Consumer Defensive: Hungering for Top-Line Gains
Even amid sluggish growth, pockets of value remain for long-term investors.
Relative to last quarter, the consumer defensive sector is now trading just a bit north of our fair value estimates, to the tune of around 2%. However, we still maintain that opportunities for long-term investors to build positions in competitively advantaged names persist.
Following the Kraft Heinz (KHC) tie-up more than two and a half years ago, the implicit mandate for firms across the packaged-food realm has continued to center on extracting efficiencies. Many, including Coca-Cola (KO), Kraft Heinz, and Diageo (DEO) have adopted zero-based budgeting strategies. Several more are slashing ineffective advertising expenses, with Procter & Gamble (PG) one of a number of companies hoping to reduce social media spending in the short term.
Other cost-saving strategies include Kellogg's (K) decision earlier this year to part ways with its direct-store delivery platform, shifting entirely to a warehouse model. Although some of its global snack food competitors, including Mondelez (MDLZ), rebuffed this move as unwise, we think it is an appropriate response to the growth headwinds in Kellogg's increasingly commodified categories.
But despite Kellogg's ability to reduce complexity of its operations and elevate its brand spending in this pursuit, we aren't of the mindset that direct-store delivery is dead. Rather, we expect wide-moat PepsiCo (PEP) and Mondelez will continue to exploit their large, established direct-store delivery networks to leverage relationships with retailers and ensure product quality doesn't falter (particularly given its chips and cookies may not be handled as gingerly through the multiple touch points of a retailer's warehouse distribution).
Further, we perceive it unlikely that no-moat Snyder's-Lance and wide-moat Campbell Soup will move the way of Kellogg for distribution of their snack fare, as this action would fail to free up substantial capital given that neither has invested in its own direct-store delivery network (but instead outsources the direct delivery of its offerings to independent contractors), and as such, would require buy-in from these independent operators (which we view as a tough sell).
In combination, efforts to extract costs (prudent as they may be) do not alter the sluggish top-line growth environment across the industry. This has been evidenced in soft volumes (compared with historical levels) combined with price/mix that has generally still been under pressure. The growth of the hard discounters in Europe, Australia, and increasingly in the U.S., and the emergence of the e-commerce channel, are lowering barriers to entry in the consumer defensive space and intensifying price competition. Meanwhile, the consumer is looking for alternatives to the big brands, either seeking better value from unbranded alternatives, or trading up to more niche, artisan products such as craft beer.
As such, we've seen a number of players opt to prop up sales by pursuing inorganic growth opportunities. In this context, wide-moat Campbell Soup announced a $6 billion cash deal to buy no-moat Snyder's-Lance for $50 per share. The strategic merit of the combination is apparent to us, as the deal materially strengthens Campbell's exposure to the faster-growing on-trend snack-food aisle beyond its Pepperidge Farm lineup to include Snyder’s-Lance's portfolio, which skews more to better-for-you snacking than the sector overall. Still, despite the more attractive growth prospects, the transaction should dilute Campbell's operating margins, given the low-double-digit marks the target generates versus Campbell's high-double-digit levels, leading to our neutral valuation assessment.
Further, Hershey opted to amplify its top-line by acquiring the second-leading ready-to-eat popcorn brand, Skinny Pop, in a $1.6 billion tie up. Amplify (Skinny Pop's parent) is forecast to generate around $375 million in sales in fiscal 2017 versus the $7.5 billion we anticipate wide-moat Hershey will chalk up, but we view the striking growth prospects (high-single-digit top-line gains) combined with the attractive margin profile (adjusted EBITDA margins approximate 23%) of this convenient and healthy fare as evidence of the strategic rationale for the deal. As such, we believe this deal affords Hershey another avenue by which to elevate its sales trajectory. We think a portion of this benefit should ensue as Hershey broadens the distribution of Amplify's product mix beyond its core grocery and club channels into the convenience, drug, and mass market retailers, where Hershey has a strong foothold.
