Consumer Defensive: Attractive Opportunities in Competitively Advantaged Stocks
Lackluster fundamentals and competitive pressures persist, but fail to warrant the recent retreat in shares.
Valuations throughout the consumer defensive sector have retreated, now trading 5% below our fair value estimates. We posit that the combination of lagging fundamentals and rising interest rates (and subsequently slightly less attractive dividend yields) have weighed on shares, but we don't believe this should prevent investors from building a position in these competitively advantaged names.
While margin improvement has taken top billing over the past several years, top-line trajectories have generally remained quite stagnant. And we don't believe these pressures stand to abate. 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.
Further, in terms of profitability, the trajectory of margin gains for a number of operators has not been as pronounced of late. As such, while we view cost savings efforts as prudent in the aggregate, we think the combination of increased brand spend (both in terms of product innovation and marketing support) combined with inflationary trends (both with regards to commodities and transportation and logistics costs) stand to constrain profit potential.
Partially stemming from the pressures on organic financial gains, a number of firms have opted to seek out inorganic growth opportunities. For one, wide-moat Nestle inked a deal with Starbucks to acquire the firm's consumer product offerings. We surmise that expanding into premium coffee could position it to reignite its sales base, as innovation opportunities are more plentiful in the premium segment. And that as a result, stronger price/mix could ensue, something that Nestle has clearly been lacking in recent quarters.
Further, Mondelez (MDLZ) continues to act as a consolidator, announcing its intentions to add Tate's Bake Shop (a domestic premium cookie manufacturer, with a portfolio centered on using simple ingredients). Despite the immaterial size, we believe the strategic rationale of the tie-up extends beyond building its presence in an attractive space to assisting Mondelez to grease the wheels of its own innovation cycle. In our view, firms throughout the industry have been tripped up by not responding to evolving consumer trends in a timely fashion. Conversely, nimbler niche startups like Tate's haven't been constrained by this factor, as evidenced by the fact that its retail sales through measured channels have soared 40% during the first three months of 2018 and have quadrupled from five years ago.
On the retail defensive side of the aisle, Walmart was also quite active in the quarter, announcing the sale of its U.K. grocery business (Asda) and the purchase of a 77% stake in Flipkart (a leading e-commerce retailer based in India). We believe that this showcases the firm's efforts to prioritize building out its footprint in faster-growing regions and online at the expense of ultra-competitive markets, where it has struggled to carve out an edge. From our vantage point, each of these moves stands to level the playing field with one of its biggest foes in Amazon (AMZN).
But this lack of sustainable fundamental improvement has also made the sector ripe for activist investor interest. In this vein, Jana Partners disclosed a nearly 10% stake in Pinnacle Foods (PF). Jana (which is pushing for a sale but may also seek an altered board composition or cost structure) has long sought change in food-related businesses, notably taking a stake in Whole Foods before its 2017 sale to Amazon. We believe its Conagra (CAG) stake could presage an outcome for Pinnacle, as the two food manufacturers have long been seen as potential merger partners. We believe the two frozen food portfolios (including Pinnacle's Bird's Eye lineup and Conagra's Healthy Choice and Marie Callender's brands) would be complementary, and could deliver value given Pinnacle's successful premiumization efforts that extend to its baking and gluten-free offerings. Regardless of outcome, we contend that the Jana push aligns with a consolidation theme in packaged food that should continue.
And although we don't believe activist investor Nelson Peltz's recent addition to P&G's board stands to accelerate change, we continue to posit that the proxy battle in of itself will ensure management remains squarely focused on delivering sustainable top-line gains longer term. In this vein, P&G announced its intentions to terminate its healthcare joint venture with no-moat Teva (TEVA) as well as a deal to acquire German-based narrow-moat Merck's consumer healthcare brands for $4 billion (3.7 times trailing-12-month sales and 20 times EBITDA). In our view, this tie up stands to replace the scale and technological know-how lost following the dissolution of its joint venture partnership. At just 1%-2% of sales, we surmise this addition evidences management's openness to selectively bolstering its reach in attractive categories (consumer health growing midsingle digits) and geographies. Further, we don't believe management maintains an appetite for more transformational deals. Instead, we think the firm will pursue select acquisition opportunities as a way to enhance its competitive capabilities or grant it entry into less penetrated geographic regions and distribution channels.
Tobacco stocks are out of favor, with the four large caps under our coverage falling by an average of almost 20%, year to date. Our pick of the group on valuation is Imperial Tobacco, which has derated slightly less than the group after having not fully benefited from the group's rerating last year. Although we regard Imperial as being one of the lowest quality of the large cap tobacco manufacturers, primarily because of its more price-sensitive consumer base and its position as a price taker in many markets, we still believe it has a wide moat because of the low price elasticity of demand and room for price increases in many markets. Although investors have been focused on heated tobacco for the next leg of earnings growth in this space, we think Imperial's wait-and-see approach is sensible, and we believe the value of the first mover advantage is being overestimated by the market. Trading at less than 10 times next year's earnings, the sell-off of Imperial looks overdone, and we think the stock offers an attractive entry point. Absent an acquisition, however, which we think is a low probability event, the rerating in Imperial may be a slow burn, given the deflated expectations around emerging categories and the rising interest rate environment, but with a comfortably covered dividend yield of just under 8%, investors will be paid to wait.
Tobacco stocks have derated this year, and we believe there is upside to British American. It has doubled-down on the combustible business with its acquisition of Reynolds American, and we view Reynolds as an incredibly strong asset in a market with plenty of remaining potential for raising prices. The bigger question for investors, however, is whether the growth of Glo, and its low-margin devices, is contributing to a slowdown in the company's margin expansion trajectory. After the significant pullback in the stock over the past seven months, we now believe this risk is accounted for in the market price. However, with heated tobacco growth beginning to slow, there appear to be few top-line catalysts in the near term.
We think the market's confidence in wide-moat General Mills' ability to restore top-line growth has faltered, considering continued softness in volume across the packaged food space as well as skepticism around the acquisition of natural pet food company Blue Buffalo. While the deal carries some inherent risk as General Mills enters a category in which it has limited experience, we remain confident in the firm’s ability to efficiently integrate Blue Buffalo and extract cost synergies from combining these operations. We believe General Mills will rely on the same strategy used for its previous acquisitions of niche players, enabling its pet food unit to benefit from its supply chain and distribution capabilities while largely leaving the acquired firm's operating model intact, which we think ensures these niche brands stay in touch with the preferences of their core customer bases. We think this approach has proved successful in the past, as exemplified by Annie's, which has increased distribution around 80% since being acquired in 2014.
Further, we expect General Mills' stringent cost management focus will facilitate additional reinvestment in its brands through research and development and advertising; we expect brand-related spending as a percentage of sales to tick up over the long term, totaling 7% of sales over our forecast, or 180 basis points above General Mills' fiscal 2017, which should support top-line gains as General Mills expands the distribution of Blue Buffalo's fare in mass-market channels. Given its discounted price (we see at least 20% upside to our current valuation) and a 4%-plus dividend yield, we think the stock provides an attractive entry point for long-term investors.
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Erin Lash has a position in the following securities mentioned above: AMZN, SBUX. Find out about Morningstar’s editorial policies.