Consumer Defensive Firms: Tightening the Belt
With increased competition from all corners, consumer defensive companies are cutting costs to offset sluggish growth.
Consumer defensive companies are facing increasing competition from hard discounters and e-commerce, as underscored by the recent entry of Amazon (AMZN) into grocery retailing. Amid weak growth, many of these firms are laser-focused on efficiency. With top-line trends still languishing, management teams are also pursuing sweeping changes. To learn more about the challenges and opportunities in the sector, I spoke with Morningstar’s Philip Gorham, who covers a number of the global players as director of equity research, Japan. Our conversation took place on Nov. 21 and has been edited for length and clarity.
Philip Gorham, CFA, FRM, is director of equity research, Japan.
Laura Lallos: You noted in your recent sector report that the consumer defensive category is becoming increasingly commodified. Will it become more difficult for companies to build and maintain moats in this sector? Are we going to see fewer Morningstar Best Ideas here?
Gorham: E-commerce is a risk to moats. The barriers to entry to get into an Amazon distribution center, for example, are much lower than they are for getting on the shelf in Kroger (KR) or Walmart (WMT) . Whether companies go directly to the consumer, like Dollar Shave Club, or sell through third-party online distributors like Amazon, they have an opportunity to gain traction with the consumer that just wasn’t available five to 10 years ago. That won’t necessarily lead to fewer Best Ideas because there’s a valuation element as well. A stock can be cheap regardless of the width of the moat, but our valuations assume a slower-growth environment in the medium term.
How disruptive is Amazon’s acquisition of Whole Foods?
Gorham: It’s disruptive because they are competing on price, and it’s particularly harmful for the branded food manufacturers. Whole Foods plays into the high-end/artisan/ natural niche. If that segment of the market grows, it probably comes at the expense of the mainstream Nestle (NSRGY) and General Mills (GIS) market and regular supermarkets. Of course, any sort of competition on prices is in general negative because growth is slowed from where it was even three years ago. Before the financial crisis, organic growth was consistently 4.5%, 5% in this space. They can't get that kind of growth anymore. They don't have the pricing power that they did a few years ago.
The presence of hard discounters is growing in the United States. Why is Aldi a greater threat than, say, Walmart?
Gorham: The hard discounters primarily sell economy-end private label; 90% to 95% of their merchandise is private label. Only a very small amount of shelf space is allocated to branded products. Nestlé sells some in Continental Europe, but it’s not a big market. If you look at markets like Germany, Netherlands, and the U.K., the combined market share of Aldi and Lidl is up to anywhere in the range of 10% to 15%. That’s a significant chunk of the market that in a short space of time become unavailable to branded-foods manufacturers.
It’s indicative of the consumer being more price conscious since the financial crisis. People have become accustomed to shopping around, and they see value in private labels in some cases. If you have a favorite mayonnaise or soft drink, you’ll go to Walmart to find it. But you may view, say, household detergents, as more commoditized. If something cleans your kitchen sink, it cleans the sink, so perhaps you’ll trade down and go to Aldi.
The consumer is more prepared to evaluate brand value, price, and transparency. The availability of pricing online facilitates that, and e-commerce contributes to the availability of cheaper options to branded products. All of this points to continued pressure on pricing power.
So, manufacturers are instead looking to drive earnings growth through margin expansion. What strategies are they using?
Gorham: A number of things are going on. There’s footprint rationalization. Kellogg (K) decided in early 2017 to shift entirely from a direct-store delivery platform to a warehouse model. Procter & Gamble (PG) in the second quarter said they significantly cut back on social media advertising, and it hadn’t made any difference to their sales growth rate. Companies threw money at social media marketing and are now starting to evaluate the bang for the buck there, particularly across the more commoditized categories like mainstream personal care and food.
Something else they’re looking at is how to optimize spending on R&D. How do you push resources to the fringes, to the local markets where smaller regional products are driving growth? Think about Nestlé. Their top line is about $90 billion a year in sales. That is an enormous business with a huge global footprint. To move the needle on the sales numbers, they are spending on the blockbuster R&D ideas. But growth is actually being driven regionally, by multiple smaller product innovations. So, how do they strike a balance between the large ideas and making sure that regional managers with their finger on the pulse of local tastes and trends get enough resources? How do they trim R&D spending but still maximize the bang for the buck? We’ve seen restructuring around that.
