Slower consumer growth in 2012 is not fully reflected in valuations, and we remain selective and focused on structural winners.
--Few outright bargains exist in the consumer cyclical sector, and near-term risk might remain to the downside.
--A fierce fight for consumers' holiday spend supports our long-term views for the retail space.
--E-commerce continues to disrupt the traditional electronics retail business model.
Few Outright Bargains Are Present in the Consumer Cyclical Sector, and
Near-Term Risk Might Remain to the Downside
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 near-term volatility in sales and profits. Additionally, for those firms with significant international exposure, sovereign debt issues in Europe have clouded the 2012 outlook, and investors are unlikely to reward companies for issuing aggressive forecasts at this point. Meanwhile, general macroeconomic conditions in the United States remain uninspiring, with stagnant unemployment levels, elevated year-over-year gasoline prices, rising Consumer Price Index readings (up more than 3% year over year), waning consumer confidence, and ongoing fiscal debates which could curtail government spending in the coming years.
Despite such overhangs, we peg the average price/fair value ratio for our retail coverage universe at 0.98. There are few outright bargains, though we continue to focus on value, differentiated products/services, and later-cycle categories such as men's apparel and home, which may strengthen as the recession cycles. We would become more interested if the market were to trade down another 10%, but we're quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand potential near-term volatility. Notably, we generally bake in a deceleration in retail sales in 2012 at this point--roughly consistent with U.S. gross domestic product trends--with stable pricing and selective promotional activity (amid lower comparable-store inventory levels) as a partial offset to slowing consumer spending.
Fierce Fight for Consumers Holiday Spend Supports Our Long-Term Views for the Retail Space
Looking at the 2011 holiday season, doorbuster and heavy promotional ads were prevalent across retail, similar to prior years. However, this year the "earlier store hours" arms race was escalated, with openings beginning on Thanksgiving Day instead of the typical "Friday morning after" store openings that had been the case in the past. For example, Wal-Mart Stories WMT started the race, deciding to start holiday deals on Thanksgiving night at 10:00 p.m. Other retailers such as Target TGT and Best Buy BBY, to name a few, retaliated with their own earlier hours, with most choosing Friday at midnight. Even Dollar General DG entered the fray and opened its doors at 7:00 a.m. Thanksgiving morning.
Although the early hours succeeded in drawing in customers on Black Friday, we highlight two overarching themes which support our, "Tale of Two Recoveries" thesis. One, holiday sales programs actually signal a weaker consumer, and two, none of these holiday promotions or timing shifts provides sustained competitive advantages, in our view.
First, the idea of aggressive holiday sales programs supports our long-term views of the retail space, while actually signaling a weaker consumer. We continue to see three particular headwinds mounting, which are likely to result in muted gains for retailers. One, we believe the retail sector is simply overstored, and Amazon.com AMZN makes the saturation problem worse. Two, retail is no longer fragmented for easy share gains against weaker local or regional players but remains far from a margin-neutral oligopoly structure, so we expect destructive pricing wars to develop. Three, households and (soon) government deleveraging in Europe and the United States will occur during the next decade.
The second theme is that we acknowledge the increased promotions, layaway programs, and pushing store-opening hours back into a major holiday likely provided a short-term sales lift. However, we believe the United States is at the precipice of tectonic shift, from an economy that is driven 70% by consumer spending to something short of that level during the next 10 years. We do not know exactly where consumer-spending levels will settle, but we believe the aforementioned forces create more downside, rather than upside, potential.
E-Commerce Continues to Disrupt the Traditional Electronics Retail Business Model
With tablet computers, e-readers, and video games expected to be among the most popular gifts in 2011, one might think that traditional consumer electronics retailers would be well-positioned to capitalize on strong consumer demand this holiday season. However, we see a number of secular headwinds plaguing traditional brick-and-mortar consumer electronics retailers going forward, driven by: increased price competition from Amazon and other mass merchants and consumers' increasing comfort with digital media distribution. These trends have fundamentally changed the way traditional consumer electronics retailers conduct business, and they indicate that market share gains will be difficult to come by not only during the 2011 holiday season but also for several years to come. As this happens, many of the competitive advantages that consumer electronics retailers have relied on to drive historical returns--including well-known brand names, prime retail locations, and influence over suppliers--will fade, pressuring store-level productivity in the process.
Amazon is poised to be one of the big winners this holiday season and beyond. With fewer overhead costs and (currently) the avoidance of sales tax in many states, Amazon already enjoys structurally lower costs, so it is nearly impossible for physical retailers to compete at the same price point, especially because the company has shown a willingness to sacrifice margins in order to breed customer loyalty. Simply put, low prices, a rapidly expanding assortment, and timely delivery (facilitated by recent fulfillment-center investments) are a powerful combination in a value-conscious consumer environment which should help Amazon take even more share from traditional retailers. Moreover, the Kindle Fire will exacerbate customer acquisition trends, particularly at the prime level, and this also offers multiple layers to our base-case assumptions, including accelerating digital media sales and a positive halo effect in general merchandise categories.
Meanwhile, Best Buy is still playing by the old rules and remains exposed to long-term margin contraction. Competition from online retailers, in our view, will most deeply affect Best Buy, which is presently feeling the pinch from depressed big-ticket sales. Longer-term, Best Buy's focus is to drive store traffic with a pleasant differentiated shopping experience that allows customers to play around with exciting new products. Best Buy's approach has merit, in our opinion, but ultimately can be replicated. In our view, it will be difficult for the firm to stem market share losses to larger online players and mass retailers.
RadioShack RSH momentum can continue in the near term, though competition looms large. Although online competition has negatively affected RadioShack, the firm has managed to offset rapid declines in many consumer electronics categories by tying itself to the rapidly growing mobility category, which now constitutes more than half of the company's total sales. Even though smartphones can also be purchased from Amazon, this category has been relatively resilient to online pressure, because consumers, in our view, prefer to consult with store associates regarding prepaid contracts. Over the long run, we remain concerned about increasing competition within this sector, as Best Buy rolls out additional Mobile stores (which can carry a fuller assortment following the firm's acquisition of The Carphone Warehouse's stake in Best Buy Mobile stores) and Amazon becomes a more formidable player in the mobility space.
Gaming is still a multi-billion-dollar industry, but the dollars are going online, too. GameStop GME stands to benefit from a robust game lineup in the near term, and the company has fared well, which management attributed to GameStop's PowerUp Reward customer-loyalty program, which has experienced a dramatic increase in the number of registered members. Over the long run, we remain concerned about secular headwinds, as the industry transitions to digital distribution, but the company is appropriately paring back its store-growth plans, recognizing its core headwinds. However, with approximately 14.5 million members (as reported in the most recent quarter), up from 5 million members just one year ago, GameStop can target a vast array of members with marketing and personalized deals, driving video game trade-ins and purchases of new games.
Our Top Consumer Cyclical Picks
Below, we highlight five sector stocks for investors to keep on their radar screens.
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 Macau's casino potential 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.
A renewed focus on the customer, in-store operations, and technology infrastructure should allow the company to generate meaningful productivity gains, leading to solid earnings growth during the next three years. The macroeconomic picture is still hazy, and the residential construction sector remains under pressure. However, Lowe's still pays a healthy dividend and is routing its nearly $3 billion in annual free cash flow toward share repurchases. Despite recent relative underperformance, 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.
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, who 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.