No Change to Outlook for Narrow-Moat Danone

Danone updated its full-year forecast Dec. 19, revealing that it is likely to miss its previous top-line guidance as a result of weakness in the dairy segment in Europe but exceed its guidance for the group-level operating margin by 10 basis points. We have trimmed our 2016 dairy segment organic growth assumption by 30 basis points to 1.7%, but the change is neutral to our 2016 earnings forecast and fair value estimates of EUR 71 for the ordinary shares and $16 for the ADRs. Our narrow moat rating and our investment thesis are intact, and we continue to expect medium-term margin expansion at the early-life nutrition business to drive high-single-digit organic free cash flow growth over the next five years.

The missed guidance on growth is another setback for a management team that we believe must repair its reputation with investors. The recent acquisition of WhiteWave appears value-neutral to us, and what appears to be poor execution in the rebranding of Activia in Europe will do little to reassure investors that capital allocation and execution are improving at Danone.

Nevertheless, we believe the volatility in organic growth and margins has more to do with the weakness of Danone's competitive positioning in bottled water and dairy than with management. Our economic moat rating for Danone is narrow rather than wide because the business comprises segments of varying business quality. We regard the bottled water business as being highly commodified, with little pricing power, operating in a category with low barriers to entry. The dairy segment suffers to a lesser degree from these challenges, but particularly so in Europe, where Activia has limited differentiation because Danone no longer markets the product as having digestive benefits. It is not surprising, therefore, that the weakness in organic growth over the past six months has occurred in these two segments, and we expect continued volatility.

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