The entrance of [activist investor] 3G Capital a couple of years ago, when they bought Anheuser-Busch InBev (BUD) and Kraft Heinz (KHC), is really changing the way these companies will be run. Shareholders are demanding that management teams focus more on shareholder returns. Their delivery of shareholder returns, in an environment of very little growth, by people with very little experience in consumer products, is making people sit up and take notice.
What they did is introduce zero-based budgeting. With an annual budget, as managers get to this time of year and realize they haven’t spent it all, they start spending on marketing they don’t need or taking trips. That’s wasted spending. With zero-based budgeting, people have to justify spending throughout the course of the year. They’ve introduced an enhanced focus on cost management and cash management in ways that weren’t implemented in the past.
It’s not a light switch to be turned on at every company. It’s cultural; it’s an ethos that runs throughout the organization. Everybody has to buy in, which means you have to financially incentivize senior management, middle management, employees at all levels. Those companies that truly grab the bull by the horns are most likely to succeed. The risk this strategy poses is that you lose a bit of operational flexibility. In the time it takes to have an expenditure approved, you may, for example, miss an investment opportunity. But where management gets to grips with the cultural issues, we’ll end up with companies that are more focused on cost, with greater financial flexibility to compete on price.
The key point is that taking cost out is going to be critical to reinvesting in the business and trying to reignite lost growth.
What companies are particularly adept at zero-based budgeting strategies?
Gorham: In addition to Kraft Heinz, definitely Anheuser-Busch. It has expanded its margins by 5% or so, and it is still taking costs out of the SABMiller acquisition. I would also point to Unilever (UN). It’s early in its case, but it seems to be taking the right approach to cost. There are a number of other firms, such as Diageo (DEO), where it’s a little early to judge execution.
What are your thoughts on activist investors forcing cost-cutting? Could this be detrimental in the long term?
Gorham: Some hedge funds aren’t exactly known for their long-term investing approach. There is certainly a risk that some companies will diverge from the optimal balance between cost savings and top-line growth, growth of market share. The risk is that they cut not just the fat, but into the muscle of the business. Even Anheuser-Busch, which has done a great job of taking out cost, has underperformed in terms of market share. Now, of course, light beer would have lost share to craft beer over the past five years in any case. But it has underperformed even against brands in the same product and price segment.
That said, the activist investors are absolutely looking in the right place. These large-cap consumer companies have been fat and happy for a long time, and there are inefficiencies to take out.
M&A activity was high in the third quarter, and it sounds like it may continue to be a key theme here.
Gorham: We’ve got a continued window of opportunity in terms of low interest rates. We’ve got incentive because balance sheets are a bit healthier. M&A is a catalyst for cost-saving opportunity and, again, that’s necessary to drive growth. So, the incentive and the opportunity are there, but the question is, do valuations allow companies to create value? The market in this space is at 19 or 20 times earnings, so there has to be a significant cost-saving opportunity.
There are not many consumer defensive names on Morningstar’s Best Ideas list right now. You cover one of the few that make the list, Imperial Brands (IMBBY).
Gorham: That reflects the space at the moment, and the fact that investors are jumping on anything that looks cheap fairly quickly. We took Anheuser-Busch and Danone (DANOY) off the list recently purely on valuation.
For Imperial, it’s all about heated tobacco and who wins share in the longer term. The market appears to be valuing tobacco stocks in a hierarchy based on business exposure to heated tobacco—which is tobacco inside a stick about the size of a cigarette that gets heated by a device to a temperature where the nicotine gets released, but not to the point that combustion takes place, so there’s much less smoke, no ash. Proponents of the technology say it’s the combustion that causes exposure to harmful chemicals and carcinogens. Of course, it’s hard to get independent scientific evidence, but if that’s true, then this product should reduce cancer risk. That would be an enormous game changer. It would prolong the life cycle of the industry; it would probably slow the decline rate of consumption. It may even improve pricing power and margins.