Some of the pressure to enhance financial performance (both through organic and inorganic means) has been exacerbated by activist investor pressure. For one, Nestle (NSRGY) sought to quiet the concerns raised by activist investor Daniel Loeb, who has taken issue with the firm's strategy and capital allocation. In that context, management recently laid out medium-term financial targets (mid-single-digit organic sales growth and a trading operating margin of 17.5% to 18.5% by 2020, implying 150 to 250 basis points of improvement over 2016), which generally aligns with our outlook, while also returning excess cash to shareholders through a share buyback program and pursuing select asset sales (which could approximate around 10% of its underlying sales base).
Further, in an about-face, wide-moat Procter & Gamble recently announced that despite the latest certified proxy results evidencing that activist investor Nelson Peltz (who owns about $3.5 billion, or around 1% of shares outstanding) fell short in his crusade for a board seat by around 500,000 votes, the firm has opted to add him to its board, ending a months-long saga. Although we've long attested that P&G has been pursuing a prudent strategic course centered on rationalizing its product mix, reinvesting behind its brands, extracting costs, and returning excess cash to shareholders, we view the firm's decision to put an end to this ordeal favorably. However, we haven't wavered in our stance that merely adding one or two individuals stands to accelerate the pace of change already under way.
Imperial Brands (LSE: IMB)
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: GBX 3,900
Fair Value Uncertainty: Low
5-Star Price: GBX 3,120
Imperial is the unloved stock in a sector that is very much in favor. The market is valuing tobacco stocks based on their exposure to heated tobacco, the emerging category that is achieving impressive growth in Japan and select markets around the world. We are bullish on heated tobacco, and we think a valuation premium for those leading and developing the category is appropriate. However, we think the market is overestimating the value of the first-mover advantage, and if heated tobacco gains traction in other markets, particularly the U.S. and Europe, we expect Imperial to leverage its wide moat and follow Philip Morris, British American, and Japan Tobacco into the space with its own technology. Imperial's current multiple discount of 9 times P/E is much larger than the historical gap, and we think this is unjustified.
Sainsbury (LSE: SBRY)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: GBX 317.00
Fair Value Uncertainty: High
5-Star Price: GBX 190.20
As one of the largest grocers with a well-known history in the United Kingdom, Sainsbury has enough scale to compete with other large rivals on price while also touting its areas of differentiation. Sainsbury has resisted the onslaught of hard discounters quite well in recent years, losing only a small amount of market share, and although operating margins have come under some pressure, they have not collapsed like those of its peers. Despite the modest pullback, JS' market share is still higher than a decade ago. Further, the firm's multichannel focus, which includes online sales, financial services, significant nonfood products, and a convenience store network, should help it withstand persistent competitive headwinds.
However, switching costs are virtually nonexistent in the grocery industry, and it's not clear that no-moat Sainsbury's points of differentiation are strong enough to ensure that excess returns on capital can be sustained over the long term. Despite numerous challenges, we view shares as attractive at current levels.
Star Rating: 4 Stars
Economic Moat: Wide
Fair Value Estimate: $51.00
Fair Value Uncertainty: Medium
5-Star Price: $35.70
Mondelez's share price came under pressure earlier this year after news that Kraft Heinz made an unsolicited offer for Unilever (UN), which was quickly rebuffed. The shares still trade at a compelling discount to our valuation, which we think partly reflects the lack of clarity regarding the strategic roadmap newly appointed CEO Dirk Van de Put (formerly CEO of McCain Foods, a privately held Canadian food firm) will embark on now that he has officially taken the reins.
While management has understandably been reluctant to speak for Van de Put, we aren't anticipating sweeping change, given the strides realized to date. This has been particularly evident in operating margin improvement, which is up approximately 400 basis points since Mondelez began its efforts to extract excess costs and improve the efficiency of its operations in 2014 to north of 15% as of fiscal 2016. And we surmise added efficiencies can be realized. Management currently targets $1.5 billion in savings through 2018, a figure we view as conservative relative to our estimation that about $2.5 billion in savings--8% of cost of goods sold and operating expenses, excluding depreciation and amortization--could ultimately be in the cards given the inefficiencies (following decades of underinvestment under its prior owners) that previously plagued its operations.
From our vantage point, the firm's efforts to extract efficiencies are crucial to facilitating further investments behind its brands (in research, development, and marketing to the tune of 8.5% of sales annually or $2.5 billion on average over our forecast). We believe this spending stands to support the intangible assets (both its brands and retail relationships) that underlay our wide moat rating.
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Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.