Pandemic-Focused Buyers Shaped Consumer Defensive's Quarter

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Eric Lash: Consumer defensive lagged the broader market's impressive rebound this quarter, generating a nearly 12% return compared with the market's more than 20% gain through June 23, but we think the space has become more heated. More specifically, the median stock in our coverage now trades at just a 1% discount to our fair value estimates, which is a sharp acceleration relative to the 14% discount the space boasted three months ago.

We think this partly reflects recent top-line acceleration, as consumers rushed to stock their pantries with essential fare. In this vein, consumer packaged goods and nonalcoholic beverages offered bargains at the outset of the pandemic in the U.S., but shares have since rebound.

As consumers switched to stock-up trips with larger basket sizes, out-of-stocks or limited supplies of certain items were common in the U.S. And in response, manufacturers halted previously slated promotions. But as the initial buying surge has waned and lockdowns lifted, items sold on sale have begun to edge higher. We think promotions may persist if a prolonged economic recession ensues. However, given a lack of switching costs, we think investments in R&D and marketing will be crucial to ensure brands and retail relationships aren’t impaired, and consumer visitation to aisles throughout the grocery store persists. But we still expect retail purchase trends will decelerate to the low-single digits over the longer term, versus the high-single-digit to double-digit clip many consumer packaged goods operators have posted in some historically staid categories throughout the store the past few months.

From our view, opportunity in consumer defensive can be found in tobacco and alcoholic beverages, which each trade at 15%-25% discounts to our assessment of intrinsic value. While the challenges plaguing tobacco are well-understood, reflecting continued volume erosion, we think alcoholic beverages came under pressure more recently as on-premise consumption ground to a standstill, with bars and restaurants closed due to the COVID-19 pandemic. Although we expect a near-term sales hit, we don’t believe this stands to impair the brand-intangible assets and cost advantages underpinning moats in the space and believe the recent retreat is creating an interesting opportunity.

In this vein, we’d call out Anheuser-Busch InBev. Simply put, we believe this stock is attractive, trading 50% below our intrinsic value assessment. Although sales have taken a hit from coronavirus disruptions, we expect revenue to pick up when social-distancing guidelines are relaxed, given about a third of sales result from on-premises consumption, with growth rebounding to the high-single digits in 2021. AB InBev is the most leveraged among the brewing group, but we think the firm has sufficient liquidity. We believe it is well positioned for the long term, with monopolylike positions and cost advantages in developing markets that continue to generate value.

Further, we think investors interested in the space should look to no-moat US Foods, which trades around a 40% discount to our intrinsic value. Consumers have avoided away-from-home food consumption since the start of the pandemic, hampering operators throughout the food-service industry. But despite the hit to sales, we expect US Food’s growth to gradually improve in the second half of 2020 as consumers revert to prior habits and don’t believe this slowdown has negatively altered its liquidity profile. Although we’ve ratcheted back our fair value estimate for US Foods by 17% since the pandemic struck, shares are down more than 50% year to date, creating an attractive margin of safety.