Our outlook for consumer defensive stocks

Despite this, we contend that the ultimate winner depends on the category at play, and analyzed how various areas of the grocery store stack up with regard to their bargaining power over retailers. We looked into the degree of concentration among the top companies in the category, the amount of private-label penetration, the level of returns on invested capital generated by the median firm in the industry, and the number of wide-moat firms in overall category coverage. Based on our analysis, the tobacco industry is highly concentrated and enjoys outsized returns on invested capital combined with a lower level of private-label penetration (or conversely, a high degree of brand power). Subsequently, we view tobacco firms (such as   Philip Morris International  PM and   Altria Group  MO) as the most aptly positioned in the battle for power with retailers. Conversely, the packaged food industry trails the other groups in nearly every metric we examined, and as a result, we contend that retailers possess the highest degree of pricing power over food manufacturers as compared with other consumer product categories.

But because retailers still depend on strong, market-leading brands to drive store traffic, possessing more leading products to offer across categories can enhance a manufacturer's negotiating position (irrespective of the category in which it plays). Deciphering the strength of a brand (on a global or local basis), though, can be more or less esoteric. There are no meaningful switching costs between products, and consumers have a choice of multiple brands in almost every category. But in our view, a strong brand is one in which higher prices don't materially hinder volumes (and ultimately market share). However, if a firm slips with regards to product innovation and the essential marketing support needed to keep consumers loyal to a brand, this eventually shows up in the financial results (such as with volume declines), which may lead to a deterioration in a firm's economies of scale. On the other hand, if a company's products are taking share (and this has proved sustainable over time), it is likely the firm is leveraging its scale more efficiently.

Even leading retailers and dominant branded manufacturers can butt heads, though. For instance, in November 2009,   Costco  COST temporarily stopped restocking some   Coca-Cola  KO products in its stores throughout the United States after the beverage giant refused to cut the prices it charged to the retailer. However, the game of chicken did not last long, as Costco began carrying Coca-Cola products after a mere three-week standoff. We were not surprised to see a quick resolution to the pricing dispute between the world's largest soft-drink manufacturer and North America's third-largest retailer, as both parties had a mutual interest in ending the conflict amicably. At the time, we thought the outcome of the price war suggested that Costco's narrow moat was strengthening, while Coke's wide moat remained intact. The fact that Coke yielded to Costco's demand implies that the warehouse club's leverage over suppliers may be growing, possibly strengthening its narrow economic moat. On the other hand, the apparent weakening of Coke's pricing power suggests that its economic moat may have eroded just slightly in North America. However, given its enormous scale advantages and brand recognition across the globe, we still place Coca-Cola firmly in the wide economic moat category. Ultimately, we believe the true winner in these clashes (which are bound to resurface from time to time) is the consumer.

Branded manufacturers aren't just competing with each other, however, as consumers' growing acceptance of lower-priced private-label offerings has added another ripple to the dynamic pricing struggle between retailers and consumer product firms. Consumers appreciate the lower price point, while retailers view these higher-margin sales as a plus. But, private-label products have failed to permeate all product categories evenly. Price tends to guide purchasing decisions for products consumed more regularly, while items related to health and beauty often garner a premium. For instance, categories most susceptible to private-label penetration are those that are faster-turning and possess very little product differentiation, like milk, fresh bakery and produce. Our analysis shows that the number one and two brands in each respective category typically still wield meaningful bargaining power over retailers. However, if a brand is the number three or number four product in a particular category, it is likely that retailers may look to rationalize stock-keeping units (SKUs) and introduce their own private-label products, rather than offering too many competing branded products. This is particularly true with retailers like Costco (Kirkland),   Kroger  KR (Private Selection),   Safeway  SWY (O Organics) and   Loblaw  L (President's Choice) becoming more adept at developing quality and branding for company-owned labels.

However, moving outside of the U.S., private-label offerings have garnered a greater share of consumers' spending, and as a result, the question repeatedly surfaces as to whether the penetration of lower-priced value offerings will ultimately trend in that direction in the United States. For instance, the value share of private-label products is as high as 49.2% of all fast-moving consumer goods (FMCG) products sold in the United Kingdom (which compares to around 20% in the U.S.). And while these stats may suggest that private-label offerings could continue gaining a larger slice of the pie in the U.S., we don't think private-label products will ultimately garner the degree of market share of their European counterparts. In fact, Sainsbury, a leading European retailer, recently recalled that about 10 years ago its private-label penetration peaked at around 60%, but consumers seemed to be turned off at that level, and private-label offerings now make up closer to 50% of their business. We think this supports our stance that consumers prefer a variety of brands rather than simply value products.

So how do branded consumer product firms battle the fierce competition value offerings are dishing out around the world? Leading consumer product firms invest heavily in product innovation to ensure their products resonate with consumers (a topic that has gotten increasing airplay this year), which ultimately differentiates national brands from private-label products (where innovation tends to be lacking). However, not all new products are successful. 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 market research firm SymphonyIRI. As such, another avenue explored by branded consumer products firms has been to utilize promo­tional spending to manage the price gap (the difference in price between higher-priced branded products and lower-priced value offerings); however, we don't view lower prices as a sustainable and profitable strategy for the long term (as the lack of success realized from similar efforts over the past few years indicates).

