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Quarter-End Insights

Our Outlook for Consumer Defensive Stocks

Are consumer staples stocks reaching an inflection point?

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  • Tipping the scales at multiyear highs, we think consumer staples stocks are far from a bargain at current levels.
  • Innovation is all the buzz, but will it be enough to drive volumes?
  • Although we've become generally more optimistic about global consumer spending trends, we believe the market is extrapolating unrealistic longer-term volume growth assumptions.

 

At an average price/value of 1.14 times, Morningstar's consumer staples coverage universe now trades at a meaningful premium to the average price/fair value of 1.02 for our full coverage universe.

The consumer staples sector has been particularly strong the past few months, which we attribute to a number of catalysts: 1) a rotation into higher-quality names amid heightened global macroeconomic uncertainty; 2) investors' appetite for yield and the strong total shareholder returns typically found among consumer defensive names; 3) renewed optimism for merger and acquisition activity following  Berkshire Hathaway's (BRK.A) (BRK.B) proposed $28 billion acquisition of  HJ Heinz (HNZ); and more recently 4) positive management commentary at the 2013 Consumer Analyst Group of New York conference in mid-February.

We believe the market's favor also reflects the fact that the consumer defensive industry is one of the more-concentrated categories with regards to economic moats (as roughly two-thirds of the approximately 100 consumer defensive companies we cover have either a wide or narrow economic moat, primarily reflecting the expansive scale advantages and solid brand portfolios with which these firms operate).

While we understand the motives behind the recent bull run on consumer defensive names and generally favor their moat-like qualities, we've concluded the market has overshot the long-run free cash flow growth potential inherent in the industry. With our consumer staples coverage universe trading at an average forward P/E of 18 times and a forward enterprise value/EBITDA multiple of 11 times (compared with historical multiples around 15 to 16 and 9 to 10 times), we expect valuations to return to more normalized levels. However, we also believe there are a few pockets of opportunity.

Consumer Staples Stocks Are Trading at Multiyear Highs
That consumer defensive names have been on a tear lately is hard to deny. Consumer staples companies tend to be viewed as safe havens in uncertain economic landscapes--given the consistent cash flows and total shareholder returns (including dividend and share repurchases) that characterize these firms--and the recent appreciation in the shares seems to support that stance. We believe the market's favor also reflects the fact that the consumer defensive industry is one of the more-concentrated categories with regards to economic moats (as roughly two-thirds of the 100 consumer defensive companies we cover have either a wide or narrow economic moat), justifying why these stocks are attractive in tough operating environments.

Innovation Is All the Buzz, but Will It Be Enough?
After several years where the impact of skyrocketing commodity costs has been top of mind in the consumer defensive space, innovation now seems to be all the rage. From our perspective, this renewed momentum likely reflects a more cautiously optimistic take on the consumer spending environment. In addition, we suspect that this is another attempt by consumer staples firms to stem the tide of consumers switching to lower-priced private-label offerings. Private-label offerings have gained share of both units and dollar sales since 2010. From our view, the fact that retailers (e.g.  Kroger (KR),  Wal-Mart (WMT), and  Costco (COST)) have continued to invest behind improving the quality of store brands has been a driving force in this shift. However, the key for branded firms--and what has been lacking over the past several years--is truly groundbreaking new products that win on the shelf and prompt consumers to trade up.

On the topic of innovation, the most telling presentation at the 2013 CAGNY conference, in our opinion, was from Kraft management, whereby the company (which was split from the former Kraft's global snack operations now called  Mondelez (MDLZ)), reflected on the fact that its innovation track record had been, in a word, dismal. Management detailed how just a few years ago Kraft was considered the worst innovator in the consumer product space, with 17 of 19 new product launches in 2008 considered failures. To make matters worse, the firm wasn't spending behind innovation; in 2009, only three of 16 launches received more than $10 million in advertising and consumer support.

But Kraft contends that it has made significant strides since that time, shifting its focus to putting resources behind more impactful launches (rather than dozens of items), and more than doubling its spending to hype each new product. One example of the firm's recent success is MiO, the water enhancer that now drives more than $100 million in annual revenue. Overall, revenue from innovation increased to around 13% in 2012, about two times the level generated just three years ago--an impressive turnaround. 

The talk about innovation hasn't stopped there, as cigarette manufacturers are also looking to build out their portfolio set, particularly in light of the fact that U.S. cigarette consumption has been on a downward spiral for some time. For instance, although  Lorillard (LO) and  Reynolds American (RAI) have entered the electronic cigarette category, industry leaders  Altria (MO) and  Philip Morris International (PM) have yet to venture into this market, and given the success of Lorillard's blu brand, we wouldn't be surprised to see either Altria or Philip Morris take the plunge into e-cigs.Philip Morris International admits that it is conducting clinical studies and expects to expand its studies in 2014. And the firm is putting its money where its mouth is: Over the next few years, PMI intends to invest an incremental EUR 500 million to build a manufacturing footprint capable of producing around 30 billion next-generation products (NGP) per year (roughly 3% of PMI's cigarette volume). In Altria's case, we think it could eventually create its own e-cig lineup or acquire a privately held e-cig brand (such as NJOY).

