Morningstar Magazine - February/March 2018 - 67

business with a huge global footprint. To move the
needle on the sales numbers, they are spending
on the blockbuster R&D ideas. But growth is
actually being driven regionally, by multiple smaller
product innovations. So, how do they strike a
balance between the large ideas and making sure
that regional managers with their finger
on the pulse of local tastes and trends get enough
resources? How do they trim R&D spending
but still maximize the bang for the buck? We've
seen restructuring around that.
The entrance of [activist investor] 3G Capital
a couple of years ago, when they bought
Anheuser-Busch InBev BUD and Kraft Heinz KHC,
is really changing the way these companies
will be run. Shareholders are demanding that
management teams focus more on shareholder returns. Their delivery of shareholder
returns, in an environment of very little
growth, by people with very little experience
in consumer products, is making people sit
up and take notice.
What they did is introduce zero-based budgeting.
With an annual budget, as managers get
to this time of year and realize they haven't spent
it all, they start spending on marketing they
don't need or taking trips. That's wasted spending.
With zero-based budgeting, people have
to justify spending throughout the course of the
year. They've introduced an enhanced focus on
cost management and cash management in ways
that weren't implemented in the past.
It's not a light switch to be turned on at every
company. It's cultural; it's an ethos that
runs throughout the organization. Everybody has
to buy in, which means you have to financially
incentivize senior management, middle
management, employees at all levels. Those
companies that truly grab the bull by the
horns are most likely to succeed. The risk this
strategy poses is that you lose a bit of operational
flexibility. In the time it takes to have an
expenditure approved, you may, for example,
miss an investment opportunity. But where
management gets to grips with the cultural issues,
we'll end up with companies that are more
focused on cost, with greater financial flexibility
to compete on price.

The key point is that taking cost out is going
to be critical to reinvesting in the business and
trying to reignite lost growth.
What companies are particularly adept at zero-based
budgeting strategies?

Gorham: In addition to Kraft Heinz, definitely
Anheuser-Busch. It has expanded its
margins by 5% or so, and it is still taking costs
out of the SABMiller acquisition. I would
also point to Unilever UN. It's early in its case, but
it seems to be taking the right approach
to cost. There are a number of other firms, such
as Diageo DEO, where it's a little early to
judge execution.
What are your thoughts on activist investors
forcing cost-cutting? Could this be detrimental in the
long term?

Gorham: Some hedge funds aren't exactly
known for their long-term investing approach.
There is certainly a risk that some companies will
diverge from the optimal balance between
cost savings and top-line growth, growth of market
share. The risk is that they cut not just the
fat, but into the muscle of the business. Even
Anheuser-Busch, which has done a great
job of taking out cost, has underperformed in
terms of market share. Now, of course, light beer
would have lost share to craft beer over the
past five years in any case. But it has
underperformed even against brands in the same
product and price segment.

That said, the activist investors are absolutely
looking in the right place. These large-cap
consumer companies have been fat and happy for
a long time, and there are inefficiencies
to take out.
M&A activity was high in the third quarter, and
it sounds like it may continue to be a key theme here.

Gorham: We've got a continued window of
opportunity in terms of low interest rates. We've
got incentive because balance sheets are
a bit healthier. M&A is a catalyst for cost-saving
opportunity and, again, that's necessary
to drive growth. So, the incentive and the
opportunity are there, but the question
is, do valuations allow companies to create value?
The market in this space is at 19 or 20 times

earnings, so there has to be a significant
cost-saving opportunity.
There are not many consumer defensive names
on Morningstar's Best Ideas list right now.
You cover one of the few that make the list, Imperial
Brands IMBBY.

Gorham: That reflects the space at the
moment, and the fact that investors are jumping
on anything that looks cheap fairly quickly.
We took Anheuser-Busch and Danone DANOY
off the list recently purely on valuation.

For Imperial, it's all about heated tobacco
and who wins share in the longer term. The market
appears to be valuing tobacco stocks in a
hierarchy based on business exposure to heated
tobacco-which is tobacco inside a stick
about the size of a cigarette that gets heated
by a device to a temperature where the
nicotine gets released, but not to the point that
combustion takes place, so there's much less
smoke, no ash. Proponents of the technology say
it's the combustion that causes exposure
to harmful chemicals and carcinogens. Of course,
it's hard to get independent scientific evidence,
but if that's true, then this product should
reduce cancer risk. That would be an enormous
game changer. It would prolong the life cycle
of the industry; it would probably slow the decline
rate of consumption. It may even improve
pricing power and margins.
This device is probably coming to the states
next year; it's under review with the Food
and Drug Administration. There's quite a lot to like
about this, and I can get to a scenario where the
margins on these sticks are higher than those
on cigarettes. The market is obviously enthusiastic.
But the market is overlooking a couple of things.
First, you can't just take the growth rate in
one market and apply it to all markets, or take
today's growth rate and project it forward.
History tells us that the adoption of a disruptive
consumer product rarely happens in a straight line.
It almost always happens in an S-shaped
curve. You have fast growth early on, from the
early adopters jumping in. Then growth slows, and
later adopters look for something superior
about the product. They want to see that the

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