By Erin Lash, CFA
The fact that consumer defensive names have been on a tear of late is hard to deny. Trading at an average price/value of 1.13 times, Morningstar's consumer staples coverage universe now trades at a meaningful premium to the average price/fair value of 1.06 for our full coverage universe. Consumer staples companies tend to be viewed as safe havens in uncertain economic landscapes - given the consistent cash flows and total shareholder returns (including dividend and share repurchases) that tend to characterize these firms - and the recent appreciation in the shares seems to support that stance. We believe the market's favor regarding names in this space also reflects the fact that the consumer defensive industry is one of the more concentrated categories with regard to economic moats (as roughly two thirds of the 100 consumer defensive companies we cover have either a wide or narrow economic moat), showing why these stocks are attractive in tough operating environments.
However, from our perspective, consumer defensive valuations are getting a little frothy these days. The Morningstar Consumer Defensive Index is trading at more than 16 times forward earnings, a premium relative to just a few short years ago (though still at a discount relative to the inflated market that characterized the dot-com boom at the beginning of the century). But, we contend that this figure understates the true multiple where the bulk of our moaty consumer defensive coverage universe trades, as the index also incorporates other less competitively advantaged sectors that don't warrant economic moats (and subsequently trade at more modest valuations) - such as grocery stores (which trade at a forward price/earnings multiple of 11 times), retail defensive (17 times), and education services (11 times). This compares with a forward earnings multiple of 20 times for the household and personal care sector, 21 times for alcoholic beverage companies, and 18 times for nonalcoholic beverage firms. Taking into account just the names within the beverages (alcoholic and non-alcoholic), food service distribution, household and personal care, packaged food, and tobacco categories, we believe the consumer defensive sector trades at a median forward price/earnings of 18 times and a forward enterprise value/EBITDA of 11 times - compared with historical multiples around 15 to 16 and 9 to 10 times - which appears a little rich compared with our implicit growth rates for these categories.
Beyond the favorable characteristics of the space (sustainable competitive advantages and robust cash flows), we also think ultralow interest rates have been driving consumer defensive valuations higher (as a whole), as many investors continue to stretch for yield. While interest rates have been abnormally low for several years, we don't perceive these low levels to be sustainable over the longer term. We caution that investors could revise required returns upward when interest rates rise in the future, which would detract from total returns on consumer defensive stocks despite steady dividend payments and earnings growth.
We believe market valuations currently overstate consumer defensive sector growth opportunities. From our view, the market is implying high-single-digit revenue growth, roughly double-digit operating income growth, and low-double-digit EPS growth (when factoring in buybacks, which historically can prop up earnings growth by about 2%-3%), all of which strikes us as mildly aggressive at first blush.
State of the Global Consumer Has Improved, But Is Not Robust
One topic that has failed to get much airplay of late is how the consumer spending environment has been holding up, but it seems that conditions may be showing some initial signs of improvement. In 2012 the unemployment rate ticked down to 8.1% (from 8.9% the prior year), while Consumer Price Inflation slowed to 2.1% (down from 3.1% a year earlier), according to Moody's Economy (January 2013). That is not to say that we are out of the woods, as the recent payroll tax increase (which amounts to around 1% of disposable personal income) combined with rising gas prices (up approximately $0.30 per gallon during the past several weeks) remain impending headwinds for consumer spending levels.
When confronted about the current pulse of the global consumer and the degree to which firms were positioned to handle challenges, management groups have been quick to point out that this is not their first time going to the dance. Kraft (KRFT) management has called attention to the fact that its renewed focus on innovation plays well in this environment, as value-added products serve to differentiate branded offerings from lower-priced private-label items. In addition, consumer product firms, such as Heinz (HNZ), have been launching smaller package sizes at lower price points to ensure products continue to win at the shelf--lessons garnered from faster-growing emerging markets.
We think that any further strain on the consumer could also prompt another round of channel shifting, as consumers have become adept at searching out the best deal. The base of retailers is consolidating, and consumers have shown a willingness to shift beyond traditional grocery stores in search of a bargain. Despite this, retailers still depend on leading brands to drive traffic in their stores, and we don't anticipate that this will change. For instance, according to Kraft management, 4% to 6% of every American grocery store's sales are Kraft products, making the firm a key supplier for retailers.
