Our outlook for consumer defensive stocks

Modest pockets of value emerge among consumer defensive companies.

Erin Lash, CFA 29 June, 2013 | 2:49AM
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Although we contend that a lower discount rate is warranted for a handful of the moaty consumer defensive firms we cover, we still believe the market's longer-term growth assumptions remain slightly inflated.
Despite rumours to the contrary, we think smaller, strategic tie-ups rather than larger transformational deals will likely take top billing in the consumer defensive space over the near term.
The growing popularity of electronic cigarettes is both a threat and an opportunity for Big Tobacco.

Market's long-term growth assumptions remain inflated

Beyond the favourable characteristics of the consumer defensive space (sustainable competitive advantages and robust cash flows), we also think that 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 see this as sustainable over the longer term. We caution that investors could revise required returns upward when interest rates rise, which would detract from total returns on consumer defensive stocks despite steady dividend payments and earnings growth.

However, upon further analysis, we now believe that an 8% cost of equity, down from 10% previously, is warranted for some of the non-alcoholic-beverage and consumer product firms we cover -- Coca-Cola KO, PepsiCo PEP, Clorox CLX, Colgate-Palmolive CL, General Mills GIS, McCormick MKC and Procter & Gamble PG -- in light of their consistent cash flows and competitive clout, in the form of solid brands combined with vast geographic reach. Supporting our stance that below-average systemic risk for these firms has merit is the fact that leverage for these operators tends to be modest compared with peers.

As a result, we've increased our fair value estimates for this handful of consumer defensive companies; however, these changes merely reflect our lower discount rate rather than a change in the assumptions underlying our discounted cash flow model or our moat assessments, all of which remain in place. After incorporating these changes, our fair value estimate for Clorox is now $92 per share, up from $81, implying fiscal 2014 price/earnings of 20 times. We've increased our fair value estimate for Colgate to $57 per share from $50 (adjusted for the firm's recent 2-for-1 stock split), implying forward fiscal 2013 price/earnings of 21 times. Looking at General Mills, our fair value estimate is now $48 per share, up from $41, implying fiscal 2014 price/adjusted earnings of 17 times. Our fair value estimate for McCormick is now $72 per share, up from $65, implying fiscal 2014 price/earnings of 20 times, and we've increased our fair value estimate for Procter & Gamble to $83 per share from $70, implying forward fiscal 2014 price/adjusted earnings of 19 times. With regards to the beverage manufacturers, we've increased our fair value estimate for Coca-Cola to $45 from $41 and our PepsiCo fair value estimate to $88 from $75, which imply a value of roughly 20 times 2014 earnings for Coca-Cola and 19 times for PepsiCo.

Even with our updated cost of capital assumptions, we believe the market is pricing in appropriate to slightly aggressive growth assumptions for our consumer staples universe, generally along the lines of high-single-digit revenue growth, low-double-digit operating income and cash flow growth, and high-double-digit earnings per share growth (when factoring in buybacks, which historically can prop up earnings growth by about 2% to 3%) over a longer horizon. While consumer staples tend to have economic moats, these assumptions strike us as mildly aggressive based on macroeconomic trends and industry pricing and volume movements. Regarding the companies affected by our cost of capital assumption changes, Clorox, Coca-Cola, Pepsi and Procter & Gamble trade at slight discounts to our revised fair value estimates, while General Mills and McCormick are trading in line with our updated fair value estimates, though with our low uncertainty ratings, we would not require much margin of safety before taking a position. Conversely, Colgate continues to trade at a premium to our increased fair value estimate, and we'd suggest investors wait for a more attractive entry point before initiating a position in this name.

Smaller, strategic mergers likely to take top billing

Recently, the consumer defensive space has been abuzz with talk about whether further consolidation could be in the cards. In fact, Berkshire Hathaway BRK.A BRK.B and 3G Capital's $28 billion deal ($72.50 per share) to scoop up Heinz (which only recently closed) sparked a round of flurried conversations on the topic. From our perspective, the packaged food industry has been ripe for value-enhancing transactions -- both marriages and divorces -- for quite some time, and this most recent deal is just another notch in that playbook.

In that light, we doubt that the Heinz deal is a precursor to further deals, although when asked, management groups at this year's Consumer Analyst Group of New York conference earlier this year 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 favourable interest rate environment).

More recently, David Murdock, chairman and CEO of Dole Food DOLE and the firm's largest shareholder (owning 40% of the shares outstanding), made an offer (valued at $12 per share or $1.5 billion) to take the company private for the second time in 10 years. Dole has struggled at the hand of the volatile commodity cost and pricing environment inherent in the fresh fruit business, and so this announcement was not all that surprising but rather strikes us as another instance of investors looking to pursue value-enhancing deals.

