While heightened competitive pressures persist in the household and personal-care space, we think Clorox's (CLX) solid brands in niche markets now warrant a wide economic moat. Divergent tales emerge in the nonalcoholic beverage space, as Coca-Cola (KO) leverages its vast scale and premium brand positioning, while negative headlines persist for Monster (MNST). Square-footage pipeline could constrain U.K. grocers' ability to sustain excess returns on invested capital.
After a strong start to the year amid investors' appetite for yield and renewed optimism for merger and acquisition activity in the space following Berkshire Hathaway's (BRK.B) $28 billion acquisition of H.J. Heinz, consumer defensive shares traded down over the summer as the market reassessed new opportunities for yield when the Federal Reserve hinted at curtailing quantitative easing activity, and now trade at an average price/fair value of 1.03 times.
Although we've seen a reversal the past two months amid ongoing questions about the timing of QE changes, we find more undervalued names in the consumer defensive space, where roughly two thirds of the 100 or so consumer defensive companies we cover have either a wide or narrow economic moat (typically stemming from expansive scale advantages and solid brand portfolios) and fundamentals that typically outperform during periods of economic softness.
While heightened competitive pressures persist in the household and personal-care space, we think Clorox's solid brands in niche markets now warrant a wide economic moat.
Consumers have continued to trade down to lower-priced options in some household categories (like cleaning products, food storage, and laundry detergent), but personal-care offerings have generally held up fairly well. However, the competitive landscape remains fierce, particularly as the 800-pound gorilla, Procter & Gamble (PG), has looked to regain lost market share on its home turf in several categories. In fact, two of its chief global competitors-- Colgate (CL), and Unilever (UN)--both cited stepped-up promotional activity in the U.S. as taking a toll on recent performance. In our opinion, promotional spending isn't a sustainable or profitable strategy over the long run but rather product innovation that wins with consumers is what will ultimately drive long-term, profitable growth.
In that light, while Clorox goes to bat against significantly larger peers and lower-priced private-label offerings daily, we think the firm's commitment to investing behind its products (both with regard to product innovation and marketing support, which equates to around 11% of sales annually) is quite noteworthy. As such, we now have greater confidence that Clorox's strong brands (nearly 90% of which are number one or two in their respective categories) and relative cost advantages should enable the company to generate excess returns on invested capital for at least the next 20 years. Thus, we raised our moat rating to wide from narrow. While we doubt the tough economic climate and fierce competition at home will subside, we believe Clorox will weather macro-driven obstacles given its solid brand set, which we view as a crucial intangible asset in light of the competitive environment in which it competes, and its focus on investing for the long-term health of the business (both at home and abroad).
We still think retailers rely on brands to drive store traffic (even when the category possesses a high level of private-label penetration), so we were encouraged by Clorox's awareness that new products that resonate with consumers are essential. In fact, Clorox continues to target generating three points of incremental growth (excluding cannibalization) from innovation annually, in line with its historic average but higher than the 1%-2% contribution to top-line growth from new launches that we think seems reasonable on average throughout the consumer products category. Furthermore, we think that Clorox's less-dominant peers (those that hold the number three or four market position) likely are feeling the heat from lower-priced private-label offerings more so, particularly as retailers look to rationalize stock-keeping units in favor of promoting value-priced goods.
Despite speculation to the contrary, we doubt Clorox is viewed as an acquisition target in the consumer products space. In fact, activist investor Carl Icahn attempted to sell Clorox in 2011, but his pitch to incite a bidder ultimately fell on deaf ears. This is not to say that its household and personal-care peers are blind to the competitive prowess Clorox brings to the table. In fact, P&G acquired Clorox in 1957; however, 10 years later, the U.S. Supreme Court ultimately ruled that P&G had to unwind the deal in light of antitrust concerns. In 2002, the two companies entered into a mutually beneficial joint venture to develop food and trash bags, food wraps, and containers under the Glad brand and related trademarks, which remains in place today. Furthermore, we anticipate that any potential tie-ups in the consumer products space will likely be bolt-on in nature, rather than the more transformational scope that would accompany a deal to digest Clorox.
