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Consumer Defensive Stocks: Why So Sluggish?

Ken Perkins

Sluggish income growth, minimal inflation, and aggressive competition are challenging defensive retailers. CAGE conference reinforces long-term emerging-market opportunities for certain consumer defensive names. Electronic cigarettes and heated cigarettes have the potential to disrupt Big Tobacco, but moats still intact.

Defensive Retailers Still Plagued by Intense Competition, Macro Headwinds
In the most recent quarter, virtually all retailers in our coverage universe reported weak comparable-store sales growth and/or guided for lower growth than originally expected. Wal-Mart's (WMT) comparable-store sales declined across the United States, well below the firm's initial guidance for flat comps at Wal-Mart U.S. and 0%-2% comparable-store sales growth at Sam's Club. The company said reductions in Supplemental Nutrition Assistance Program benefits had a larger impact on sales than originally expected, while muted inflation and intense holiday promotions further weighed on the top line.

Target (TGT) also struggled in the quarter, although we think comps were positive before the customer data breach, which drove a 2.5% decline in fourth-quarter same-store sales. Dollar General (DG) reported 1.3% comparable-store sales growth in the quarter (well below the 4%-5% comp growth in recent quarters), reflecting intense competition and arguably unfavorable weather, which can reduce fill-in trips. From a top-line perspective, we believe Costco (COST) reported some of the strongest results (U.S. comp-store sales increased 4% excluding fuel), as memberships and traffic continued to increase.

We believe competition could intensify as different channel players compete for market share in a low-growth environment. Volatile weather conditions have plagued many firms during the beginning of 2014, and we expect sluggish wage growth and minimal inflation will be a persistent drag on industry growth. That said, we think conveniently located small-format stores and the online channel could continue to outperform, while membership and traffic trends at Costco remain encouraging. Overall, we believe most firms will make investments in new formats and online capabilities to defend market share from alternative channels.

Wal-Mart has been most aggressive in accelerating its multichannel strategy. The company recently increased its U.S. small-format growth expectations materially: It now expects to open 270-300 small stores this year, double the previous expectation of 120-150. Given that dollar stores, drugstores, and online players continue to exhibit positive momentum, we believe the company's decision to accelerate its small-format growth reflects a strong desire to pull forward its defense against these threats. An accelerated store rollout should help Wal-Mart fight for share, as its small stores continue to comp around 4%.

CAGE Reinforces Long-Term Emerging-Market Opportunities for Certain Consumer Defensive Names
After a prolonged recession and several banking aftershocks, European consumer product companies are benefiting from economic stabilization in their domestic markets. Led by the largest economies, such as Germany, and those that have gone through the austerity process, such as the United Kingdom, Europe as a whole is finally bottoming out. There are still weak regions, however, with laggards like Spain expected to reach peak unemployment at around 26% next year. In all, the recovery remains tepid at best. Annualized inflation in February was 0.8%, significantly below the European Central Bank's 2.0% target rate, leaving the eurozone facing real deflationary pressures. With refinancing rates at an all-time low of 0.25%, the ECB has limited scope for cutting rates (short of taking rates to zero or even negative, which we would not expect unless there was a high probability of immediate-term deflation) but a quantitative easing program similar to that executed in the U.S. appears more likely.

The sluggish economic recovery leaves Western European consumer companies with few catalysts to return to normalized growth levels in the near term. At the recent Consumer Analyst Group of Europe conference in London, we noticed a marked difference in tone between the mature market-focused consumer companies and the more geographically diverse firms with emerging-market exposure. Slow growth in mature markets, channel shifts to online and to the mass channel in the U.S., and falling effectiveness of traditional marketing channels are presenting significant challenges. In emerging markets, however, the global recovery is bringing renewed opportunities for volume expansion and premiumization, and the challenge for consumer companies is to win share from local brands. At CAGE, there was a clear difference in mood between those companies with emerging-market opportunities (such as SABMiller (SBMRY), Diageo (DEO) and Coca-Cola (KO)) versus those facing the more challenging mature markets (such as Kraft Foods (KRFT)). In contrast to the product innovation discussed by Diageo, Kraft said it was cutting its number of product lines.

