“The consumer goods industry is in turmoil, I need to act now” – Stefan De Loecker, CEO of Beiersdorf, whose main brand is Nivea. 
The above quote and the consequent margin reset of Beiersdorf illustrate very succinctly the view we have had on the staples sector for the last few years.
There are multiple headwinds for the top line in this sector: lower volume due to a backlash against big brands and a rise of niche brands, low to zero pricing power (both with consumers and retailers) and slow and/or lacklustre innovation. The result is that organic growth, which reached high single-digit to low double-digit levels just before the financial crisis, has been coming down to the 3-4 per cent level.
To counteract this, companies tried to cut costs and increase margins. However, ZBB (zero based budgeting) and severe cost cuttings led to a reduction in marketing and R&D spend, which in turn led to the aforementioned slower innovation.
Our belief is that if you are a consumer-orientated company, it is imperative to invest in innovation and marketing to continuously keep your customers interested in your products. However, many large companies took the alternative approach and are now paying for it with low or even declining volumes.
An excellent example is KraftHeinz. Between 2014 and 2017, KraftHeinz’s margin expanded by close to 10 per cent with the result that volumes deteriorated and were consistently negative during 2017/18.
This was not sustainable. At the full year presentation, we learned that some brands suffered so badly in the wake of cost cutting and changing consumer tastes that their brand value had to be written down.
Both Kraft and Oscar Mayer brands saw their carrying value reduced by a combined $15.4bn. This was the big wake-up call the industry needed. We now expect to see companies increasing investment back to a more sustainable level in order to regain customers’ favour. However, this additional spending will drive down margins.
As the chart below highlights, for most companies Y2 forward margin expansion estimates have come back from the red dots to the blue dots since the start of the year. In the case of Henkel, Colgate and Beiersdorf, the market now expects margin declines over the next two years. We believe this might also be the case for other companies and that over the next couple of years we’ll see further margin misses and disappointments.
Source: Bloomberg, Societe Generale, company data
At Saracen we have reduced our exposure over recent years. However, we are not ruling out buying staples share again. The issue is that most of the defensive staples are still trading on close to 20x Y1 consensus PE, with the caveat that the consensus ‘E’ is probably too high. On this multiple, we could not justify owning these shares at present.
The exception to the rule is Mondelez. The company was spun out of Kraft in 2013 and represents mostly the old snacking business: biscuits, chocolate, gum and candy.
It had a slightly different strategy to most staple companies. Over the last few years it invested heavily in innovation and has excelled at bringing new and exciting products to the market. Also, when Dirk van de Put took over as CEO in April 2018, he made clear that his emphasis would be on top line growth and not margins.
Looking at Mondelez’s products, you would be forgiven if you thought they were in terminal decline as everybody is trying to eat more healthily and cut out chocolate and sweets.
However, the snacking industry is growing in high single digits in emerging markets and low single digits in developed markets, partly because of time constraints and more on the go eating due to longer commutes. Mondelez is trying to capture this with innovation like chocobakery, which combines Milka and Oreo, mindful snacking (smaller portion sizes) and improved ingredients: non GMO, wholegrain, gluten free, low sugar, high protein.
We also like the fact that private label exposure is very low and that Mondelez generates 40 per cent of its sales in emerging markets, which grew close to 6 per cent in 2018. We bought the shares in June 2018 and have already seen a strong rerating as the market is getting more comfortable with the company’s strategy and business model.
Another approach is to invest in advertising companies as the fall in the marketing spend of consumer staples companies, which so hurt the likes of WPP and Publicis in 2016-18, looks likely to be reversed. Our holding in Interpublic (IPG) plays to this potential. It is the fourth largest advertising and marketing services conglomerate globally.
Like all agencies IPG suffered in 2017 amidst the slowdown in ad spending, especially in the fast moving consumer goods (FMCG) industries. However, the company’s exposure to FMCG companies was relatively low compared to its peers.
Recently it has been gaining new contracts, which, added to its sector exposure versus WPP and Publicis, sets it up as the main winner among the top 4 global advertising companies. During 2018 the company singled out that the FMCG vertical was one of the top performing sectors for the group. Management put this down to its ability to adapt to rapid changes and gain contracts.
This trend should continue as the competition (WPP and Publicis especially) are only just starting to acknowledge the fact that their business models are too rigid and they will have to go through a transition period; something IPG did in the early 2000s, therefore being a decade ahead of its peers.
Interpublic posted 2018 organic revenue growth of 5.5 per cent and we expect this to continue into 2019-20. Margins increased by 70bps and again, there will be more to come. At 12x Y1 PE and with a 4.3 per cent yield, we view the valuation as very attractive.
Consumer staples took a wrong turn, stepping away from a focus on brands and detailed, on-the-ground consumer research and paid heavily for it. Currently a reset of the sector is taking shape but it is too early to tell whether this will turn matters around sufficiently for the stocks to become interesting to value investors.
There are still opportunities in this sector, either among some of the companies that stood apart from the rest and developed their brand or by betting on those firms likely to benefit from the return to an advertising and marketing focus among consumer staples companies.
Bettina Edmondston is a global analyst at Saracen Fund Managers. The views expressed above are her own and should not be taken as investment advice.