We doubt the competitive intensity will abate anytime soon, but we think Clorox has sufficient scale, retail relationships, and brand equity to hold or increase market share where it competes.
Divergent tales emerge in the nonalcoholic beverage space, as Coca-Cola leverages its vast scale and premium brand positioning, while negative headlines persist for Monster.
Although both Coca-Cola and PepsiCo (PEP) benefit from wide economic moats bolstered by a bevy of strong brands and vast distribution systems, we feel that Coca-Cola is much better positioned to capture outsized growth in the global nonalcoholic ready to drink, or NARTD, beverage category over the course of the next decade. Our wide economic moats are based on both companies' cost advantages and the intangible assets inherent in their brand portfolios, but we believe Coke benefits more from its superior global scale in beverages, greater collaboration with its key bottling partners, and stronger beverage brands for which consumers are willing to pay a higher price.
In most countries, Coca-Cola enjoys dominant market share (compared with Pepsi) in the carbonated soft drink, or CSD, category, which is the result of decades of developing a premium brand among consumers. The volume growth that comes with this brand leadership enables the Coca-Cola system--Coca-Cola and its regional bottlers--to more efficiently spend its marketing budget and more optimally run its distribution system. This results in a material cost advantage and a positive feedback loop that should enable Coca-Cola to maintain its leadership position and premium price point for decades to come.
Coca-Cola's relationship with its key international bottling partners also tends to be more symbiotic than that of Pepsi. Coca-Cola has substantial economic interest in several of its largest and most strategic international bottling partners, which approached $17 billion at year-end 2012, or approximately 10% of Coca-Cola's year-end market capitalization. This compares with Pepsi, which owned around $1.4 billion of its international bottlers at the end of 2012 (excluding the value of the Tingyi call option in China), or roughly 1.3% of PepsiCo's year-end market capitalization. With Coke owning sizable equity stakes in many bottlers, and Coca-Cola products making up the preponderance of many Coca-Cola bottlers' overall portfolios, it helps to keep the entire system aligned with the same goals.
Coca-Cola is optimally positioned to gain worldwide value and volume share over the coming decade as a result of its wide moat supported by strong brands, and an unmatched distribution system. Pepsi's dominance in the snacks category will be the primary driver of its future growth. While we think both Coke and Pepsi will increase revenue at roughly 5% over the next five years, we expect that the bulk of Pepsi's growth will come from its snacks business, and that Coke will continue to outpace Pepsi in the global NARTD category.
Conversely, Monster Beveragecould prove to be a more volatile stock, as the U.S. Food and Drug Administration continues to investigate adverse event reports, or AERs, related to energy drinks. The FDA's initial release included AERs received from Jan. 1, 2004, through Oct. 23, 2012, for Monster, 5-Hour Energy Drink, Rockstar, and Red Bull. Unsurprisingly, a subsequent maelstrom of bad press afflicted the energy drink companies. We speculated that this heightened focus on energy drinks could result in additional AERs being filed with the SEC. As such, we filed a Freedom of Information Act request with the FDA to obtain any new AERs concerning Monster. A total of 22 new AERs were filed pertaining to Monster in the past year, with three new reports linked to deaths, and 16 cases of hospitalization. We believe this new information supports our high uncertainty rating on the company and may provide fuel to the regulatory fire that could result in labeling changes, marketing restrictions, or, in more extreme scenarios, age-gating energy drinks.
Although AERs reflect only "as reported" information and do not represent any conclusions drawn by the FDA about whether the product actually caused the adverse events, the additional claims purporting deaths and hospitalizations may result in increased marketing and product restrictions. Possible regulatory actions include additional labeling requirements, marketing restrictions, age-gating, and restrictions on the quantity of caffeine in a given container.
