Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
Despite the recent market pullback, the consumer defensive sector in aggregate still trades at a slight premium to our fair value estimate, but we still see several pockets of opportunities among high-quality companies.
The consumer defensive sector trades roughly 1% above our fair value estimate, but we see a handful of undervalued industries and companies.
We believe the market undervalues Mondelez(MDLZ) and see upside stemming from the wide-moat manufacturer's cost-savings initiatives.
The market currently offers a discount on global beverage behemoths Coca-Cola(KO) and PepsiCo(PEP), in our opinion. We expect long-run earnings growth to rebound despite near-term challenges.
Although we see few economic moats in the European defensive retail industry, French retailer Casino Guichard-Perrachon (CO) offers exposure to faster-growing Latin America, and trades a sizable margin of safety, in our opinion.
The consumer defensive sector trades at a median price/fair value of 1.01, substantially more overvalued than our entire coverage universe, which trades at a median price/fair value of 0.92 following the recent market falloff.
Investment opportunities remain. However, many of the stocks we see as the most undervalued (such as Coca-Cola and PepsiCo) are seeing severe foreign currency headwinds from the strong U.S. dollar and threats to their growth from slowing international consumer spending, particularly in China. Or they are going through fundamental business changes (like top pick Procter & Gamble(PG)) that could continue to challenge these companies' revenue and earnings over the near term, albeit with the long run looking quite a bit rosier.
Overall, we remain cautious of global consumer spending, particularly in emerging and developing markets. We generally recommend focusing on companies in the sector with narrow or wide moats that enjoy strong brand intangible assets and/or sustainable cost advantages.
The consumer staples industry continues to see involvement by activist investors, including most recently Mondelez. These shareholders typically advocate for substantial change, and in this case, we view Bill Ackman's 7.5% stake in Mondelez as a positive for other owners. Given the firm's bloated cost structure versus that of its peers, we view the company's already-announced cost-cutting plan as prudent. However, we contend there is significantly more upside in its results than management's guidance or market estimates suggest, and it appears Ackman shares our view. We also believe that given Mondelez's brand intangible asset (the basis for our wide moat), it could be an attractive acquisition target down the road if it fails to achieve meaningful margin expansion, providing a floor to its downside risk.
We also see a rare opportunity in wide-moat beverage manufacturers Coca-Cola and PepsiCo. These firms are fighting falling developed-economy volumes for carbonated soft drinks and stiff currency headwinds. However, we remain encouraged regarding the industry's long-term growth because of rising noncarbonated volumes, disciplined pricing, and the opportunity for increasing per-capita packaged beverage consumption levels in several key emerging markets (which are currently extremely low). Although there are near-term concerns surrounding emerging-markets growth and the firms' abilities to continue to enact their own recent cost-savings initiatives, we believe the market underestimates this long-term potential and also offers dividend yields topping 3% at both.
Beyond the consumer product manufacturers, we continue to see opportunity in some defensive retailers. In this space, we believe that a firm with an economic moat should be able to charge material price premiums for comparable products and/or have the ability to drive more traffic and sell more products than its competitors. The latter case involving higher throughput tends to drive an economies-of-scale-based cost advantage, which we view as more durable (for retailers) than pricing power alone. We assign wide moats to the small number of firms that have the strongest (and potentially mutually reinforcing combinations of) brand intangible assets and cost advantages, such as Wal-Mart(WMT), a name we see as undervalued at present.
That said, we also believe no-moat European retailer Casino Guichard-Perrachon offers a decent margin of safety at its current price. Investors remain cautious about macro risks in European and Latin American economies, most notably Brazil. In addition, growth in France remains tepid, and Casino has been forced to respond to Carrefour and other discounters by lowering its prices, which has subsequently hindered profits. While Casino has considerable scale in these regions, limited switching costs and razor-thin margins limit our confidence in Casino's ability to sustain excess returns on capital over the long term. That said, we believe that many of these risks are priced into Casino's stock, and we see opportunity for patient, long-term investors looking for exposure to European grocers.
Top Consumer Defensive Sector Picks
Fair Value Estimate
Fair Value Uncertainty
Procter & Gamble
Data as of 09-24-15
Procter & Gamble(PG) Wide-moat Procter & Gamble strikes us as a particularly attractive investment idea. The market's confidence in the firm's competitive edge and its ability to drive accelerating sales growth (to a mid-single-digit level over the next several years) continues to wane. We stand by our contention that P&G's strategic endeavor to rightsize its brand mix is a wise course that shows the firm aims to become a more nimble and responsive operator, without sacrificing its scale and negotiating leverage with retailers. Further, we think this should enable P&G to increase its focus (from both a financial and personnel perspective) on the highest-return opportunities, which is critical in the intensely competitive environment in which it plays. However, we've long thought these initiatives would play out over the next few years rather than a couple of months, and as such, we look for it to drive profitable growth longer term, despite muted progress to date.
Casino Guichard-Perrachon(CO) We believe that Casino Guichard-Perrachon's shares remain undervalued relative to our EUR 85 fair value estimate, as we think that the firm is well-positioned to benefit from stabilizing trends in Europe and long-term consolidation in Latin America. Growth in France remains tepid, but Casino is lapping price cuts, and results have largely supported our view that the firm's price cuts have helped to stabilize volume trends at hypermarkets. (Traffic was up 4.0% and volume was up 5% at Geant hypermarkets in the most recent quarter.) Improved volume and pricing should help sales and profits. Cost pressures are also weighing on growth in Latin America, but we think cost-cutting efforts should support margins abroad. Moreover, we believe that Casino should be able to leverage its distribution network as sales increase in Latin America over the long term. Thus, although we see near-term macro pressures weighing on Casino's markets, we believe that the firm should be able to capitalize on growth opportunities going forward.
Wal-Mart(WMT) We still believe that wide-moat Wal-Mart looks attractive. As the world's largest retailer, Wal-Mart has struggled to generate meaningful sales growth recently; encouragingly, traffic trends accelerated in the second quarter, suggesting that recent investments may be gaining traction. We think that investors are struggling to reconcile positive sales growth trends with the investment needed to sustain such growth, as evidenced by margin headwinds from lower pharmacy reimbursement rates, higher shrink, and weakness in emerging markets. Combined with Wal-Mart's decision to increase wages and e-commerce investments, these headwinds have left minimal room for leverage. Still, we think that investors could realize decent risk-adjusted returns if Wal-Mart is able to generate even modest growth over the medium to long term. The company still commands scale advantages that give it negotiating leverage over suppliers and help it to support its brand perception as a low-priced leader.