Morningstar Magazine - February/March 2018 - 68

Investors

product is cheaper, safer, cleaner-a better
mousetrap. If that's the case, then growth
eventually reaccelerates. If it's not true, then the
product will flop. We are very much still
in the early adopter stage, even in Japan, where
it's been a huge success, up to about 20%
of the market.
The market is also overlooking the margins.
Margins on the sticks might be high, but
I think we'll move to a razor-and-blade-type model,
where the devices are essentially given
away, probably at break-even or less, and the
margin's recouped through the sticks. So, it's very
early to be overexcited about this.

growing emerging-markets exposure as a
percentage of sales could be margin-enhancing
or margin-dilutive. As a growth driver, it's
generally quite important to have that exposure.
You're not going to get all your organic growth
from Western Europe or North America;
it's going to have to come from emerging markets.
But it depends. Some companies, particularly
the brewers, for example-Ambev ABEV in Latin
America, Heineken HEINY in Europe-
they're just in the right place at the right time.
They've got slightly premium brands, which
is perfect for the trade-up that's going on
in those markets. Over time, they should gain
share as the consumer trades up. But for

The key point is that taking cost out is
going to be critical to reinvesting in the business
and trying to reignite lost growth.
Philip Gorham

We've got Philip Morris International PM trading
at 19 or 20 times next year's earnings because
they are the category leader. In the middle, we've
got British American Tobacco BTI and Japan
Tobacco trading at 15 or 16 times; they are in the
game, but lag PMI. And then there's Imperial, with
no exposure to heated tobacco, trading at
around 11 times. That gap is historically extremely
high. I think it'll close, and it'll close from the
bottom up, because it's highly likely that Imperial
will move into heated tobacco sooner rather than
later. [Editor's note: After this conversation,
Imperial announced that it will test-market heated
tobacco products.]
How important is the growing emerging-markets
consumer base to companies in this sector?

Gorham: It largely depends on the individual
company and category that they're in;

68

Morningstar February/March 2018

high-end cosmetics such as Estée Lauder EL and
L'Oréal OR, or for distillers such as Diageo
and Pernod Ricard RI:FR, that opportunity is much
further away.
Valuation is an issue in this sector right now, but
is there a name you are particularly enthusiastic about
should a buying opportunity arise?

Gorham: Reckitt Benckiser RBGLY is becoming
interesting. I've covered this for a number of years,
and it's always traded slightly rich, in the
low 20 times earnings range, but it's sold off over
the past six months or so because of a number
of things that I think are fairly short term in
nature. If an investor has a 12- to 18-month time
horizon, I think we'll cycle through these issues.

One was a cyberattack that disrupted logistics
and totaled about GBP 100 million off its sales.

Another was disruption in Korea; it sold a
dehumidifier cleaning product that was toxic;
it actually killed people, and that crushed the
whole business across South Korea. In 2016,
it had a really good year for product innovation,
and it hasn't replicated that since. For these
reasons, growth has slowed year over year.
It's essentially a flat year, well below what it has
been posting.
But the reason I like this story is that the company
is repositioning the business away from
commoditized categories such as home care and
food, and into strong brand franchises with
pricing power. It has a great consumer health
business. It has painkillers like Strepsils
and Nurofen; it owns Durex. People will pay
for this stuff because there's a natural risk aversion
with these kinds of products. These businesses
still have pricing power.
It just acquired Mead Johnson. The market
hates this deal, but it is too focused on cost
savings. This is not really a cost-savings
opportunity; it's more about repositioning business
for growth in the long term, because infant
formula has pricing power. Again, it's consumer
risk aversion; parents tend to stick to a
baby food brand that works. Because of that, you
can raise prices a little bit at a time. Half the
business now is in categories with pricing power.
That positions the company for growth in the
longer term. K
Laura Lallos is the managing editor of Morningstar magazine.



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