-commerce channel (acquiring Jet.com last year for $3 billion, as well as Bonobos, an Internet clothing brand, in June) to gain further insights into the channel and close the gap with its bigger foe. As such, we haven't wavered on our expectation that Wal-Mart is poised as one of the few traditional retailers that can compete in e-commerce and stay relevant over the next decade.

Conversely, we fail to see how the Amazon-Whole Foods deal is a significant negative for consumer product operators. The acceptance of purchasing groceries online has failed to amass much traction until recently in the U.S. (accounting for just a low-single-digit percentage of total sales), and we portend that this deal may accelerate consumer adoption of purchasing through this channel.

Further, the differing assortment mix at Whole Foods (which consists primarily of natural and organic fare) compared with Amazon's existing grocery efforts (consisting mostly of traditional consumer packaged goods) also supports our contention that this combination is unlikely to constrain the negotiating leverage of consumer product firms. Even before this tie-up was inked, we surmised that consumer product operators would need to adapt their go-to-market approach and product mix to support these faster-growing channels or risk missing out on a growing number of purchase occasions--factors that fail to change after the combination.

Similar to what we've seen in physical retail outlets, we continue to believe that consumer packaged goods firms with significant resources to invest behind their brands (both from a product innovation and marketing perspective) can entrench themselves with online retailers and support their brand intangible assets.

In an industry where sales growth has proved elusive as efficiency efforts have taken top billing (particularly after the merger of Kraft and Heinz two years ago), we aren't surprised that consumer product firms are now pursuing more drastic actions to ignite improved financial performance. For one, in a break with industry norms,

We believe this shift affords the firm the ability to more effectively reinvest behind its brand set (as opposed to its capital-intensive distribution network) and to further entrench its relationships with retailers (one aspect of its intangible asset), which we view as prudent. However, we doubt the decision to abandon direct-store delivery will materially bolster Kellogg's sales or margin prospects beyond our current expectations, which call for low-single-digit annual sales growth and 300-400 basis points of operating margin expansion to 19% by fiscal 2026. And despite the soundness of its actions, the shares fail to represent a compelling proposition at current levels, trading in line with our valuation at almost 20 times forward earnings.

Top Picks

Kroger

KR

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $28.50

Fair Value Uncertainty: Medium

5-Star Price: $19.95

The grocery industry has been plagued by deflation and price cuts lately, partially as Wal-Mart and Amazon work to prompt traffic and in anticipation of Aldi and Lidl entering the U.S. While these challenges are heightened after the tie-up between Amazon and Whole Foods, we surmise that Kroger's sufficient scale, regional market share dominance, and brand equity should enable it to counteract material degradation to either its cost advantage or intangible assets. Kroger is the largest traditional grocer in the United States by revenue at $115 billion in annual sales, nearly double the level generated by number-two player Albertsons, with $60 billion. Kroger holds a number-one or -two position in 98 of 120 major and minor markets (three or more stores present), which, paired with its national and local scale, gives it a cost advantage over smaller foes. It also benefits from strong data analytics (amassed over decades) that enables it to tailor its merchandising mix and promotions to more effectively align with customer preferences. We believe the combination of its cost edge and intangible assets positions it well to compete with other mass merchants as well as alternative outlets including e-commerce and hard discounters such as Aldi and Lidl.

Symrise

(

)

Star Rating: 4 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 switching costs, 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.

Dollar Tree

DLTR

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $90.00

Fair Value Uncertainty: Medium

5-Star Price: $63.00

Although we see competition intensifying, we think these competitive threats are more than priced in and view Dollar Tree as offering a favorable risk/reward opportunity, trading at about a 25% discount to our fair value. Moreover, we think the firm's narrow moat positions it well to defend against these competitive threats and deliver excess returns to shareholders. In line with our contention, Dollar Tree blends value and convenience for its low- and fixed-income customer base, enabling above-average markups (between 35% and 45% versus the low teens to high 20s we estimate Wal-Mart and

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