Consumer stocks and premium valuations
Current valuations and investor thinking do not seem to be in line with the ongoing disruption in the consumer space
It has become very fashionable these days for every investor to talk about buying consumer franchises and holding them forever. This is understandable as the strategy has worked remarkably well over the past few years. There are numerous consumer stocks in India which have delivered outsized returns for their investors. Many of these stocks now trade at nosebleed valuations. Forty or 45 times earnings have become par for the course. Still no one wants to sell. It has been drilled into these investors that one should never sell a consumer franchise with a strong moat. A moat is the competitive advantage of the company and is the reason it can generate high returns on capital.
There are very good reasons why consumer franchises trade at high valuations and at a premium to the market. These companies generate substantial free cash flow, have high returns on capital, penetration growth, and are seen to be very predictable and stable businesses. Such a predictable and growing cash flow stream is enormously valuable, especially in today’s global zero interest rate environment. The cash-flow streams are protected by the moats built around the business, be it brand, distribution, technology, etc. These moats give a sustainable competitive advantage to the business and are very difficult to dislodge.
The reality is that disruption is underway even in the consumer space. Be it packaged food or consumer products, the moats around these businesses are under threat. Current valuations and investor thinking do not seem to be adjusting for this oncoming disruption.
The classic consumer business model used to revolve around building a dominant brand through significant marketing investments and then dominating the distribution channels by blocking retail shelf space. Scale was a huge advantage as it allowed you to invest in national TV advertising (the most efficient tool for building a brand) and defray distribution and promotion expenses over a larger volume. Retailers supported this strategy as it suited them to deal with a limited supplier base straddling multiple products. Branded products were sold at a premium, therefore delivering greater absolute margin to the retailer. Retailers also demanded slotting fees to try out new products/ brands on the shelf. Once established, the brand and distribution edge were almost impossible to dislodge. This was then, today the reality seems different.
As Jeff Bezos has pointed out, because of the internet power is shifting to the consumer and away from the retailer and manufacturer. Consumers are taking greater control of what, why and how they buy. They are better informed. In this new world, companies need to spend 70 per cent of their energy and money into building a better product/service and only 30 per cent into shouting about and marketing the product to the world. This is the exact opposite of what was needed in the previous regime, where-in 70 per cent of effort was put into marketing.
All the incumbent advantages are being disrupted.
National television viewership is actually dropping for the younger demographics, with consumers spending more time online and on social media. Online, it is more of a level- playing field, unlike national TV, money is not everything. Smaller and more innovative companies are usually better than the incumbents at using social media and digital advertising to build brands.
With e-commerce, online retailers have unlimited shelf space. No longer is this an insurmountable edge for the incumbents. There is far greater willingness to experiment with new products and brands. The marginal cost for the online retailer of keeping an additional brand is near zero.
Scale is no longer the edge it once was. Consumers are also better informed and less willing to pay a brand premium.
For anyone in doubt, take the case of dollar shave club. Set up in 2011 by two men tired of being fleeced by shaving product manufacturers. It was an online subscription model selling a decent product at a deep discount to the incumbent. Within five years it had garnered almost 15 per cent volume share and had only raised $160 million in capital. It’s brand was built online through clever use of social media. It was a directto-consumer model with no retail gatekeeper to extract rent. The success of dollar shave club and other online models ultimately forced Gillette to drop prices by 20 per cent.
In the old world, Gillette would have been perceived to have an insurmountable moat. It dominated the retail channel, had 70 per cent market share and 90 per cent of the industry profit pool. It sold a non-substitute consumable. No one would have even dared to challenge its market position. Just to get any shelf space at all, the challenger would have had to make heavy upfront marketing investments. This was as strong a moat as could be seen in any consumer product. Yet in less than five years, it was disrupted, lost share and forced to drop prices.
There are many other examples of consumer disruption, mostly driven by Amazon and its use of Prime. Already more than 50 per cent of the searches on Amazon are based on the product and not the brand, allowing Amazon to customise the search results. The percentage of searches based on product rather than brand was less than 40 per cent two years ago. Clearly Amazon is gaining power over the brands.
In such a context, can we justify paying 40-45 times earnings for the consumer brand franchises? Maybe they were worth these multiples when they had a moat around the business which could not be challenged. However, the longevity of the moat must now be questioned. The competitive advantage period for these companies has clearly shortened. However valuation multiples and investor psychology do not seem to have adjusted to the new reality. These may no longer be buy and hold forever stocks. If Gillette can be disrupted so can almost any other brand. Disruption is not only in Tech. 3G capital has also demonstrated that the management teams of many of the consumer giants are not ready for disruption, they are too wedded to their old operating models.
If we do get even a mild derating, the stocks will be in trouble.