Further, Nestle (OTCPK:NSRGY) brought to market a few years ago a lineup - which it refers to as Popularly Positioned Products (PPP) - to directly cater to a strained consumer base. According to the company, PPPs offer a similar quality and nutritional profile as its core product base, but at more affordable price points. The success of these efforts is evident, as this item set at growing two times faster than the rest of Nestle's portfolio, and these offerings lend themselves to the dollar and instant-consumption channels, where fixed-income consumers are increasingly shopping.
In light of the state of the global consumer spending environment, a high-single-digit rate of top-line growth (which underlies the market's forecast) assumes a very favorable backdrop from our perspective. We recognize that emerging markets will remain a top prospect for growth for consumer staples companies for years to come. However, deteriorating economic conditions in Europe combined with sluggish growth in North America are unlikely to immediately reverse course. Our expectation is that the competitive landscape in more-mature developed markets will remain intense for the foreseeable future, as consumer product firms battle for a larger slice of consumers' reduced discretionary spending budgets. So while volume growth could stay elevated within developing markets (at low-double-digit levels), we anticipate that volumes in developed markets will remain much more modest (low-single-digits), and we doubt volumes will reach the mid-single-digit level the market is forecasting.
Innovation Is All the Buzz, But Will It Be Enough?
After several years in which the impact of skyrocketing commodity costs has been top of mind in the consumer defensive space, innovation now seems to be all the rage. This renewed momentum likely reflects a more cautiously optimistic take on the consumer spending environment. In addition, we suspect that this is another attempt by consumer staples firms to stem the tide of consumers switching to lower-priced private-label offerings. However, the key for branded firms - and what has been lacking over the past several years - is truly groundbreaking new products that win on the shelf and prompt consumers to trade up.
On the topic of innovation, the most telling presentation at the 2013 CAGNY conference, in our opinion, was Kraft management's discussion of the firm's dismal innovation track record and recent investments to right its course. Just a few years ago Kraft was considered the worst innovator in the consumer product space, with 17 of 19 new product launches in 2008 considered failures. But Kraft contends it has made significant strides since that time, putting its resources behind more significant launches and more than doubling its spending to hype each new product. An example of the recent success is MiO, the water enhancer that now drives more than $100 million in annual revenues. Overall, revenue from innovation increased to around 13% in 2012, about 2 times the level generated just three years ago.
Kraft's presentation gave credence to our take that the North American grocery operations had been used as a cash cow to fund growth in the global snacks business. We think the market is overlooking the substantial cash flows that Kraft Foods' grocery business generates (which we forecast at 10% of sales on average), and income investors would be wise to consider Kraft's shares, because paying a top-tier dividend (which is yielding nearly 4%) is to be its main use of cash.
In contrast to Kraft's more concentrated approach to innovation, Campbell (CPB) - struggling to reignite its domestic soup business as well as its North America beverage operations - appears to be taking another track. More specifically, Campbell intends to bring to market more than 200 new offerings across its business next year. Though the company maintains a pulse on consumer trends, our concern has been that Campbell is more focused on launching new products than ensuring that its offerings truly resonate with consumers. Admittedly, Campbell has been slow to combat current challenges (and we have assigned the firm a negative moat trend rating to reflect continued share losses in the U.S. wet soup aisle), but we contend that its dominant position and continued investments should ultimately enable it to navigate through this difficult operating environment. Despite this, we don't think that the shares represent a compelling value (particularly given that the road ahead could be bumpy) at the current price.
Packaged food firms aren't the only ones touting the value of bringing new products to market, as household and personal care players also seem to want in on the action. Procter & Gamble (PG) and L'Oreal both provided a look into the new products each has in the queue recently. We sensed a dearth of new premium offerings in the hair-care aisle, historically an ultra-competitive category and one in which P&G has stubbed its toe in the past, as with the Pantene reset just a few years ago that left consumers dazed and confused. P&G's lineup is to be marketed under the Pantene franchise (priced at a 200% to 250% premium to the base Pantene line) and L'Oreal's will be an extension of the L'Oreal Paris brand.
The fact that both of these new sets are to target a more premium price tier signals to us their take that consumers are more open to paying up, but we will be paying attention to how these new lines resonate with consumers. Until we get more comfortable that P&G's recent results prove sustainable and its latest innovation is winning with consumers, we will remain on the sidelines.
