As macro headwinds mount, we would look for a larger valuation discount among consumer cyclical names.
--Near-term outlook dims slightly as macroeconomic concerns surrounding the U.S. credit downgrade, and sovereign debt issues in Europe outweigh positive sales trends.
--E-commerce remains a powerful channel for brick-and-mortar retailers, and it's not too late to join the party.
--We're not bullish, but some companies can still pull revenue and cost levers to drive growth in 2012.
Near-term outlook dims slightly as macro concerns surrounding the U.S. credit downgrade, and sovereign debt issues in Europe outweigh positive sales trends.
All in, we have been pleasantly surprised by the U.S. consumer's resiliency, as year-to-date same-store sales across our coverage universe are up an average of 5% (through August). Weekly September sales data indicate that the shopping trends have continued, supportive of a strong back-to-school selling season. In isolation, these data points paint an encouraging picture of the U.S. economy (as consumer activity drives roughly 60% of gross domestic product).
However, taking a step back, we maintain our stance that even though many of our consumer cyclical firms are still performing well, macro headwinds remain substantial, which leads us to only muster a "cautiously optimistic" outlook. For our coverage universe, even after the recent 15% market sell-off, normalized growth prospects are generally reflected in current valuations.
Chief among our concerns as we look ahead: reported GDP growth slowed to a 1% annualized rate in the second quarter (up only slightly from the revised first-quarter number), the employment situation hasn't improved in the last three quarters. Unemployment still sits above 9% (at 9.1%) and the U-6, or "underemployment" rate, is hovering near 16%. Meanwhile, the average gasoline price at retail is up 32% year over year (to $3.58 per gallon), and the CPI (excluding fuel and food) reached 2% in August, for the first time since November 2008--both of these items have undoubtedly placed additional strain on consumers. Finally, elevated macro fears related to fiscal austerity in Europe and the downside risk to U.S. GDP growth (confirmed by the Federal Reserve's latest intervention) suggest that it will be more difficult for retailers to universally accelerate revenue growth at a time when an increased number of consumers around the globe might be paring back spending.
So, who will win out this holiday season: retailers or the cash-strapped consumer? Heading into the all-important holiday shopping season, a period which represents a disproportionately large portion of annual sales and income for most retailers, we still project a slow (and somewhat labored) recovery for many consumer cyclical firms. Our "tale of two recoveries" theme remains intact, as both higher-end retailers (such as Ralph Lauren
The introduction of so-called daily deals (think services like those of Groupon) and further adoption of the e-commerce channel (now approaching $200 billion in annual sales, and growing at a 15% clip) have conditioned consumers to search for (and often expect) discounts at retail, a slippery slope which could permanently damage brand perception and pricing. For firms without a competitive advantage (cost leadership and/or differentiated product, service, or distribution) this could translate into a tough quarter (to the consumer's benefit).
The flip side, however, is that companies which have been able to lure shoppers and drive traffic through either compelling value (TJX Companies
E-commerce remains a powerful channel for brick-and-mortar retailers, and it's not too late to join the party.
Growth in online sales have proved to be a solid source of revitalization for mature retailers ranging from Macy's
Still, brick-and-mortar chains have a lot of catching up to do. E-tailer Amazon.com
During the past year, Aeropostale
Retailers are constantly looking for profitable ways to leverage their online infrastructure to better serve customers. In the last year, Barnes & Noble
As a point of product or service differentiation, we recognize the potential value of the online strategy, particularly for those firms with distinct brands (Ralph Lauren) and retailers offering unique assortments, like Urban Outfitters
We're not bullish, but some companies can still pull revenue and cost levers to drive growth in 2012.
