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Our Outlook for Consumer Cyclical Stocks

As macro headwinds mount, we would look for a larger valuation discount among consumer cyclical names.

Peter Wahlstrom, 09/28/2011

--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 RL, Saks SKS, and Hermes and firms serving the lower-income population (including dollar stores, warehouse clubs, and Ross Stores ROST, for example) are holding up relatively well. As we look for winners this holiday season, we think that the consumer is again in a relatively strong position, particularly if the macro environment fails to stabilize or improve slightly. For example, inventories, as reported during the past several weeks, are generally up over last year's levels (though some of this can be attributed to new square footage and cost inflation), which could prompt aggressive markdown activity if holiday sales don't materialize early enough.

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 TJX and Home Depot HD) or fresh fashion/merchandise, such as Limited Brands LTD and Inditex (ESP: IDX), have performed relatively well. We think it's notable that three of the four the companies highlighted here, in our view, carved out economic moats. These firms have generally displayed prudent expense controls which limit at-risk inventory and/or have been able to adjust their merchandise midseason to react to changes in consumer trends and preferences. During the current environment, where it's not uncommon for management teams to cite "limited visibility" and external uncertainties, we continue to focus on those firms which we believe have established a long-term (sustainable) competitive advantage.

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 M to Best Buy BBY which have seen year-to-date online sales increase 40% and double digits, respectively. Wal-Mart Stores WMT, the world's largest brick-and-mortar retailer, has spent noticeable time and effort building up its walmart.com business which, according to management, has seen "considerable gains" across electronics (televisions, wireless, and home office), hardlines (tires and automotive categories), and home (furniture).

Still, brick-and-mortar chains have a lot of catching up to do. E-tailer Amazon.com AMZN generated more than $34 billion in sales in 2010 (up 39% year over year), which we estimate is more than triple the Web sales of the number-two player, Staples SPLS. With e-commerce sales at just 4.6% of total U.S. retail sales in the second quarter of 2011 (according to the U.S. Census Bureau), we expect ongoing investments in e-commerce by nearly every retailer given the high returns and increasing interest from consumers to shop online. In addition to being a viable distribution channel, the Web has proved to be an effective, low-cost tool to gauge consumer demand.

During the past year, Aeropostale ARO and American Eagle AEO tested their new preteens concepts online before launching physical stores, and Williams-Sonoma's Home concept now lives solely in cyberspace following the closure of its 11 brick-and-mortar locations late last year. Other firms such as Polo Ralph Lauren, Gap GPS, Inditex, and Vera Bradley VRA have launched country-specific international websites, in an attempt to build brand equity and ultimately help customers purchase, "Whatever, wherever, and whenever" they want.

Retailers are constantly looking for profitable ways to leverage their online infrastructure to better serve customers. In the last year, Barnes & Noble BKS and Sears Holdings SHLD launched third-party marketplaces to bring other retailers' products to their community of online users. Others, such as Home Depot HD and Lowe's LOW have gone the social media route and established online clubs and posted how-to tutorials for general home improvement projects in an attempt to deepen their customer relationships. Although we are watching trends closely and think investments in e-commerce will likely lead to incremental margin improvement, we don't see gains as universal.

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 URBN and Williams-Sonoma WSM. For others however, the Internet can create cracks in the business model, as it increases consumers' awareness of price, which is likely to drive head-to-head competition, particularly for commoditylike goods. We think this gives low-cost leaders (like Amazon) an advantage as the online retail-sales growth rate outpaces that of total retail sales.

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.

Retail Expansion
Firms like Vera Bradley, lululemon athletica LULU, dollar-store chains, and auto-parts retailers are aggressively increasing their retail square footage. As sales ramp up to normalized levels (which can take upward of three years), that could generate a nice tailwind for same-store-sales, even though the underlying mature/vintage stores might not be seeing much growth. Additionally, we think these growth firms are also in a position to negotiate more favorable lease rates which, while not a sustainable advantage, can provide a medium-term relative boost to cash flow.

Global Growth
VF VFC plans to double its store base during the next four years, to 1,500 locations, though most of this growth is coming from international markets. Likewise, Guess GES is targeting major sales and profit growth from Europe and Asia. Even Williams-Sonoma, the home-furnishings giant, has entered into joint-venture agreements in the Middle East and now ships its products to more than 70 countries worldwide.

E-Commerce Explosion
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 LVS
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 AEO
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.

Home Depot HD
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.

eBay EBAY
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.

Collective Brands PSS
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.

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