Description

Thesis Summary

Although Danone shares have performed strongly YTD, they have broadly matched the performance of the European food peer group and remain at a substantial discount to peers. Over the next couple of quarters we expect growth to accelerate and margins to continue to expand as the company laps a number of factors that have depressed recent growth rates. 

As we enter 2020 at an accelerated pace of growth and margin expansion, it will become increasingly apparent that Danone will meet or exceed its 2020 targets which in turn will lead to a rerating to (at least) peer average multiples. Achieving these targets may actually help Danone’s management finally receive the credibility they deserve and the company may receive the premium valuation to which it should be entitled thanks its superior category exposure and market position, but this would represent upside vs our base case. 

Applying the European Food (SX3P index) NTM P/E to our 2021 EPS estimates for Danone, we get a prospective 12 months return of 28% (including the 3% dividend). Conversely, given Danone’s discount valuation and resilient business we see little downside, even in a general recessionary environment. 

Business description

We believe Danone is the best positioned European consumer staples company thanks to its superior category exposure and margin upside, combined with a management team that has enacted a massive cultural shift towards an accountable, public markets minded culture with a clear and articulated goal of building sustainable long term growth and cost discipline (which in the past was absent at Danone). 

Over the past 2 decades, through a series of divestitures and acquisitions the company’s product portfolio has been positioned as a pure play on the long-term structural shift towards healthier and wellness focussed diets. Today, roughly half of Danone’s profits are derived from its Specialized Nutrition segment which includes the Aptamil and Nutrilon infant nutrition brands and the Nutricia medical nutrition business. Another third of profits are generated from the Essential Dairy and Plant-based segment (EDP) which following the WhiteWave acquisition includes the global leader in alternative milk and plant-based products, Alpro, and the #1 milk alternatives, coffee creamers and fresh foods brands in North America. Milk alternatives and coffee creamers are high growth categories with a huge untapped global addressable market that are more than offsetting the pressures in the traditional dairy products category where Danone is also the global leader with brands such Activia, Actimel, etc, and a strong presence in Greek yoghurts. In addition, the company has invested significant resources and reorganized the management of the dairy segment around regional cluster teams to focus on innovation initiatives for local preferences and trends. The remaining c.15% of Danone’s profits are generated in its waters division, which has grown at high single-digit rates over the past decade+, as the company benefits from best in-class, single-sourced bottled water brands (Evian, Volvic) which have pricing power, a strong presence in aquadrinks, particularly in China (Mizone), and vertically integrated distribution networks in several large emerging markets such as Indonesia resulting from decades of investments in local infrastructure.

In addition, within the large-cap packaged food sector and the consumer staples group overall, there are many companies who have dramatically reduced their advertising & promotion (A&P) spending over the past few years to boost operating margins, usually due to pressure from shareholders. This reduced investment in brand equity and innovation has hurt the growth rates of these businesses and exposed them to disruption from new entrants and the rapid shift in channel mix towards e-commerce. Danone is positioned firmly among the companies that have continued to invest, innovate and when necessary acquire, to maintain their growth prospects and strengthen the barriers to entry for their respective businesses over the longer term. A&P as % of sales is among the highest in the group and it has achieved strong organic sales growth over the past decade, at the top end of the peer group. 

Source of the opportunity

Danone’s shares have been a perpetual disappointment for investors and have significantly underperformed the peer group over almost any long-term period measured due to the company’s long history of poor expense management, expensive acquisitions and poor management of capital. Investors have spotted Danone’s potential and bought into it many times in the past and have been repeatedly disappointed

However, a deep dive into the management and cultural changes at Danone under its current leadership have convinced us that this time is different and Danone currently offers a highly asymmetric risk-reward investment opportunity. In addition to our primary research and interviews with Danone veterans across Danone’s business segments, which have all commented the cultural change towards a strong focus on cost discipline, we have already started to see tangible evidence in Danone’s reported results and investor communication that substantiate our claim. 

• Margin Opportunity:

Danone has a significant opportunity to improve its operating margin. Despite best-in-class gross margins, Danone earns the lowest operating margin among its peer group. Due to the large volume decline in Danone’s traditional dairy business over the past few years, its footprint of production facilities has become extremely inefficient. Improving efficiency of the dairy production base alone could offer close to 10 percentage points of margin upside. To address this, in early 2017 the company’s management team under the leadership of Emmanuel Faber has launched a cost efficiency program (‘Protein’) that will save €1 billion by 2020, of which €300 million will drop to the bottom line and the remaining €700 million will be reinvested into further enhancing the company’s competitive position. This €300 million represents 120bps of margin expansion over the 2017 base of 14.4%. 