Although there's reason to support our relatively cautious near-term outlook, we're still comfortable with our mid-single-digit comparable-store sales growth assumption for 2011, which implies a modest deceleration in the growth rate for the balance of the year. The combination of inflation, selective pricing, and stabilizing (albeit high) unemployment levels should partially offset the risk of weaker pricing and volumes later this year, which provides a measure of confidence, given firms are already three fourths of the way through the year. Turning to 2012, lackluster economic growth remains a major concern, yet there are still ways for some firms to increase sales and maintain (or even improve) margins, which are currently sitting at or near peak levels.
Firms like Vera Bradley, lululemon athletica
As mentioned above, the Internet is becoming a powerful tool for retailers, one which has the potential to not only reach existing and potential customers with minimal effort, but the incremental returns and margin-expansion opportunities for this channel are immense. Although not large enough to move the needle yet (in many cases), firms that have a dedicated (and well-thought-out) Internet strategy have another lever to pull in the war against contracting margins.
Lower Costs Ahead
Costs of goods sold (transportation, commodity, wages) spiked during 2011, and though some remain at high levels (oil) and could still increase from here, the year-over-year impact in 2012 is poised to be less severe. In some instances (notably cotton) the price per pound has retreated more than 50% from mid-2011 peak levels. Most management teams have acknowledged that buying prices have come down meaningfully, though they were quick to note that the ultimate benefit likely won't appear in the financial statements until the back half of 2012.
As mentioned above, we're still concerned about lackluster economic growth and the increased reliance on the high-end consumer (consistent with our "tale of two recoveries" theme), which could result in monthly (and quarterly) sales volatility. Following last month's mini-correction (the S&P 500 is off nearly 10% since then) we peg the average price/fair value ratio for our retail coverage universe at 1.00. There are few outright bargains, though we continue to focus on later-cycle categories, such as men's apparel and home, which might strengthen as the recession cycles. We would become more interested if the market were to trade down another 5%-10%, but we are quick to gravitate toward firms with established economic moats, as these companies might be in a better relative position to withstand potential near-term volatility.
Top Consumer Cyclical Picks
Las Vegas Sands
The market is underestimating the growth potential for the company's operations in Singapore, similar to when the market significantly underestimated the size of the Macau casino market when it was still a nascent market. In addition, a corruption probe in Macau has created an unnecessary overhang on the stock. Our research indicates that similar probes have resulted in fines of less than $10 million, and even if there is a larger fine, the company has nearly $4 billion in cash and can adequately reserve for a higher fine.
American Eagle Outfitters
Aggressive price cuts at rivals and elevated teen unemployment have pressured recent results. However, current sourcing initiatives, and better inventory management should begin to buoy results heading into 2012. Additionally, we think growth in the aerie lingerie concept and international expansion will boost American Eagle's sales and profits during the next few years. Given a debt-free balance sheet and strong cash-flow characteristics, American Eagle could attract interest from financial buyers.
Significant operational investments (supply chain and IT infrastructure upgrades) should continue to drive margin expansion, leading to solid earnings growth during the next three years. The removal of government stimulus presents mild short-term headwinds, and residential construction remains under pressure. However, with management focused on operational gains and cash flow generation, we believe the firm is positioned to benefit from a multiyear housing recovery.
The auction business has been plagued by cyclical and secular headwinds in recent years, but PayPal's role as a leading online payment standard, new innovations in the marketplaces segment, and complementary acquisitions have reshaped eBay into a major e-commerce player for years to come. Although we expect greater top-line growth from Amazon during the next several years, we believe eBay is more attractive from a valuation perspective and find the stock suitable for investors looking to diversify their exposure to e-commerce growth.
We still view Collective Brands shares as undervalued, even after the stock traded up sharply on the announcement that the firm's board is reviewing "strategic alternatives." The stock has been excessively penalized by concerns over rising costs and sensitivity of working-class consumers, which could be disproportionately affected should another recession take hold. However, these pressures are cyclical, and we believe the fast-growing wholesale segment of the business could be worth upward of $1 billion; roughly the current enterprise value of the business. Cash flow at the core Payless domestic division could be attractive to private equity.