Consumer Defensive: Thirst for Growth Has Yet to Be Quenched

• Valuations across the global consumer defensive coverage landscape have ticked up modestly, now trading at just a 2% discount to our fair value estimates on a market-cap-weighted basis, versus a 5% discount three months prior.
• Retailers and consumer product manufacturers alike are working to facilitate further e-commerce penetration.

Relative to last quarter, the consumer defensive sector is now trading at just a 2% discount to our fair value estimates (up from 5% a quarter ago). However, we still maintain that opportunities for long-term investors to build positions in competitively advantaged names remain.

Given tepid growth prospects persist across the industry, we aren't surprised that leading players in the category are continuing to opt for inorganic opportunities to accelerate their sales trajectory. For one, Conagra finally quelled persistent rumors and added

PF to its mix. From a strategic perspective, we can appreciate the rationale behind the deal, which will make Conagra the number two player in the domestic frozen food category. We contend Conagra enjoys entrenched relationships with retailers that depend on its brands to fuel store traffic and expect the addition of billion-dollar label Birds Eye to enhance its existing portfolio (which already includes a billion-dollar entry in the frozen category in Marie Callender's).

Consolidation also ensued among the leading nonalcoholic beverage manufacturers, with Pepsi adding SodaStream and Coca-Cola adding Costa to its respective portfolios. We portend Pepsi's tie-up aligns with recent efforts to build out its water portfolio, including the launch of its Bubly brand sparkling water earlier this year. We appreciate SodaStream's leading position within the sparkling water category, which we surmise is poised for further growth as consumers increasingly opt for lower-calorie, more natural products. Further, the inclusion of Costa should bolster Coca-Cola's presence in the fast-growing coffee category, particularly in the U.K., where Costa holds more than a one third share of coffee houses.

One reason for the continued interest in acquisitions is that organic growth remains sluggish for both retailers and manufacturers (in many instances amounting to a low-single-digit clip or less), with volumes 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., as well as the emergence of the e-commerce channel, are lowering barriers to entry in the consumer defensive space and intensifying price competition.

In this vein, questions have surfaced as to whether the relationships between retailers and consumer product manufacturers will hold the same clout online, particularly in snacking, where impulse purchases are commonplace and small, niche startups are also vying for share. While e-commerce sales are relatively negligible at this point, representing just a low- to mid-single-digit percentage of industry revenue, our forecasts suggest that online consumer product sales will account for a mid- to high-single-digit percentage of the market over the next five years. But as a means to take advantage of this growth, operators will need to launch packaging innovation to appeal to an online shopper, with a focus on ensuring product and quantity are clearly visible. Rather than compressing prices,

HSY management recently suggested that these efforts have bolstered averaging selling prices online, which now stand at 1.2-3.5 times the level Hershey derives across its portfolio in brick-and-mortar outlets.

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.

Top Picks

Imperial Brands

IMB

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: GBP 37

Fair Value Uncertainty: Low

5-Star Price: GBP 29.60

Tobacco stocks are out of favor, with the four large caps under our coverage falling by an average of almost 20%, year to date. Our pick of the group on valuation is Imperial Tobacco, which has derated slightly less than the group after having not fully benefited from the group's rerating last year. Although we regard Imperial as being one of the lowest quality of the large cap tobacco manufacturers, primarily because of its more price-sensitive consumer base and its position as a price taker in many markets, we still believe it has a wide moat because of the low price elasticity of demand and room for price increases in many markets. Although investors have been focused on heated tobacco for the next leg of earnings growth in this space, we think Imperial's wait-and-see approach is sensible, and we believe the value of the first mover advantage is being overestimated by the market. Trading at less than 10 times next year's earnings, the sell-off of Imperial looks overdone, and we think the stock offers an attractive entry point. Absent an acquisition, however, which we think is a low-probability event, the rerating in Imperial may be a slow burn, given the deflated expectations around emerging categories and the rising interest rate environment, but with a comfortably covered dividend yield of around 7%, investors will be paid to wait.

Anheuser-Busch InBev BUD

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $124

Fair Value Uncertainty: Low

5-Star Price: $99.20

Investors have loved to hate AB InBev in recent months, as the world's largest brewer has been battling headwinds on a number of fronts. We believe these headwinds are primarily short term in nature, however, and we think the stock offers material upside to its current market valuation.

One of the market's concerns relates to AB InBev's balance sheet. It is highly leveraged at just under 5 times net debt/forward EBITDA following the SABMiller acquisition. Although we believe the dividend (currently yielding 4.5%) is safe the payback period on the acquisition debt will be fairly long. Other headwinds include a loss of share to craft in the U.S., volatility in Brazil, and more recently, a slowdown in South Africa. Given the very favorable underlying demographic trends in emerging markets, however, we believe the issues in Brazil and South Africa will prove fleeting, and that AB InBev's cost advantage will ensure the company maintains or grows share in these markets. In the U.S., craft continues to grow and we expect the larger brands (such as AB InBev's Goose Island) to ultimately come out on top.

It seems unlikely that the reversal of AB InBev's recent troubles will occur in the short term, so investors may have to be patient for the upside to be unlocked. The above average dividend yield means investors will be paid to wait for AB InBev's turnaround.

Philip Morris International PM

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $102

Fair Value Uncertainty: Low

5-Star Price: $81.60

Our wide-moat rating stems from Philip Morris' brand equity and regulatory barriers to entry in the tobacco industry. The value drivers in the tobacco business are sales growth (composed of volume growth, pricing, and increasingly since the advent of NGPs, mix) and margins, which in turn are affected by mix, operating leverage, and the efficiency of investments made in brand equity and physical infrastructure. As Philip Morris was the first mover and remains the most advanced NGP supplier, NGPs already command almost 13% of the company's top line, and we think this can expand to the high-20s by 2022. This has a knock-on effect on margins, as devices are a component of that revenue and are margin-dilutive. We forecast an average annual drag of 30 basis points on the EBIT margin from unfavorable mix, the largest such assumption in the group. However, the current market value is 15 times forward earnings—a slight premium to competitors, which we think is appropriate, but 2.5 turns below the five-year historical average multiple. We view shares as attractive.