Consumer Defensive: Valuations More Reasonable After Third-Quarter Retreat

• Following a modest retreat early in the third quarter, valuations in our global consumer defensive coverage are now just 1% above our fair value estimates on a market-cap-weighted basis.
• M&A was once again top of the agenda this quarter, with Nestle particularly active on the acquisition front, Reckitt Benckiser Group disposing of its food business, and rumors circulating, later denied by the company, that Estee Lauder might be in play.
• Amid weak growth, activist investors are increasingly forcing companies to focus on a cost-cutting agenda, with activists taking stakes in P&G, Nestle, and Danone in the third quarter. 
• Although there are signs that inflation may be creeping back in the U.S. and the U.K., and deflationary pressures have abated in Europe, continued competition from discounters and Amazon's entry into grocery retailing could weigh on medium-term organic growth in the consumer defensive sector.

 

After two quarters of slightly inflated valuations, the consumer defensive sector retreated modestly early in the third quarter, and now trades in line with our fair value estimates. Nevertheless, opportunities remain for the selective investor.

Despite the valuation pullback, M&A remains a key theme in consumer staples. This quarter,  Reckitt Benckiser (RB.) sold its food business to  McCormick (MKC) for a whopping $4.2 billion, or more than 20 times the unit's EBITDA.  Nestle (NSRGY) was active in the last quarter, spending $500 million on Blue Bottle Coffee and an undisclosed amount on Sweet Earth, a plant-based food manufacturer. Having made its own move into the growing category of plant-based products through the acquisition of Whitewave,  Danone (DANOY) disposed of the Stonyfield dairy brand. Lactalis picked up the asset for $875 million.

With growth being driven largely by small, niche categories, we expect small deals like these in growing categories to be part of the large-cap manufacturers' medium-term strategies. Having said that, transformational deals are still an option, and Estee Lauder (EL) was rumored this quarter to be a target for  L'Oreal (OR) and  Unilever . Estee Lauder's management later denied the reports.

One reason for the continued interest in acquisitions is that organic growth remains sluggish for both retailers and manufacturers, with volumes remaining soft relative to historical levels, and price/mix still under pressure. The growth of the hard discounters in Europe, Australia, and increasingly in the U.S., and the emergence of the e-commerce channel, are lowering barriers to entry in the consumer defensive space and intensifying price competition. As we had suggested in last quarter's outlook, on the day its acquisition of Whole Foods closed,  Amazon (AMZN) slashed prices on a number of products in its newly acquired stores. Meanwhile, the consumer is looking for alternatives to the big brands, either seeking better value from unbranded alternatives, or trading up to more niche, artisan products such as craft beer.

In response to this rather tepid outlook for sales growth, several manufacturers are looking to margin expansion in order to fuel earnings and cash flow growth. Many, including  Coca-Cola (KO), Kraft Heinz (KHC), and  Diageo (DEO) have adopted zero-based budgeting strategies. Several more are slashing ineffective advertising expenses, with  Procter & Gamble (PG) one of a number of companies hoping to reduce social media spending in the short term.

Pressure to expand margins is coming from activist investors. This quarter, Trian Partners' Nelson Peltz announced that he is to seek a board seat at P&G, Daniel Loeb's Third Point built a stake in Nestle and published an open letter to management asking for changes to strategy and capital allocation, and activist investors Corvex invested $400 million in Danone.

Other cost-saving strategies include  Kellogg's (K) decision earlier this year to part ways with its direct-store delivery platform, shifting entirely to a warehouse model. Although some of its global snack food competitors, including  Mondelez , rebuffed this move as unwise, we think it is an appropriate response to the growth headwinds in an increasingly commodified category.

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 (WMT) 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 U.S. 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.

 Imperial Brands (LSE: IMB)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: GBX 3,900
Fair Value Uncertainty: Low
5-Star Price: GBX 3,120

Tobacco valuations have rerated significantly as investors focus on the potential of the emerging heated tobacco category, in which a device heats tobacco to a temperature at which nicotine is released but combustion does not take place. In the third quarter, both Japan Tobacco with Ploomtech and  British American Tobacco (BTI) with glo entered new trial markets in Japan.  Philip Morris (PM) has already achieved a double-digit market share in Japan with its heated tobacco product, iQOS.

The market is valuing the tobacco companies with the greatest exposure to heated tobacco at a premium. While competitors increase heated tobacco capacity and achieve wider commercialization, Imperial remains on the sidelines, and the market is valuing the stock at a significant discount to peers. We think the valuation discount of almost 10 turns of P/E is too deep to ignore, primarily because we think investors are a little overexcited about heated tobacco. First, we acknowledge that the category probably has a long-term future, but we are not convinced that it will benefit cash flows materially. Second, we do not think it is too late for Imperial to step in to the heated tobacco category, and we think it ultimately will if commercialization is successful outside of Asia.

 Sprouts Farmers Market (SFM)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $23.50
Fair Value Uncertainty: Medium
5-Star Price: $16.45

Investors did not look favorably on Amazon's decision to slash grocery prices in Whole Foods from the perspective of regional competitor Sprouts Farmers Market, with the stock down by around 20% since the announcement. Nevertheless, the firm has strong store economics and cash flow generation, which have enabled it to grow at an above-average rate over the last five years (double-digit top-line growth versus peers at mid-single-digits or less).

But Sprouts has maintained an eye on growing profitably, as pretax cash-on-cash returns are 35%-40% within three to four years, which is the second-highest on our coverage list behind the dollar stores, which boast payback periods of two years or less. Helping drive these unit returns are its small box units at 30,000 square feet (grocery stores typically are closer to 50,000 square feet), which enjoy strong new unit productivity at around 80%, higher than the average 60%-70%. Given these unit economics and white space opportunities, we believe the firm can double its footprint by 2025 to 500 units.

Despite attractive unit economics, however, we recognize its lack of an edge, and heightened competition could lead to faltering scalability and/or quality standards as it grows its footprint, calling into question the sustainability of such results long term.

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