Monster management continues to assert that its beverages are safe, conform to all FDA regulations, and contain less caffeine than many coffees. CEO Rodney Sacks continues to defend the safety of energy drinks. He notes that since inception, more than 10 billion Monster Energy drinks have been sold and safely consumed, that the ingredients in Monster's drinks are all "generally regarded as safe," and that the principal sources of caffeine for teenagers are not energy drinks but coffee, soft drinks, and tea.
Headline risk and regulatory risk result in a high level of uncertainty. Media scrutiny has and could again result in tempered consumer demand for energy drinks. Negative press may also serve as a catalyst to weaken the brand's pricing power. This could have negative implications for revenue, operating margin, and free cash flow growth. The regulatory risk we are most worried about, a reduction in the caffeine levels, appears to be a distant probability, but nonetheless is possible.
Square footage pipeline could constrain U.K. grocers' ability to sustain excess returns on invested capital.
Value-conscious consumers are shopping with multiple competitors in many different channels, no doubt a function of minimal customer switching costs--a phenomenon that is evident around the world but particularly in the U.K. These trends have been exacerbated by weak economic growth coupled with high food inflation, giving privately held discounters Aldi and Lidl the ideal opportunity to expand their presence in the region. The rise of these discounters, as well as high-end grocer Waitrose, has left traditional market players struggling to fight for market share. Many have become more aggressive on price, and despite calls for an end to the space race and reduced square footage growth plans, most growth-hungry firms are still adding square footage (primarily convenience stores) on a net basis. These investments in square footage expansion could prove worthwhile with a marked improvement in the U.K. economy, but we are also cautious that there is a material probability of industry sales and profits per square foot declining and returns on capital remaining at or below costs of capital for most industry players.
After visiting with several U.K. grocers this fall, we think most (if not all) of the big players have acknowledged the unsustainability of industry square footage growth, and several have called an end to the space race and reduced capital expenditure plans. However, a slowdown in the growth rate, while a step in the right direction, still means that more net new square footage is coming onto the market. In our conversation with Tesco (TSCO) the firm downplayed the square footage problem, in our view. Tesco stated that while gross food retail square footage has grown at around 4%-5% per year, net food retail square footage has grown about 1%-3%, suggesting that things aren't really as bad as they seem. Moreover, Tesco defended square footage decisions by providing its view that U.S. per capita square footage is 3 times greater than in the U.K. We are sympathetic to this view, but we also note that most U.S. grocers' sales per square foot are much, much lower than those generated by U.K. grocers.
We do not assign any of the U.K. grocers an economic moat, as we think the grocery industry's nonexistent switching costs could make it difficult for most U.K. grocers to sustain excess returns on capital over the long term. The U.K. grocery industry is mature and consolidated, with the top four U.K. grocers (Tesco, Asda, Sainsbury (SBRY), and Wm Morrison (MRW)) accounting for more than 75% of total grocery sales. However, we don't see strong evidence that any firm commands a clear cost advantage, as we think each firm benefits from enough regional scale to remain competitive on price while touting minor points of differentiation (most of which we think are replicable for a 10-year period).
Absent a sharp uptick in the U.K. economy, we are cautious that grocery industry sales will slow during the near term. Food inflation has fueled industry growth during the last several years, in part the result of broad-based commodity price inflation around the globe. The fact that food inflation has outpaced wage growth by nearly 200 basis points (since 2006) leaves reason for caution, as moderating food inflation or more pronounced volume contractions could weigh heavily on profits when combined with the amount of new square footage coming to market. We think increasing per capita square footage, sluggish macroeconomic fundamentals, and intensifying competition represent real downside risks, but we think Tesco presents the best risk/reward opportunity at current price levels.
Our Top Consumer Defensive Picks
While several names in the space look fairly valued or slightly overvalued at current market prices, we still see a few pockets of value. Overall, we stress that long-term investors looking for exposure to the consumer staples industry should still keep an eye on the moaty names in this space.
