Consumer Defensive: Meaningful Opportunity in Tobacco

The Morningstar Global Consumer Defensive Index held up comparably well in the fourth quarter, sliding 7% through Dec. 20 versus a 14% drop for the broader market. Still, consumer defensive shares are off 10% for the year, in line with the overall market (Exhibit 1) amid concerns about the competitive landscape and the ability of firms to offset higher commodity and transportation costs by increasing prices.

Exhibit 1: Sector has modestly outperformed the market

We don't believe the consumer defensive sector offers much value in the aggregate, with the median stock we cover trading at a modest 7% discount to our valuation. Nevertheless, we see comparably more buying opportunities in the sector than in most, with 9% of consumer defensive shares trading in 5-star territory.

In particular, we think tobacco offers investors meaningful opportunity, with all of our industry coverage trading in 4- or 5-star territory (Exhibit 2), as shares have declined over concerns about slowing heated tobacco growth in Japan and a potential ban on menthol in the U.S. By contrast, the retail defensive and nonalcoholic beverage industries are trading in line with our valuations or modestly above.

Exhibit 2: Tobacco uncertainty is creating an investment opportunity

We expect a more modest level of cost inflation could temper the degree of margin pressure facing consumer packaged goods operators and facilitate added brand investments. For example, in the U.S., transportation cost inflation is likely to moderate considerably. We anticipate truckload, or TL, pricing will moderate to a low-single-digit clip in 2019 (Exhibit 3), down from the industry's recent high-single-digit pace.

In contrast to other industries, e-commerce sales in CPG are relatively negligible, presently at 6% globally (Exhibit 4). The U.S. is a relative laggard here at around 1%, but we forecast that U.S. online consumer product sales will approach the global average over the next few years.

Exhibit 3: Although still positive, truckload pricing set to ease in 2019

Exhibit 4: Consumer product sales online materially lag the global average

In light of this shift, questions have surfaced as to whether retail relationships (an aspect of a CPG manufacturer's intangible asset moat source) will persist online. But we believe operators positioned to win are working with retail partners to meld online and offline strategies, an essential undertaking, given three fourths of the time when consumers initiate a search, it occurs on retailer websites.

Top Picks

General Mills GIS

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $57

Fair Value Uncertainty: Low

5-Star Price: $45.60

We think the market’s confidence in wide-moat General Mills’ ability to restore sales growth has faltered, considering continued softness in volume across packaged food as well as skepticism around the acquisition of natural pet food firm Blue Buffalo. While the deal carries some inherent risk, we remain confident in the firm’s ability to efficiently integrate Blue Buffalo and extract cost synergies, using the same playbook it relied on after the tie-up with Annie’s four years ago. We see about 35% upside to our current valuation, and with a 4%-plus dividend yield, it provides an attractive entry point for long-term investors.

British American Tobacco BTI

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $59

Fair Value Uncertainty: Low

5-Star Price: $47.20

British American has declined along with the rest of the group this year after a sequence of bad news. First, heated tobacco slowed in Japan, causing investors to rethink the assumption that it would support volume trends over the medium term. Then, the U.S. Food and Drug Administration announced that it would seek to ban menthol in cigarettes. Having doubled down on the U.S. market, an attractive market in our view, with plenty of headroom for pricing, British American will be hit hardest by such a measure. Nevertheless, a worst-case scenario appears to be priced in to the stock, and we see long-term upside.

Anheuser-Busch InBev BUD

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $118

Fair Value Uncertainty: Low

5-Star Price: $94.40

Despite battling a number of headwinds, we think AB InBev’s stock offers material upside. Following its dividend cut, management has removed an overhang that concerned investors. We estimate the incremental $4 billion to $5 billion in free cash flow will deleverage the balance sheet to 3 times net debt/EBITDA by 2022. Other headwinds include volatility in Brazil and a slowdown in South Africa. But given favorable underlying emerging-market demographic trends, we believe these issues will prove fleeting. In the U.S., any slowdown in craft-beer growth could stabilize volumes in mainstream price segments and act as a catalyst for the stock.

Exhibit Sources: Morningstar, Cass Truckload Linehaul Index, Hershey 2018 Investor Day, Kantar World Panel, Fung Global Retail/BEA. Data as of Dec. 20, 2018.