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STRAT DOC 1Q18 – RISING RATES AND “BOND PROXIES”

05 February 2018

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by Blake Allen

The Consumer Staples sector is particularly topical at present. It is rightly seen by many as comprising “bond proxies” because of the sector’s relatively stable earnings streams, and relatively high sensitivity to interest rates. But rising interest rates, which we think will be an important feature of 2018, could put pressure on the sector. We have responded to this risk in two ways: first, we are underweight Consumer Staples; second, we have continued to shift this allocation to the more attractively valued component of the sector. One such shift, executed during the prior quarter, was a replacement of Nestlé with British American Tobacco. In what follows we briefly discuss the logic of this move.

Nestlé has recently appointed a new CEO, Mark Schneider, who is pursuing an interesting and attractive turnaround story. The company’s earnings profile has languished over the last decade, reflecting a combination of margin pressure, sagging organic growth, and unfavourable currency trends. For some years, Nestlé counteracted disappointing earnings by raising its dividend payout ratio. But, with that ratio having now reached a 40-year high, at roughly 70% of earnings, this game is also apparently over. Nestlé must again deliver earnings growth, and that is Schneider’s objective.

Traditionally, the company aimed to deliver 5-6% p.a. organic sales growth, but weak emerging market (EM) volumes and soft developed market (DM) pricing have kept this number closer to 3% p.a. Schneider aims to get back to “mid-single digits” by 2020. Further, he aims to expand the company’s EBIT margin from its current 16%, to a goal of 17.5%-18.5% by 2020; this is to be effected largely through cost efficiencies, with some help from a better pricing environment. Successfully delivered, these targets could see Nestlé’s 2020 EPS about 37% higher than the 2016 base (an 8% p.a. CAGR). Furthermore, we note that Nestlé has untapped value in its relatively unlevered balance sheet (0.9x Net Debt / EBITDA ratio, versus a European peer-group at c. 1.5x). A relatively conservative debt funded buyback could, by our estimates, rebase EPS by +8%.

What is Nestlé’s likelihood of successfully delivering this value-enhancing strategy? On their organic growth targets, we think their odds look favourable: much of the weakness in DMs has been due to a deflationary price environment which is likely to start reversing. Provided EM growth remains respectable, the partial normalisation of DM pricing should put them very close to their organic growth ambitions. The company will still, however, need to invest in its products (e.g. through advertising) in order to reach these levels.

Nestlé’s margin targets, on the other hand, look more challenged. First, while there is indeed scope for cost-efficiencies, Nestlé has been cutting costs for some years already, so these may prove hard to come by. Second, the goal of growing volumes while simultaneously cutting costs may be challenging to deliver. Even if Nestlé is able to deliver its cost efficiencies, there is a significant risk that these won’t flow through into margin expansion, for much of the industry now has similar margin-expansion targets (including, but not limited to, some major players: Kraft Heinz, Mondelez, and Unilever). The risk, then, is that in margin terms they may have to take “two steps forward” in order merely to stand still. Indeed, Schneider has referred to the pervasive margin targets as an “arms race” which they watch with “some apprehension”. A successful outcome, then, is by no means in the bag, and may indeed prove out of reach.

How does this compare to the current share price? At a trailing PE of 24x, we think Nestlé’s share price is already discounting a fairly successful outcome. To deliver market beating returns from here, Nestlé would probably need to outperform the already sanguine growth and margin targets we have outlined above. Therefore, although we still think it is an extremely high-quality business, and will continue to follow the unfolding of its turnaround story, we no longer believe it offers sufficiently compelling value.

The value case for British American Tobacco (BAT) is, we believe, somewhat more attractive. It is grounded on an undemanding PE multiple, in both absolute and relative terms, a respectable long-term EPS growth outlook, and an attractive and growing dividend yield.

On the basis of management’s guidance, and BAT’s strategy for next generation products, we expect the company to deliver c. 4% p.a. organic revenue growth, and c. 10% p.a. constant currency EPS growth, over the medium term. This compares favourably with Nestlé’s “turnaround” story – c. 8% CAGR over the medium term. Further, one pays only a 16.5x fwd PE for BAT (Dec 2018), versus 21x for Nestlé. Similarly, BAT has a somewhat superior dividend yield: 4% in CY18, versus Nestlé’s anticipated 3.1%.

The main critique of the investment case for BAT is that the global tobacco industry is gradually shrinking (at a rate of about 1% p.a.). Thus, it could be argued, what appears to be a value gap may be merely a value trap. We think this conclusion is mistaken. Although industry volumes are indeed shrinking, for BAT these are more than offset by: (1) the effects of extremely high growth rates in next generation products (NGPs); (2) unit price increases which are typically inflation-beating, reflecting the industry’s extremely strong pricing power; and (3) actual and potential M&A activity.

At present NGPs only account for a tiny slice of BAT’s revenue, roughly 3.5% of 2018E revenues. Yet, at over GBP1bn this year, BAT’s NGPs should more than double their sales levels seen in FY17. Due to this rapid growth, NGP’s actually add a c. 2.5% growth tailwind to Group revenues.

From a longer-term perspective, these products could be as much as 40% of BAT’s revenue by the early 2030s. While it is true that that is over a decade away, the number illustrates the radical transformation which is afoot in some of the large Tobacco players. BAT’s strategy with NGPs is to pursue a “multi-product platform” including e-vapour, hybrid, and heating products. We find this strategy very attractive (compared to, say, Philip Morris’s focus on heat not-burn products) as it gives BAT exposure and experience to a far broader base, which can be ramped-up in focus areas as the NGP industry matures.

Regarding M&A potential, BAT is large enough to be an industry consolidator, but still small enough that there is material scope for acquisitive growth. Excluding China – effectively a closed market – BAT has a c. 23% share of global cigarette volumes. On this metric, BAT is again well placed.

Taken together, the potential for M&A and the extremely high-growth potential of NGP’s mean that BAT should deliver good EPS growth for some years to come, and we think management’s guidance of 10% p.a. EPS growth looks achievable. In our view, the current share price inordinately reflects the theme and associated negative sentiment of a shrinking tobacco industry, but insufficiently reflects the company-specific countervailing forces of NGPs and M&A potential. In light of these metrics, we decided to reallocate capital from Nestlé to BAT.

Figure 1: BAT versus Staples, an attractive value gap

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