Top Consumer Defensive Sector PicksData as of 12-12-13
Star Rating: 4 StarsFair Value Estimate: $45.00Economic Moat: WideFair Value Uncertainty: LowConsider Buying: $36.00Coca-Cola's vast distribution network and powerhouse brands are second to none and have helped the company create one of the widest economic moats in our consumer defensive coverage universe. Because the strength of the brand resonates with consumers across borders, we contend that Coke has amassed a high degree of pricing power over retailers. While we believe volume growth during the next decade will be led by emerging markets, we also think sales in mature geographies will likewise expand as the company continues to broaden its portfolio of still beverages. As a result of Coke's expansive scale and prospects for emerging-market growth, we think the stock should trade at an above-industry-average multiple, and we view the shares as relatively undervalued at the current price.
Nestle SA (NESN)
Star Rating: 4 StarsFair Value Estimate: CHF 71.00Economic Moat: WideFair Value Uncertainty: LowConsider Buying: CHF 56.80The diversity of Nestle's product portfolio, with 20 brands that each have more than CHF 1 billion in annual sales, protects the firm's overall financial performance from weakness in any single category, and the depth and breadth of its product set have enabled it to gain favorable shelf space at retailers and charge premium prices for many of its products. Nestle possesses a high degree of pricing power, as volume has held up despite the fact that the firm has raised prices across its product portfolio over many years. We think investors would be wise to consider an investment in Nestle, which trades at a modest discount to our fair value estimate, particularly in light of the broad category and geographic exposure the packaged food giant offers.
Philip Morris International (PM)
Star Rating: 3 StarsFair Value Estimate: $93.00Economic Moat: WideFair Value Uncertainty: MediumConsider Buying: $65.10With ample cash and three major secular tailwinds, we think investors should give Philip Morris International a second look. Tobacco enjoys tremendous pricing power, thereby enabling the company to steadily increase prices around the globe in good economic times and in bad. In addition, the company is well positioned in many emerging markets that are seeing increasing levels of tobacco usage. And finally, Philip Morris' premium brands (including Marlboro and Parliament) should capture outsized share gains as emerging market smokers increasingly opt for higher-priced (and higher-margin) premium cigarettes rather than value-brand cigarettes.
Tesco PLC (TSCO)
Star Rating: 4 StarsFair Value Estimate: GBX 380.00Economic Moat: NoneFair Value Uncertainty: MediumConsider Buying: GBX 266.00We believe Tesco is a solid operator with purchasing scale in multiple product categories, well-established multichannel operations, and strong consumer analytics capabilities. We think these attributes will allow Tesco to outperform its peers for some time. However, although Tesco commands a lead in some areas, we do not have enough confidence in Tesco's ability to sustain excess returns for 10 years to assign the firm an economic moat. We think Tesco's international segments could be the biggest drag on returns over the near to medium term, but we'd use any sell-off related to short-term macro pressures in these regions as a buying opportunity.
Unilever NV (UN)
Star Rating: 4 StarsFair Value Estimate: 45.00Economic Moat: WideFair Value Uncertainty: MediumConsider Buying: 31.50Beyond its portfolio of essential products, Unilever's status as a giant consumer product firm resulted partly from its foresight to secure a first-mover advantage in international markets, particularly in fast-growing developing and emerging markets, which now account for about 55% of the firm's consolidated sales. While slowing global demand is taking a toll on Unilever--given its vast geographic footprint-- we think Unilever's pulse on consumer trends and investments related to bringing new products to market and marketing spend will ensure that challenges in emerging markets are ultimately resolved. With its robust cash flow (free cash flow amounted to 9.5% of sales in fiscal 2012), we think Unilever (which is attractively valued) to continue investing behind its brands, pursuing acquisition opportunities as they arise, and returning excess capital to shareholders.
Erin Lash, CFA, does not own shares in any of the securities mentioned above.
- Consumer Discretionary
- Consumer Staples