PepsiCo (PEP), which remains well balanced between snacks (51% of sales) and beverages (49%), is also keeping a steady eye on innovative new products across its portfolio. The firm's partnership with Yum Brands' (YUM) Taco Bell expanded, following last month's launch of Cool Ranch Doritos shells. Since the introduction of the Doritos Locos Taco last year, 325 million shells have been sold (representing roughly one taco for each member of the U.S. population), making it the most successful new product in Taco Bell's history, and we expect similar success from this latest extension. Pepsi has also been focused on its Lay's product set. For instance, the "Do Us a Flavor" contest drove buzz within the social media channel by engaging consumers to recommend wacky flavor combinations, which included Cheesy Garlic Bread, Chicken & Waffles, and Sriracha. Should a flavor prove to be a hit, PepsiCo's vast scale would enable the firm to quickly ramp up production and broadly distribute the product across its markets.
Although Pepsi Next, with 60% fewer calories than regular Pepsi, has already achieved $150 million of retail sales in its first year, we believe that Pepsi will continue to increase its sales of low-calorie soft drinks. Both at CAGNY and on the company's recent earnings call, management hinted that it's working on fundamental changes to sweeteners that will be used in its carbonated soft-drink platform and that should provide evolutionary change to the company's carbonated drinks sometime in 2014 or 2015. We believe Pepsi's wide economic moat centers on its strong brands and vast distribution system, which is a great advantage when looking to roll out product-line extensions for its snacks and beverage portfolios. However, at the current price, we view the shares as fairly valued.
The talk about innovation hasn't stopped there, as cigarette manufacturers are also looking to build out their portfolio set, particularly in light of the fact that U.S. cigarette consumption has been on a downward spiral for some time. For instance, although Lorillard (LO) and Reynolds American (RAI) have entered the electronic cigarette category, industry leaders Altria (MO) and Philip Morris International (PM) have yet to venture into this market, and given the success of Lorillard's blu brand, we wouldn't be surprised to see either firm make the plunge. Over the next few years, PMI intends to invest an incremental EUR 500 million to build a manufacturing footprint capable of producing around 30 billion next-generation products (NGP) per year (roughly 3% of PMI's cigarette volume). In Altria's case, we think it could eventually create its own e-cig lineup or acquire a privately held e-cig brand (such as privately held NJOY). Overall, we believe that the wide economic moats that these tobacco giants have created over the course of many decades will prove to be valuable assets as tobacco alternatives continue to grow in popularity. However, neither strikes us as attractively valued at this time.
Finally, in the alcoholic beverage category, SABMiller (SAB) continues to add brands to support differing consumer preferences around the globe. In Africa, where homemade alcohol captures most of the market, the company is adding capacity to support the low end of the beer market. Affordable beer made from sorghum (Eagle Lager) and cassava (Impala beer) and packaged in plastic (PET) bottles is helping to grow the category and shift consumers from lower-quality home brews to higher-quality (and profitable) SABMiller brands. Likewise, in the United States, SABMiller's MillerCoors joint venture is further growing its craft beer segment with the launch of Third Shift amber lager, Redd's Apple Ale, and continued seasonal extensions of Leinenkugel's and Blue Moon. Scale and distribution are key attributes for brewers, and we believe that wide-moat SABMiller will be able to leverage these new beers across its breweries in America and Africa.
Overall, we think the market is a little too optimistic regarding the prospects for this pending stream of innovation, forecasting approximately mid-single-digit volume growth this year. Our expectation is that approximately half of that will result from existing products, with the rest driven by new products. However, based on commentary from management groups throughout the space, we think a 1%-2% contribution to top-line growth from new launches seems reasonable (even two of the more innovative firms we cover - Clorox (CLX) and McCormick & Company (MKC) - have pegged the annual impact from new products at just 2%-3%). And the proof has been in the pudding: In 2011, Reuters cited that 81% of the hundreds of new consumer packaged goods launched failed to hit $7.5 million in first-year sales, according to SymphonyIRI. As such, we think the market is overshooting reality in this case by assuming the entire sector garners around 3% growth or more from new products.
Further, after several years during which higher prices ran rampant throughout the grocery store (and developed-market consumers traded down to lower-priced private-label offerings), we doubt consumer product firms will look to play the price card again unless prompted to do so. As a result, we anticipate that prices will increase between 1% and 3% this year throughout the sector. However, if we enter a period during which commodity costs skyrocket again - an unlikely outcome absent another major drought this summer - prices throughout grocery aisles could trend higher. Innovation is the one wild card that could favorably impact both volumes and prices (new products tend to come with a higher price tag and are designed to bring consumers back to a particular brand). In general, we expect sales growth at consumer defensive firms to only marginally exceed GDP-type growth in 2013, as high unemployment levels and austerity measures keep a lid on developed-market consumer spending and emerging-market consumers are unable to fully offset the challenging landscape in developed markets.
