Morningstar Magazine - February/March 2018 - 66

Investors

Tightening the Belt
Consumer defensive companies are
cutting costs to offset sluggish growth.

SECTOR RAP

Laura Lallos

Consumer defensive companies are facing
increasing competition from hard discounters and
e-commerce, as underscored by the recent
entry of Amazon.com AMZN into grocery retailing.
Amid weak growth, many of these firms are
laser-focused on efficiency. With top-line trends
still languishing, management teams are
also pursuing sweeping changes. To learn more
about the challenges and opportunities in the
sector, I spoke with Morningstar's Philip Gorham,
who covers a number of the global players
as director of equity research, Japan. Our
conversation took place on Nov. 21 and has been
edited for length and clarity.
Laura Lallos: You noted in your recent sector report1

that the consumer defensive category is becoming
increasingly commodified. Will it become more difficult
for companies to build and maintain moats in this
sector? Are we going to see fewer Morningstar Best
Ideas here?
Philip Gorham, CFA, FRM, is
director of equity research, Japan.

or sell through third-party online distributors
like Amazon, they have an opportunity to
gain traction with the consumer that just wasn't
available five to 10 years ago. That won't
necessarily lead to fewer Best Ideas because
there's a valuation element as well. A stock
can be cheap regardless of the width of the moat,
but our valuations assume a slower-growth
environment in the medium term.
How disruptive is Amazon's acquisition of
Whole Foods?

Gorham: It's disruptive because they are
competing on price, and it's particularly harmful
for the branded food manufacturers.
Whole Foods plays into the high-end/artisan/
natural niche. If that segment of the market grows,
it probably comes at the expense of the
mainstream Nestlé NSRGY and General Mills GIS
market and regular supermarkets. Of course,
any sort of competition on prices is in general
negative because growth is slowed from
where it was even three years ago. Before the
financial crisis, organic growth was consistently
4.5%, 5% in this space. They can't get that
kind of growth anymore. They don't have the
pricing power that they did a few years ago.
The presence of hard discounters is growing
in the United States. Why is Aldi a greater threat than,
say, Walmart?

Gorham: E-commerce is a risk to moats. The
barriers to entry to get into an Amazon distribution
center, for example, are much lower than
they are for getting on the shelf in Kroger KR
or Walmart WMT. Whether companies go directly
to the consumer, like Dollar Shave Club,

1 Gorham, P. 2017. "Consumer Defensive Sector Report." Sept. 27.

66

Morningstar February/March 2018

Gorham: The hard discounters primarily sell
economy-end private label; 90% to 95% of their
merchandise is private label. Only a very
small amount of shelf space is allocated to
branded products. Nestlé sells some in Continental
Europe, but it's not a big market. If you look

at markets like Germany, Netherlands, and the U.K.,
the combined market share of Aldi and Lidl is
up to anywhere in the range of 10% to 15%. That's
a significant chunk of the market that in
a short space of time become unavailable to
branded-foods manufacturers.
It's indicative of the consumer being more price
conscious since the financial crisis. People
have become accustomed to shopping around, and
they see value in private labels in some cases.
If you have a favorite mayonnaise or soft
drink, you'll go to Walmart to find it. But you may
view, say, household detergents, as more
commoditized. If something cleans your kitchen
sink, it cleans the sink, so perhaps you'll trade
down and go to Aldi.
The consumer is more prepared to evaluate brand
value, price, and transparency. The availability
of pricing online facilitates that, and e-commerce
contributes to the availability of cheaper
options to branded products. All of this points
to continued pressure on pricing power.
So, manufacturers are instead looking to drive earnings
growth through margin expansion. What strategies
are they using?

Gorham: A number of things are going on.
There's footprint rationalization. Kellogg K decided
in early 2017 to shift entirely from a directstore delivery platform to a warehouse model.
Procter & Gamble PG in the second quarter
said they significantly cut back on social media
advertising, and it hadn't made any difference to their sales growth rate. Companies threw
money at social media marketing and
are now starting to evaluate the bang for the
buck there, particularly across the more
commoditized categories like mainstream personal
care and food.

Something else they're looking at is how to
optimize spending on R&D. How do you
push resources to the fringes, to the local markets
where smaller regional products are driving
growth? Think about Nestlé. Their top line is about
$90 billion a year in sales. That is an enormous
http://www.Amazon.com
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