Instead of larger transactions, we believe it is more likely that consumer defensive firms will continue to use excess cash to build out their distribution platforms at home and abroad -- pursuing smaller, bolt-on transactions. Firms like Mondelez International MDLZ (which likely has its sights set on emerging-market players), Hershey HSY (which is targeting sales of $10 billion by 2017, an unlikely achievement without the benefit of an acquisition) and Sysco SYY (which has been quite active on the deal front for the last several quarters) all have suggested that targeting smaller, family-run businesses could be in the cards. We view this positively, as these deals offer 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.

However, this failed to quell rumours that activist investors are seeking to drive a larger industry shake-up. For one, in April 2013, PepsiCo acknowledged that it had been discussing various alternatives to drive long-term growth and shareholder value with Trian Fund (which is run by activist investor Nelson Peltz). Given Trian's holdings of both Pepsi and Mondelez stock, and that Mondelez CEO Irene Rosenfeld is a PepsiCo alum, rumours have circulated that PepsiCo could look to acquire Mondelez. At first blush, we believed the potential combination of these two wide-moat behemoths would strengthen their competitive advantages. Both PepsiCo and Mondelez have strong brand portfolios (including Pepsi, Lays, Oreos and Ritz) that carry solid pricing power and are demanded by retailers and consumers. In addition, combining portfolios could result in manufacturing and distribution synergies. We estimate that within four years of the deal, $1.8 billion of cost synergies could be generated, representing roughly 4% of our forecast for Mondelez's 2016 annual sales.

Should a deal occur, we believe Mondelez shares could be purchased by PepsiCo for about $38 (a 30% premium to our base scenario) and Pepsi shares could rise to $94 (a 7% premium above our base scenario). Excluding synergies, we think a potential deal would value Mondelez at 13.8 times EV/EBITDA. However, EV/EBITDA would drop to less than 11 times when including $1.8 billion of synergies we expect the firms to realize. These synergies equate to 4% of Mondelez 2016 revenue (compared with 3%-7% synergies as a percentage of sales obtained from other packaged food acquisitions). We believe that PepsiCo could finance what would be an $82 billion deal with a combination of debt ($46 billion), stock ($32 billion) and cash ($4 billion).

While we initially assigned a 25% probability of a PepsiCo-Mondelez deal, recent management commentary seems to suggest that a tie-up is far less likely. More specifically, at a conference, Pepsi CEO Indra Nooyi emphatically denied that her company would need to pursue an acquisition, saying that "we do not need any transformational M&A to accomplish our goals. And we are very happy with the PepsiCo portfolio and that's how it's going to be." In addition, bond rates have drifted higher, which would make such a deal less financially appealing than it would have been just a few months earlier. As such, the odds are in favor of both PepsiCo and Mondelez continuing to operate as stand-alone companies for the foreseeable future.

Electronic cigarettes create threat, opportunity for Big Tobacco

U.S. cigarette consumption has been on a downward spiral for some time, and as such, cigarette manufacturers have been looking to build out their portfolio set. American smokers are increasingly turning to electronic cigarettes as an alternative, and we believe this popularity could represent an inflection point. Following Lorillard'sLO 2012 acquisition of blu, its e-cigarette availability at retail has greatly expanded (50,000 points of distribution at year-end 2012, compared with 10,000 at the time of acquisition) and we believe the e-cig market will likely top $1 billion in sales during 2013. However, electronic cigarettes are still new, opening the door for potential regulatory risks. It is possible that lawmakers could look to blunt segment growth by implementing new regulations or taxes on the burgeoning category. If electronic cigarettes eventually make up more than 5% of total cigarette market, or if they are proved to be medically harmful, we believe it is highly likely that the federal government and some states will look to levy excise taxes on e-cigs.

Although numerous small, privately held firms control much of the e-cig market, the marketing might and distribution network enjoyed by Big Tobacco could squash many smaller competitors. Lorillard's 2012 acquisition of blu e-cigs clearly puts the firm at the forefront of this new and growing market. However, we believe other large tobacco firms including Altria Group MO, Reynolds American RAI and Philip Morris International PM have the financial means to either acquire privately held e-cig makers like Lorillard did, or develop and market new electronic cigarette solutions. In fact, in August, Altria will launch the MarkTen e-cig brand into parts of Indiana. The product will be available as either a disposable e-cig or a rechargeable device with both menthol and tobacco flavor offerings. Further, Reynolds American, the second-largest American tobacco company, recently entered the fast-growing electronic cigarette market by launching its VUSE Digital Vapor Cigarette in Colorado. VUSE was created within the company's wholly owned subsidiary RJ Reynolds Vapor Company, and we expect that later this year and next, Reynolds will conduct a broader rollout of VUSE across the United States. Although the electronic cigarette category is growing quickly, we believe that it will likely be several years before VUSE generates meaningful operating income.