This device is probably coming to the states next year; it’s under review with the Food and Drug Administration. There’s quite a lot to like about this, and I can get to a scenario where the margins on these sticks are higher than those on cigarettes. The market is obviously enthusiastic.
But the market is overlooking a couple of things. First, you can’t just take the growth rate in one market and apply it to all markets, or take today’s growth rate and project it forward. History tells us that the adoption of a disruptive consumer product rarely happens in a straight line. It almost always happens in an S-shaped curve. You have fast growth early on, from the early adopters jumping in. Then growth slows, and later adopters look for something superior about the product. They want to see that the product is cheaper, safer, cleaner—a better mousetrap. If that’s the case, then growth eventually reaccelerates. If it’s not true, then the product will flop. We are very much still in the early adopter stage, even in Japan, where it’s been a huge success, up to about 20% of the market.
The market is also overlooking the margins. Margins on the sticks might be high, but I think we’ll move to a razor-and-blade-type model, where the devices are essentially given away, probably at break-even or less, and the margin’s recouped through the sticks. So, it’s very early to be overexcited about this.
We’ve got Philip Morris International (PM) trading at 19 or 20 times next year’s earnings because they are the category leader. In the middle, we’ve got British American Tobacco (BTI) and Japan Tobacco trading at 15 or 16 times; they are in the game, but lag PMI. And then there’s Imperial, with no exposure to heated tobacco, trading at around 11 times. That gap is historically extremely high. I think it’ll close, and it’ll close from the bottom up, because it’s highly likely that Imperial will move into heated tobacco sooner rather than later. [Editor’s note: After this conversation, Imperial announced that it will test-market heated tobacco products.]
How important is the growing emerging-markets consumer base to companies in this sector?
Gorham: It largely depends on the individual company and category that they’re in; growing emerging-markets exposure as a percentage of sales could be margin-enhancing or margin-dilutive. As a growth driver, it’s generally quite important to have that exposure. You’re not going to get all your organic growth from Western Europe or North America; it’s going to have to come from emerging markets. But it depends. Some companies, particularly the brewers, for example— Ambev (ABEV) in Latin America, Heineken (HEINY) in Europe— they’re just in the right place at the right time. They’ve got slightly premium brands, which is perfect for the trade-up that’s going on in those markets. Over time, they should gain share as the consumer trades up. But for high-end cosmetics such as Esstee Lauder (EL) and L'Oreal (OR), or for distillers such as Diageo and Pernod Ricard, that opportunity is much further away.
Valuation is an issue in this sector right now, but is there a name you are particularly enthusiastic about should a buying opportunity arise?
Gorham: Reckitt Benckiser (RBGLY) is becoming interesting. I’ve covered this for a number of years, and it’s always traded slightly rich, in the low 20 times earnings range, but it’s sold off over the past six months or so because of a number of things that I think are fairly short term in nature. If an investor has a 12- to 18-month time horizon, I think we’ll cycle through these issues.
One was a cyberattack that disrupted logistics and totaled about GBP 100 million off its sales.
Another was disruption in Korea; it sold a dehumidifier cleaning product that was toxic; it actually killed people, and that crushed the whole business across South Korea. In 2016, it had a really good year for product innovation, and it hasn’t replicated that since. For these reasons, growth has slowed year over year. It’s essentially a flat year, well below what it has been posting.
But the reason I like this story is that the company is repositioning the business away from commoditized categories such as home care and food, and into strong brand franchises with pricing power. It has a great consumer health business. It has painkillers like Strepsils and Nurofen; it owns Durex. People will pay for this stuff because there’s a natural risk aversion with these kinds of products. These businesses still have pricing power.
It just acquired Mead Johnson. The market hates this deal, but it is too focused on cost savings. This is not really a cost-savings opportunity; it’s more about repositioning business for growth in the long term, because infant formula has pricing power. Again, it’s consumer risk aversion; parents tend to stick to a baby food brand that works. Because of that, you can raise prices a little bit at a time. Half the business now is in categories with pricing power. That positions the company for growth in the longer term.
This article originally appeared in the February/March 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.
Laura Lallos has a position in the following securities mentioned above: AMZN. Find out about Morningstar’s editorial policies.
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