Beyond coming to market with entirely new products, recent experience suggests penetrating alternative outlets and adjusting pack sizes should better position consumer product firms. For example, Nestlé 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 is growing two times faster than the rest of Nestlé's portfolio. In addition, these offerings lend themselves to the dollar-store and instant-consumption channels, and as a result, management contends that PPPs will be a means of growth for Nestlé's business for years to come.

However, one branded manufacturer that has taken a completely different stance is   ConAgra  CAG. We've long believed that ConAgra is at an even greater competitive disadvantage than its peers in that it operates with a portfolio of second- and third-tier brands, which fail to garner the same level of pricing power. But by extending its portfolio beyond these lacklustre brands (with the addition of Ralcorp's private label business earlier this year), the firm may be able to benefit as consumers opt for lower-priced products and retailers increasingly tout value offerings. Ralcorp's portfolio includes cereals, pasta, frozen bakery, snacks, sauces and spreads--which fails to meaningfully overlap with the branded categories where ConAgra already competes. Management contends this distinction is what will ultimately enable it to succeed in both segments of the market even though others have failed, although we aren't entirely convinced as of yet.

The Amazon effect

Competitive forces within the retail landscape are also heating up. In July,   Amazon  AMZN rolled out its AmazonFresh online grocery business to parts of Los Angeles, with plans to expand to the San Francisco market later this year and as many as 20 urban markets in 2014 (including international markets). This development follows five years of testing the AmazonFresh program in Seattle, and we believe the program will be facilitated by Amazon's existing fulfillment center network. Consumer adoption rates are the key to success for AmazonFresh, but we believe there is adequate consumer demand to support online food/consumable sales, and Amazon's low-cost advantages should make it a formidable player for market share.

It will take time for Amazon to forge the appropriate supplier relationships to accelerate consumer adoption rates (particularly in the fresh food and organic product categories), but given its wide consumer reach and expansive fulfillment center network (which now stands at more than 46 locations spanning 33.6 million square feet in North America, according to supply chain consultant MWPVL), we believe consumer packaged goods companies will be eager to partner with AmazonFresh (especially given the capital requirements needed to build out their own online distribution capabilities).

Presently, the U.S. online grocery market (a small percentage of the US$850 billion in food and beverages purchased for off-premise consumption in 2012) is highly fragmented (with an estimated 1,500 industry participants) in North America with the top three players (Peapod, FreshDirect.com and Safeway.com) making up less than 20% of total sales. But over the next five years, we expect U.S. online grocery sales to grow at a mid-teen clip, fuelled by increased food/grocery offerings from larger online retailers, consumer adoption of online food purchases, technology advancements and increased urgency among traditional grocers to adopt what we consider to be an inherently more efficient business model generating significantly less waste. This equates to almost US$25 billion in online food sales by 2017, with online grocers growing at a slightly faster pace than direct sales from consumer product companies themselves. If we assume that traditional grocers grow at roughly inflationary growth rates (approximately 2.5%) over the same time period (implying US$960 billion in food and beverage purchases by 2017), online food retailers will have doubled their market share by 2017 to almost 3% versus 1.4% today.

We believe this fragmentation gives the upper hand to consumer packaged goods companies, which online grocers need to establish credibility and drive traffic. Nevertheless, we believe the rollout of AmazonFresh across major urban centers in 2014 could be a key turning point in the evolution of online grocery sales, much like   Wal-mart's  WMT introduction of supercenter formats in the late 1980s. Because the online channel is too large to ignore (particularly Amazon's wide reach), we expect it to be a partner of choice for consumer packaged goods companies, even if it comes at the expense of margins.

A critical concern for consumer product companies is to ensure that its prod­ucts are positioned in channels where consumers are purchasing, and because consumers are getting increasingly comfortable purchasing packaged goods online, we think consumer product firms that garner a foothold in this space could get a leg up on the competition. Further, by distributing products online, consumer product firms could reach new customers more efficiently as well as trial pending product development ideas. Overall, however, we still think the consumer is the ultimate winner in the battle between retailers (both traditional and online) and consumer product firms, getting the products they demand through the channels they prefer.

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 Defensive Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
	Clorox		$95.00	Narrow	Low	$76.00
	Coca-cola		$45.00	Wide	Low	$36.00
	Nestle		$75.00	Wide	Low	$60.00
	Philip Morris International		$95.00	Wide	Medium	$66.50
	Unilever		$45.00	Wide	Medium	$31.50
	Data as of 9-20-13

  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. Shares 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. 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.

Nestlé
The diversity of Nestlé'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 favourable shelf space at retailers and charge premium prices for many of its products. Nestlé 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 Nestlé, 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
With 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.

  Unilever  UN
Beyond 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. We're also impressed by Unilever's cash flow generation (EUR 4.9 billion or 9.5% of sales in fiscal 2012), which indicates that the global consumer products firm is realizing the benefits of its efforts to reduce the complexity of its supply chain. We think this will enable Unilever (which is attractively valued) to continue investing behind its brands, pursuing acquisition opportunities as they arise, and returning excess capital to shareholders.

Please see our detailed take on each sector in the reports that follow.

•  Our outlook for the U.S. economy
•  Our outlook for the U.S. stock market
•  Consumer cyclical
•  Basic Material
•  Energy
•  Tech&Telecom
•  Health Care
•  Financials
•  Utilities