Overall, we believe that the wide economic moats that these tobacco giants have created over the course of many decades will prove to be valuable assets as tobacco alternatives continue to grow in popularity. Whereas there are numerous privately held e-cig companies that sell their products online, these major tobacco companies have the financial might and vast distribution systems to more broadly capture the growing market opportunity surrounding electronic cigarettes. 

The Market May Be Overestimating Consumer Defensive Growth Opportunities
We believe that the market is implying high-single-digit revenue growth, roughly double-digit operating income growth, and low-double-digit EPS growth (when factoring in buybacks, which historically can prop up earnings growth by about 2% to 3%), all of which strikes us as mildly aggressive at first blush. Overall, we think that current valuations may be hitting a rich chord.

One topic that has failed to get much airplay lately is how consumer spending has been holding up, but it seems that conditions may be showing some initial signs of improvement. More specifically, in 2012 the unemployment rate ticked down to 8.1% (from 8.9% the prior year), while Consumer Price Inflation slowed to 2.1% (down from 3.1% a year earlier), according to Moody's Economy (January 2013). That is not to say that we are out of the woods, as the recent payroll tax increase (which amounts to around 1% of disposable personal income) combined with rising gas prices (up approximately $0.30 per gallon over the past several weeks) remain headwinds for consumer spending levels. Further, it's hard to deny the pressure placed on consumers over the past few years. The percentage of consumers who have been pushed into the lower-income bracket has increased more than 200 basis points since 2009.

We think that any further strain on the consumer could also prompt another round of channel shifting, as consumers have become adept at searching out the best deal. The base of retailers is consolidating and consumers have shown a willingness to shift beyond traditional grocery stores (towards club stores and dollar stores)  in search of a bargain. Despite this, retailers still depend on leading brands to drive traffic in their stores, and we don't anticipate that this will change. For instance, according to Kraft management, 4% to 6% of every American grocery store's sales are Kraft products, making the firm a key supplier for retailers.

Top Consumer Defensive Sector Picks
  Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Kraft Foods 
$53.00 Narrow Medium $37.10
Lorillard 
$43.00 Wide
High $25.80
Sysco 
$36.00 Wide Medium $25.20
Molson Coors Brewing  $55.00 Narrow Medium $38.50
Monster Beverage  $55.00
Narrow
High $33.00
Data as of 03-15-13. 

 Kraft Foods (KRFT)
Following its split from the global snacks business earlier this year, Kraft Foods still possesses sizable competitive advantages, including a solid brand portfolio and substantial economies of scale in the North American market. One of the opportunities for the domestic grocery business lies in the fact that as a part of the consolidated organization several brands had been underinvested in; we think it was the cash cow that funded the growth of the global snack business.

 Lorillard (LO)
We believe that Lorillard is attractively priced versus our $43 fair value estimate. The tobacco firm is the leading menthol cigarette company in the United States. Additionally, its blu electronic cigarette division (while still small) is rapidly growing as it gains shelf space in 75,000 retail store fronts and maintains an online presence. We believe that the addictive nature of cigarettes, the barriers to entry facing new players, and the strength of the Newport brand give Lorillard a wide economic moat.

 Sysco (SYY)
While there have been some underlying positive trends that support our thesis that an expansive distribution network will enable Sysco to remain the dominant player in North American food-service distribution, generating strong cash flows and outsize returns for shareholders over the longer term, Sysco is not out of the woods. The firm's business transformation efforts are taking longer to put into place than management initially anticipated, and the lumpy economic recovery is still plaguing domestic consumer spending. Despite this, we continue to believe the market's concerns regarding sluggish restaurant traffic and persistent food cost inflation are overdone and are unjustly weighing on Sysco's shares, and with a dividend yield of nearly 4%, we think income investors should consider Sysco's shares.

 Molson Coors Brewing (TAP)
While we believe that shares of Molson Coors remain undervalued versus our fair value estimate, we note that there is no likely near term catalyst. Molson Coors' volumes predominantly come from mature markets that have limited growth opportunities. Nonetheless, we believe the current share price is attractive; and expect that as the employment situation in the United States improves, Molson Coors' MillerCoors joint venture should see improving financial results.

 Monster Beverage (MNST)
Monster Beverage shares continued to trade below our fair value as the possibility of heightened regulations and restrictions for the energy drink sector continue to abound. We however, continue to believe that any potential regulation will be benign. Additionally, the firm's international operations should continue to generate impressive growth in 2013, and turn profitable.

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Thomas Mullarkey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.