Consumer Defensive: Still Thirsty for Growth
Although growth remains sluggish, opportunities in consumer defensive stocks are still available for selective investors.
While opportunities still exist, sector valuations currently outpace our fair value estimates by about 6%, reversing a 4% discount last quarter and returning to the premiums we had seen about a year ago. Although we believe margins of safety have compressed after the recent runup (in part due to M&A speculation, in our view), we continue to see opportunities in certain parts of the consumer landscape where idiosyncratic factors have obscured firms' long-term potential. Broadly, however, investors are looking for firms with a competitive edge that are likely to be able to fend off rivals amid volatile, slowing growth around the world.
Unimpressive top-line outlooks across the industry are driven by intense competition and low input costs, limiting companies' ability to raise prices. However, the input cost environment has generally failed to translate into higher margins, with the competitive picture often leading firms to use savings to reduce list prices (as a means by which to take share) or increase trade spending. The most competitive, commodity-linked industries have seen the greatest pressure, such as meat processors (including Tyson (TSN), Pilgrims Pride (PPC), and Sanderson Farms (SAFM)), as lower beef prices have pushed all animal proteins cheaper while leaving firms' cost profiles unchanged. Although we continue to see emerging markets as a long-term growth source across the broader consumer products landscape (driven by explosive population growth, urbanization, and rising incomes), we have a less rosy view of the short-term picture, apart from companies in the earlier stages of growth, such as Blue Buffalo (BUFF) in premium pet food.
With top-line growth muted and creating associated cost deleverage pressure, firms have looked to reduce expenditures as a means to protect earnings. While we generally have a favorable view of efforts to improve operational efficiency, firms risk cutting too far and underinvesting in advertising, innovation, and other brand-building activities. As a result, we have paid special attention to the source of savings in this recent round of corporate austerity.
The prevalence of intangible asset-based moats among the firms we cover in the sector means much of companies' value depends on the degree to which they can use their brands to ward off competition, either by gaining consumers' esteem or by building deep relationships with retailers. Maintaining these advantages amid intense competition requires investment, and so we look at current cost reductions with a long-term lens to determine whether management teams are mortgaging the future to meet investor demand for near-term earnings growth.
Similarly, we are skeptical that the margin expansion that firms like Kraft Heinz and Campbell (CPB) have seen will prove sustainable given the need to reinvest more behind brands to offset competitive pressures and bolster the top line. Additionally, as firms have redeployed funds to favor share repurchases in the current slow-growth environment, we take a cautious view of the buybacks as sector valuations are high, potentially making this capital allocation strategy value-destructive despite the EPS benefit (for example, Tyson).
While we anticipate that elevated valuations across the space reflect the consistent cash flows and returns that consumer product firms boast combined with the income streams offered to shareholders, we also surmise that speculation surrounding further industry consolidation has placed upward pressure on stock prices. In that vein, Kraft Heinz's $143 billion attempt to take over Unilever failed, but speculation that the firm's appetite for consolidation is undeterred has led potential targets to rebound from levels seen when the proposed deal was first announced.
We anticipate acquisitions will remain an avenue for growth in the sector as firms attempt to use synergies to boost efficiency amid a slow sales growth environment, and suspect the packaged food industry could be particularly active, with firms like Mondelez (MDLZ) and Pinnacle Foods (PF) serving as potential targets for larger peers. That said, because we see sector valuations as high (in part due to acquisition premiums already built into share prices), the line between a synergistic acquisition and a value-destructive purchase at an overly optimistic price can be perilously thin.
As the world's fourth-largest supplier of flavors and fragrances, with an 11% market share, we believe Symrise stands to benefit as emerging-markets populations grow, urbanize, and increase processed food consumption as female workforce mobilization rises. With developing economies accounting for 43% of sales, Symrise is poised to augment developed-market demand drivers stemming from an increased focus on health and wellness issues and clean labeling. While pricing power is limited, we assign Symrise a narrow moat rating on the basis of the switching costs clients face, as the firm's customers hesitate to take risks with other suppliers that would face the daunting task of replicating proven tastes or fragrances (around 95% of sales are customized). Shares trade at an attractive price/fair value ratio of 0.8, which we believe offers a favorable risk/reward profile.
Pilgrims Pride (PPC)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $28
Fair Value Uncertainty: High
5-Star Price: $16.80
While its shares have risen about 15% thus far in 2017, we believe market sentiment still modestly underestimates Pilgrims' ability to use its balanced portfolio, premium products, and Mexican operations to generate 3%-4% average annual top-line growth even as the industry benefits from contracting changes that have reduced risk.
Pilgrims' no-moat rating is consistent with industry peers, but we believe the company can use its diverse mix of bird sizes to benefit from increased protein and poultry consumption across all parts of the retail and foodservice spectrum. With corn and soybean meal prices still attractive, we believe the company should be able to weather price deflation spurred by falling ground beef prices.
Recent avian influenza outbreaks remain a concern, but we are encouraged that regulators globally are increasingly taking a regionalized approach to import bans from affected areas, rather than the country-wide restrictions seen in years past.
We also do not see recent pricing scandals in the chicken industry (in particular, concerns regarding the composition of a price benchmark and potential indirect collusion) as likely to affect leading producers such as Pilgrims. As the stock still trades at about a 20% discount to our valuation, we would suggest that long-term investors looking to gain exposure to the industry should consider building a position in Pilgrims Pride shares.
Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Estimate: $16
Fair Value Uncertainty: Medium
5-Star Price: $11.20
We see Danone at a crossroads and believe the painful ride investors have seen over the past several years should yield to strengthening prospects as a new management team centralizes the firm's structure and refocuses on profitability.
Although medium-term growth looks likely to undershoot management's 2020 guidance (though our 4%-5% annual organic growth estimate for the next five years still outpaces most packaged food competitors), we expect it to be high-quality, helping to drive 280 basis points of margin improvement in the medium term. We contend there is little reason Danone cannot sustain an operating margin closer to its peers of around 15%.
In our view, the firm's early-life nutrition unit should drive improvement beyond market expectations that seem to assume that segment margins will simply be maintained. While we see the firm's competitive positioning, derived from its leadership and near leadership in multiple categories, as middle-of-the-pack (and worthy of a narrow, rather than wide, moat rating) due to its vulnerability against some of its large-cap competitors, we view the shares' current trading level, which correspond to about a 10%-15% discount to our valuation, as an attractive entry point for investors looking to build a position.
More Quarter-End Insights
Market Outlook: Lofty Valuations Call for Careful Stock-Picking
Video Report: Few Values Left in the Global Stock Market
Economic Outlook: First-Quarter Underscores Slow Growth Expectations
Credit Market Insights: Bond Indexes Perform Well as Spreads Tighten Further
Basic Materials: The Most Expensive Sector We Cover
Consumer Cyclical: Still Opportunity in a High-Confidence Environment
Financial Services: Weighing the Strategic Tradeoffs of the Fiduciary Rule
Industrials: Solid Fundamentals, but Few Screaming Buys
Zain Akbari does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.