In addition, while we anticipate that these new products could contribute anywhere from 1%-2% to annual revenue growth, we aren't forecasting material margin expansion due to this fresh set of offerings. In our view, the added investment required to tout new lineups, combined with the fact that several new products are likely to appear in international markets (which inherently are lower-margin already), is likely to provide some buffer to margin expansion. We anticipate that consumer product firms will continue controlling overhead costs, but we think a portion of any savings generated will be reinvested in the business (in the form of both marketing support and research and development) given competitive pressures show no signs of abating. Elevated raw material prices over the past several years have weighed on the cost structures of many consumer defensive firms, leaving limited options (namely cost-cutting initiatives, increased prices, and product innovation) to preserve margins. In order to increase profits without disgruntling consumers, most companies strive to reduce operating redundancies on an ongoing basis, but cost-cutting is inherently limited, and we contend that a majority of firms throughout the space already run efficient and lean operations, with minimal, if any, fat left to cut. From our perspective, mid- to high-single-digit operating income growth and high-single-digit to low-double-digit earnings growth seem more feasible, as these firms leverage their scale.
M&A, Dividends and Buybacks Will Continue, But We're Skeptical They're Enough to Support Current Valuations
Following the news that Heinz will be acquired by Berkshire Hathaway (BRK.A) (BRK.B) and 3G Capital in a $28 billion deal ($72.50 per share), the market has been abuzz with talk as to whether the industry is on the cusp of another round of take-outs. From our perspective, the packaged food industry has been ripe for value-enhancing transactions - both marriages and divorces - for quite some time. In that light, we doubt that the Heinz deal is a precursor to further deal activity, although when asked, management groups at this year's CAGNY conference seemed to acknowledge that if they failed to run businesses efficiently and accelerate top-line growth, financials buyers could step up to the plate (particularly given the favorable interest rate environment).
Instead of larger transactions, we believe consumer defensive firms will continue building out their distribution platforms at home and abroad - pursuing smaller, bolt-on transactions. Firms such as Mondelez (MDLZ), Hershey (HSY), and Sysco (SYY) have suggested that targeting smaller, family-run businesses could be in the cards (offering the ability to get a better handle on the local consumer without the need to incur significant financial leverage). But given that deals of this nature only occur when the current owners want to exit the business, the timing can be tough to pin down. Hershey's management has said that an attractive acquisition (likely in the $300 million-$400 million range) would provide it with broader geographic exposure or additional go-to-market strategies. However, we question whether the Milton Hershey School Trust (which controls more than 80% of the voting shares) will actually stand behind a larger, more transformational deal that could potentially throw its stable cash flows into question. Hershey still benefits from the economies of scale in its manufacturing and distribution as well as its iconic brands (the basis for our wide economic moat), but it has been unable to demonstrate that it can leverage its brands to grow in the consolidating global confectionery industry (and we believe a negative moat trend is warranted).
For Sysco's part, the leading North American food service distributor has completed more than 10 acquisitions since the end of June and expects that acquisitions will contribute more than 1.5% to sales growth in the current fiscal year (up from just five deals and 0.6% added to sales on average over the past five years). Overall, we think the market's concerns regarding sluggish restaurant traffic and food cost inflation are overdone and are unjustly weighing on the shares. At less than 18 times our fiscal 2014 earnings estimate (versus the implied 18 times in our fair value estimate) and with a dividend yield around 3.0%, the shares are slightly undervalued and should appeal to growth and income investors, in our opinion.
Beyond pursuing acquisition opportunities, we think that returning cash to shareholders will remain a top priority for cash at consumer defensive firms, as nearly every firm at this year's CAGNY conference took the opportunity to address the topic. Consumer staples firms tend to generate a sizable amount of cash (with free cash flow as a percentage of sales projected to average 12% among the firms in our coverage universe that presented at this year's conference), paying out nearly half of earnings in the form of dividends annually. The average dividend yield among the firms we cover that presented at CAGNY this year amounts to 2.5% (ranging between 0.8% and 5.0%), and we anticipate that income investors will likely find favor in the consumer defensive landscape for some time to come.
Overall, we anticipate that the prospect of additional M&A, dividend increases, and share repurchases may support valuations across the consumer defensive space over the near term, but we believe the market may be overestimating the total benefits of these positive catalysts.