Consumer Defensive: Looking to M&A, Online Sales for Growth

• Consumer defensive valuations have pulled back, with the sector trading at about a 2% discount to our fair value estimates on a market-cap-weighted basis.
• With sales trends languishing, mergers and acquisitions persisted this quarter, as  General Mills (GIS) scooped up  Blue Buffalo and  Dr Pepper Snapple Group (DPS) announced plans to merge with privately held JAB Holding.
• E-commerce continues to remain a focus to support retailers' top-line growth, even with the potential hit to margins.
• Despite the benefit from efficiency efforts, inflationary headwinds are starting to eat into profits.

After multiple quarters of slightly inflated valuations, the consumer defensive sector retreated modestly and now trades at a roughly 2% discount to our fair value estimates. As such, we now see a few more opportunities for patient investors to build positions in some competitively advantaged names.

In light of tepid top-line pressures, companies have continued to look to inorganic opportunities as a means to bolster growth prospects. For one, wide-moat General Mills announced its intentions to purchase narrow-moat Blue Buffalo, a natural pet food brand. Overall, the deal strikes us as strategically sound, as it stands to improve General Mills’ growth trajectory without compromising its ongoing efforts to enhance its bottom line. Blue Buffalo operates in the attractive U.S. pet food market, which has increased retail sales at a 3%-4% rate over the past several years, outpacing the negative to low-single-digit growth in the traditional packaged food space and brings a higher-operating-margin business (operating margins in the mid-20s versus General Mills’ high teens) to the mix.

This followed wide-moat Dr Pepper’s disclosure that it intends to merge with Keurig Green Mountain (which has been privately held by JAB Holding since March 2016); the combined firm remaining in the public markets. The rationale for this tie up is also quite apparent to us; the new entity should possess material brand strength and gain diversification benefits away from the declining carbonated soft drink category with further benefits of bolstering each firm’s distribution capabilities. Further, management sees significant cost savings, targeting $600 million (or 5%-6% of combined pro-forma sales) in annualized synergies by fiscal 2021, which we view as tangible but unlikely to exclusively prop up profitability. Rather, we surmise that 30%-40% of these savings will be reinvested in Keurig Dr Pepper’s brands to support the intangible assets (brands and entrenched retail relationships) that support our wide moat, prudent spending from our vantage point.

While consumer product firms are using M&A to drive growth, several defensive retailers are increasingly looking to build out e-commerce platforms to ignite growth prospects, particularly in light of changing consumer habits. In addition, competitive pressures abound, particularly following the tie-up last year between  Amazon.com (AMZN) and Whole Foods, which has exacerbated the speed of transaction and pressure on retailers across the space. But despite this,  Walmart WMT,  Target (TGT),  Costco (COST), and  Kroger (KR) all exuded robust growth through this channel in the most recent quarter, which aided each firm’s transaction growth (which has averaged a low-single-digit increase over the past year). Although a mere 3% to 5% of each firm’s consolidated sales base, we think investments to expand this distribution channel will facilitate 10% or more of sales orchestrated online for each over the next decade.

Beyond top-line growth aspirations, we aren’t blind to the fixed and variable costs associated with a higher penetration of e-commerce sales. As retailers invest in technology and add the extra cost to fulfill shipments online, defensive retailers have seen operating profits pressured to the lowest levels in the past decade. And in light of intense competitive angst, we don’t anticipate these headwinds will subside, but believe that those with significant resources (both financial and personnel) stand to win out.

Cost pressures are also plaguing consumer product firms. Even though these operators have maintained a focus on extracting excess costs over the past few years, inflationary headwinds have again resurfaced. For one, firms are facing increased freight expenses that have dented profitability. In this vein, General Mills recently called out that spot rates are near 20-year highs and can be up to 60% higher than contract rates. Further,  McCormick (MKC) has alluded to rampant inflation in both vanilla and garlic prices (which are up high-double to even triple-digit rates lately) that is also eating into its profits. And we don’t anticipate that these pressures will abate over the near term.

Top Picks

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

Imperial is the unloved stock in a sector that is very much in favor. The market is valuing tobacco stocks based on their exposure to heated tobacco, the emerging category that is achieving impressive growth in Japan and select markets around the world. We are bullish on heated tobacco, and we think a valuation premium for those leading and developing the category is appropriate. However, we think the market is overestimating the value of the first-mover advantage, and if heated tobacco gains traction in other markets, particularly the U.S. and Europe, we expect Imperial to leverage its wide moat and follow  Philip Morris (PM),  British American Tobacco (BATS), and Japan Tobacco into the space with its own technology. Imperial's current multiple discount of 9 times P/E is much larger than the historical gap, and we think this is unjustified.

 General Mills (GIS)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $59
Fair Value Uncertainty: Low
5-Star Price: $47.20

We think the market’s confidence in wide-moat General Mills’ ability to restore top-line growth has faltered, considering continued softness in volumes across the packaged food space, as well as the firm’s recently announced acquisition of natural pet food company Blue Buffalo. While the deal carries some inherent risk as General Mills enters a category in which it has limited experience, we remain confident in the firm’s ability to efficiently integrate Blue Buffalo and extract cost synergies from combining these operations. We contend General Mills will rely on the same strategy used for its previous acquisitions of niche players, enabling its pet food unit to benefit from its supply chain and distribution capabilities while largely leaving the acquired firm’s operating model intact, which we surmise has ensured these niche brands stay in touch with the preferences of their core customer base. We think this approach has proved successful in the past, as exemplified by Annie’s, which has increased distribution around 80% since being acquired in 2014. 

Further, we contend General Mills' stringent cost management focus should facilitate additional reinvestment in its brands through research and development and advertising; we expect brand-related spending as a percentage of sales to tick up over the long term (totaling 7% of sales over our forecast, or 180 basis points above General Mills’ fiscal 2017), which should support top-line gains as General Mills expands the distribution of Blue Buffalo’s fare in mass-market channels. Given its discounted valuation (we see at least 20% upside to our current valuation) and a greater than 3% dividend yield, we think the stock provides an attractive entry point for long-term investors.

Japan Tobacco 2914:JP
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: JPY 3,750
Fair Value Uncertainty: Low
5-Star Price: JPY 3,000

We think the combustible cigarette business has a wide moat underpinned by intangible assets and a cost advantage. However, the stock is trading at a 28% discount to our fair value estimate, despite our earnings projections being 1%-7% below the consensus over the next three years. The current share price seems to imply flat earnings over the next five years, whereas we expect that growth in emerging markets, combined with prices hikes and share recovery in Japan, will sustain low-single-digit growth. Our fair value estimate implies fiscal 2019 price/earnings of 16 times and enterprise value/EBITDA of 10 times, trading at in the middle of the valuation range of Big Tobacco peers and toward the lower end of the firm's historical average.

Quarter-End Insights

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Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018
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Healthcare: Values Among Drug, Biotech, and Supply Chain Firms
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Real Estate: Rising Rates Won’t Derail Strong Fundamentals
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Technology: Shift to Cloud Computing Most Important Story
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Utilities: Under Pressure in Early 2018
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Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain
We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows
As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.