Beyond commentary at CAGE, food inflation in the U.K. has outpaced wage growth and square footage growth has outpaced population growth, which has made it very difficult for U.K. retailers to grow without taking market share. The online and discount channels continue to perform well, but at the expense of the largest traditional grocers. In response, Wm Morrison (MRW), the U.K.'s fourth-largest grocer, recently issued a profit warning in conjunction with an announcement that it will invest GBP 1 billion to lower prices over the next three years. This is a very aggressive stance from Morrisons, which has consistently lost market share (a function of high customer overlap with the discounters and a less established convenience store and online presence).

The announcement sent shares of Morrisons, Tesco (TSCO), and Sainsbury (SBRY) down further, as the investment community remains very nervous about a price war beginning. Tesco recently refrained from defending its 5% U.K. trading margin target because it wants more flexibility to invest in pricing as competitive dynamics dictate. Sainsbury has parried questions about the potential for a price war, as it believes that those firms defending themselves against the discounters (Morrisons and Tesco are lowering prices, and Morrisons is cutting its stock-keeping unit count 20% over the next three years) leave an opportunity for Sainsbury to differentiate itself with its own range. Overall, we are very cautious about the U.K. grocery market, and while we see these names as undervalued, we think investors should wait until they trade at considerable discounts to our fair value estimates.

We continue to believe that in the long term, companies with economic moats are best suited to meet the challenges and exploit the opportunities facing consumer staples companies. Strong intangible assets create demand in emerging markets and higher levels of brand loyalty in developed markets across channels, while cost advantages give companies the financial flexibility to adapt to the changing competitive landscape.

Electronic and Heated Cigarettes Have Potential to Disrupt Big Tobacco, but Moats Still Intact
Although pricing power, significant scale, and regulatory barriers have played critical roles in tobacco companies' ability to develop wide moats and steadily increase cash flow and annual dividend payments, the disruptive factors of electronic cigarettes, excise tax increases, and new regulations could shake up the otherwise consistent tobacco sector.

We believe some players are better positioned than others to withstand potential disruptions, with large multinational tobacco firms like Philip Morris International (PM) and British American Tobacco (BTI) offering more compelling risk/reward propositions than domestic cigarette companies. That said, we believe e-cigs will continue to be a growth category for the next several years and heated cigarettes could become more prevalent in 2016 and beyond.

In recent years, the underlying trends in tobacco have been relatively consistent: Cigarette volume has been declining in the low single digits in many developed economies (like the U.S. and Western Europe); price increases have more than offset these volume declines; there are pockets of volume growth in smokeless tobacco products and in select emerging markets; and there are sporadically excessive regional excise tax increases. However, in the past year, the e-cig category has boomed, creating both an opportunity and a threat for Big Tobacco. In our opinion, e-cigs have the potential to hasten the decline of cigarettes in developed markets (where the tax burden is high) and result in margin erosion for the combined cigarette/e-cig category.

The e-cig market is currently highly fragmented, barely taxed, and lightly regulated. Should e-cig taxation and regulation be benign, we believe e-cig margins could be a fraction of the hefty (often exceeding 40%) operating margins currently enjoyed by Big Tobacco. Currently, every major tobacco company is selling, or about to sell, an electronic cigarette. Additionally, as Lorillard's (LO) acquisition of U.K.-based SKYCIG and various other tobacco executives' commentary show, borders will be crossed, resulting in an e-cig market that is likely to prove more competitive than the traditional cigarette market.

We believe that it may be in the financial self-interest of Altria (MO), Reynolds American (RAI), Philip Morris International, and British American Tobacco to get e-cigs taxed and regulated on par with traditional cigarettes, thereby stunting the category's growth and protecting the profit stream of traditional cigarettes. However, we believe e-cigs are much lower on the risk continuum. Logically, regulation and taxation of e-cigs should, for now, be substantially less than those facing cigarettes.

Beyond e-cigs, Philip Morris International is betting big that its heatable cigarettes will be a hit. Although the tobacco industry has seen several failed attempts at commercializing heatable cigarettes (namely Philip Morris' Heatbar and R.J. Reynolds' Eclipse cigarette), Philip Morris International is in the process of investing more than EUR 500 million to bring to market two new heatable cigarette products. These products have already had successful trials and should be available in test cities later in 2014. Should the Food and Drug Administration approve these tobacco products, Altria will have the right to sell them in the U.S.