On top of that, there are cost synergies from the 2017 WhiteWave acquisition which will add another 80bps to the operating margin, operating leverage benefits in the Specialized Nutrition segment and mix effects (higher margin segments are growing faster) that will further enhance Danone’s margins by 30-50bps over the next few years.

The company targets an operating margin of 16% in 2020. Putting the above together, we believe this is a highly achievable target with a wide margin-of-safety, especially considering the €700m buffer for the Protein cost savings program. 

Since Emmanuel Faber took charge in 2015, Danone’s operating margin has expanded every year (+31bps in 2015, +87bps in 2016, +57bps in 2017 and +51bps in 2018) and guidance is for another 50bps+ expansion this year ahead of achieving the 16% target for 2020. 

• Growth Reacceleration:

Whilst Danone has been delivering steadily on the margin opportunity, organic growth in recent periods has slowed from the target range of 4-5% to 2-3%. There were 3 key factors for this and all 3 are now turning which will result in growth reaccelerating towards the 2020 target of returning to 4-5%. 

• Dairy & plant-based: Danone suffered the double problem of declining sales for its large dairy brands in Europe at the same time as the north American WhiteWave brands slowed significantly due primarily to disruption from the longer than expected time it took to close the acquisition and some post closure disruption. The European dairy business has now broadly stabilised (thanks to the introduction of a host of new ‘more relevant’ products) and the NA WhiteWave brands are firmly recovering. Excluding the Morocco boycott (next bullet point), Danone’s ex-North American dairy & plant based segment has returned to growth in 2018 and has been growing consistently in recent quarters. In Q2, sales in France and Spain were stable for the first time in 7 years.  The North American segment has also been accelerating and is now achieving growth rates of 3%+ (ex-Earthbound which was disposed)

• Morocco: In April last year in a revolt against Western brands, consumers in Morocco started to boycott Danone’s products in the country (primarily fresh milk which is low margin, but high volume). Sales dropped c.50% causing a 200bps drag to sales growth in the EDP International segment (c.130bps drag on the whole EPD division). As of May 2019, the company has not only lapped this, but sales have started to recover this year so this will turn from 100bps+ drag to EDP growth into a tailwind for the next 12 months. 

• Chinese Birth rates: After the Chinese 1 child policy was relaxed there was a surge in the country’s birth rate which drove very high sales growth for Danone’s Specialized Nutrition segment (Early Life is 3/4 of divisional sales and China is a big part of that). As of H2 2019 we started crossing these tough double digit comps so whilst underlying growth continued to be strong, China was a drag leading to flattish growth in the past 4 quarters. This is now behind us and growth will reaccelerate to mid-high single digits in Danone’s most important segment.

Given the improving underlying dynamics in each segment combined with the various headwinds abating, we expect Danone’s organic growth to reaccelerate to the target rate of 4-5% in H2 and throughout 2020. 

• Management credibility

Although the quality of Danone’s key businesses are well-known, sentiment has been negative on this company for a long time due to a long history of poorly timed and expensive acquisitions, various partnership blow-ups, unpredictable margins and terrible capital markets communication. When the new management under Faber’s leadership started to show result investors started to believe there is real change. Then they did the WhiteWave deal and people lost confidence again.  We are confident that WW was a necessary acquisition rather than a continuation of the past. The revenue synergies by combining the #1 dairy business with the #1 plant based business are extraordinary and building this platform was a strategic must for Danone. Since then, management has repeatedly said they are not in the market for deals and they have even started disposing non-core assets such their stake in Yakult, Earthbound and a number of small brands/units.

Why we believe Danone should trade at a premium to its peers:

•  Unique business mix that is a pure-play on the Health & Wellness trends that all peers are attempting to increase exposure to

• Highest historical growth and exposed to categories with best growth prospects compared to the European peer group

• Best geographic balance of the food group with c.50/50 split between DMs/EMs

• Largest margin expansion potential of the group

• Infant nutrition, the group’s largest profit contributor, has highest barriers to entry with structurally higher margins

• Ideal stock for any ESG portfolio which should drive long term demand for Danone shares as ESG investing gains prevalence

Upside calculation

We expect c.4.5% organic top line growth in 2020 and 2021 (consensus is 4% in each year) and we expect operating margins to expand to 16.4% by 2021 after achieving the 16% target in 2020 (consensus 15.8%). This drives EPS of €4.6 in 2021 which on 22x forward P/E drives a share price of €101 next year, 25% above the current price. Add in the 3% dividend yield and you make 28% in 12 months with very little that can go wrong from here.

Catalyst

Accelerating growth and achieving 2020 targets