During a CNBC interview concerning VUSE, Reynolds CEO Daniel Delen said that the company "designed the product to be margin enhancing." However, even though electronic cigarettes are not burdened by excise taxes or master settlement agreement payments, we are somewhat skeptical of this claim. We forecast that Lorillard, which already has scale in the e-cig market and sells the product online, is unlikely to generate e-cig margins above 20% for about three years. Given that VUSE does not plan to have an Internet presence, lacks the scale of NJOY and blu, and the competitive environment is much more fragmented than the cigarette market, we are unconvinced that VUSE's margins could approach the roughly 30% margins generated from Reynolds' RJR cigarette business anytime soon.

Meanwhile in the international markets Philip Morris International said that it is conducting clinical studies and expects to expand its studies in 2014. And the firm is putting its money where its mouth is: Over the next few years, PMI intends to invest an incremental 500 million euros in order to build a manufacturing footprint capable of producing around 30 billion next-generation products (NGP) per year (roughly 3% of PMI's cigarette volume). Additionally, we wouldn't be surprised if Lorillard, Altria or Reynolds eventually tried to market their e-cigs in international markets, thereby stepping on the toes of Philip Morris, British American Tobacco BTI, Japan Tobacco and Imperial Tobacco Group.

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. Whereas there are numerous privately held e-cig companies that sell their products online, these major tobacco companies have the financial might and vast distribution systems to more broadly capture the growing market opportunity surrounding electronic cigarettes. The big risk remains if the e-cig category takes off, market shares could shuffle and operating margins could decline. Given this risk, we think it makes sense that market leaders Altria and Reynolds are doing small-scale e-cig rollouts (to prevent cannibalization of their high-margin cigarettes while learning more about the category) and that Lorillard (about 14% market share) opted to acquire blu (a leading national brand) which is more likely to poach Marlboro and Camel smokers than cannibalize its own Newport customers.

Our top consumer defensive picks

While several names in the space look fairly valued or slightly overvalued at the current market price, we still see a few pockets of value today. 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 Cyclical Sector Picks
Star Rating Fair Value
Fair Value
Clorox $92.00 Narrow Low $73.60
Coca-Cola $45.00 Wide Low $36.00
Pepsi $88.00 Wide Low $70.40
Procter & Gamble $83.00 Wide Low $66.40
Molson Coors Brewing $55.00 Narrow Medium $38.50
Data as of 6-24-13

Clorox CLX
Clorox competes in categories with high levels of private-label penetration and derives the bulk of its revenue from mature, developed markets, but we think its strong brands--the basis for its narrow economic moat--are driving healthy results. We've long believed Clorox's brand equity and continued investment in product innovation are a plus. The strength of Clorox's brand portfolio is evident in the fact that since 2005 the firm has taken 66 price increases, of which an impressive 64 remain in place. The shares trade at 20 times our fiscal 2014 earnings estimate, and appear modestly undervalued relative to other names in the household and personal care space.

Coca-Cola KO
Coca-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. While we believe volume growth during the next decade will be led by emerging markets, we also think Coca-Cola's 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.

PepsiCo PEP
Pepsi's strengths go well beyond the Pepsi-Cola brand. The company's snacks business is a dominant force in the highly profitable North American snacks market and holds commanding share in many other countries. Pepsi's wide economic moat is bolstered by 19 brands that garner more than $1 billion a year in retail sales and are distributed through its vast distribution network. Additionally, the company's marketing and research might is focused on developing new products that please consumers. The shares strike us as somewhat attractive at the current market price.

Procter & Gamble PG
P&G operates with a portfolio of leading brands across the household and personal-care arena, making its products essential for retailers to drive traffic in their stores. With its market share in some categories slipping, P&G needed to roll back some of the pricing it had taken previously to offset commodity input costs. Despite its challenges, we still regard the firm as a wide-moat giant that enjoys the benefits of scale with an extensive global manufacturing and distribution network and unprecedented brand reach. Trading at 18 times our fiscal 2014 earnings per share estimate (versus the 19 times implied by our recently revised fair value), the shares strike us as mildly attractive at the current market price.

Molson Coors Brewing Company TAP
While we believe that shares of Molson Coors remain undervalued versus our fair value estimate, we note that there is no likely near-term catalyst. Molson Coors' volumes predominantly come from mature markets that have limited growth opportunities. Nonetheless, we believe the current share price is attractive, and expect that as the employment situation in the United States improves, Molson Coors' MillerCoors joint venture should see improving financial results.

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Erin Lash, CFA

Erin Lash, CFA  Erin Lash, CFA, is a director of consumer sector equity research for Morningstar.

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