Still, we believe that in the coming decade, cigarettes will remain the primary source of nicotine for the world's 1 billion tobacco users. Smoking is an addiction, and it is a challenge to change behaviors and brand loyalties. As such, we believe the moaty characteristics of Big Tobacco's proven business models (which include strong brands and low-cost production) should yield healthy dividends for tobacco investors for years to come.

Our Top Consumer Defensive Picks
Roughly two thirds of the 100 or so consumer defensive companies we cover hold either a wide or narrow economic moat, evidence of strong scale and brand name advantages. The sector still trades at a relative discount to the broader Morningstar universe, and we see several opportunities for long-term investment in wide-moat companies.

Top Consumer Defensive Sector Picks
Data as of 3-18-14.

Unilever NV (UN)
Star Rating: 4 Stars
Fair Value Estimate: $45.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 0.82
Concerns regarding slowing global growth have created an interesting buying opportunity for Unilever's shares, which now trade at a price/fair value estimate of 0.82. The company is reducing the complexity of its widespread operations and has generated underlying revenue growth in the midsingle digits, reflecting a balanced contribution from volume gains and price increases (which we view positively). As the third-largest packaged food firm in the world (behind Nestle (NSRGY) and Mondelez (MDLZ)) and one of the largest global household and personal product firms, its top 14 brands generate more than EUR 1 billion in sales each year. A broad portfolio gives Unilever negotiating leverage with retailers, while size and scale enable it to realize lower costs than smaller rivals.

Philip Morris International (PM)
Star Rating: 4 Stars
Fair Value Estimate: $90.00
Economic Moat: Wide
Fair Value Uncertainty: Medium
Price/Fair Value: 0.90
With a strong presence in emerging markets and a portfolio skewed toward premium brands, we think Philip Morris' underlying business is well positioned to deliver long-term earnings growth. In our opinion, the recent pullback in the company's stock probably stems from continued softness in Europe and weakening emerging-market currencies, which will probably provide a stiff headwind to near-term financial results. Still, we believe investors benefit from the firm's wide economic moat bolstered by strong brands (in particular Marlboro), leading market shares, geographic diversity, and an addictive product, and we project the company's revenue will increase 5%-6% annually with earnings per share climbing at a 9% clip.

Coca-Cola (KO)
Star Rating: 4 Stars
Fair Value Estimate: $44.00
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 0.87
Management remains committed to Coke's 2020 vision and its long-term growth algorithm (which includes high-single-digit growth in constant currency EPS). Even though Coke's 2013 volume growth was tepid--partly the result of emerging-market headwinds--we believe the firm's economic moat remains wide with a strong brand portfolio that commands pricing power. Longer term, we believe that Coca-Cola will benefit from rising per capita emerging-market consumption across its entire beverage portfolio, as government-led wage rate increases and infrastructure investments, a flight to urban centers, and younger populations are all conducive to favorable emerging-market disposal income trends. This should help drive volume growth of 3%-4% and sales growth of 5%-6%.

Nestle (NSRGY)
Star Rating: 4 Stars
Fair Value Estimate: CHF 71.00
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 0.91
Even in challenging market conditions, Nestle remains an important partner for retailers across the globe. In its most recent quarter, the firm said that it was forced to lower prices for some product lines and that pricing remains difficult in categories such as bottled water, and we believe commodified categories are likely to remain highly competitive. However, consumers, particularly millennials, are willing to pay a premium for functional consumer staples products, and we believe Nestle's repositioning as a health and wellness company will help the firm raise prices and increase margins in the long term. We continue to believe Nestle is in a relatively strong position to negotiate with retailers for primary shelf space in stores, and we've afforded the firm a wide moat.

Wal-Mart (WMT)
Star Rating: 4 Stars
Fair Value Estimate: $80.00
Economic Moat: Wide
Fair Value Uncertainty: Low
Price/Fair Value: 0.93
Wal-Mart's shares have underperformed the retail sector in recent months, weighed down by market concerns about trading up at one end of the consumer spectrum and continued dollar store shopping at the other. However, an improving employment picture should bolster results as low-income consumers return with greater disposable income. We also think the international segment opportunities in nontraditional emerging markets have been underappreciated. At a 6% free cash flow yield and 14 times earnings despite one third of cash from operations funding growth capital expenditures, this stable firm has upside, in our view.

Neither Ken Perkins nor Philip Gorham own shares in any of the securities mentioned above.