Consumer Cyclical: Confidence, Demographics Support Consumption Gains

• Consumer cyclical sector valuations remained at slightly elevated levels with a weighted average price/fair value ratio of 1.04 versus last quarter's 1.03. We attribute this to rising consumer and corporate confidence, a factor that should support spending across numerous discretionary industries.
• We see consumer spend aided by baby boomer, millennial, and emerging market demographic tailwinds over the next several years.
• Travel is one industry that stands to benefit from favorable sentiment and demographics but should profit from technology investments that support brand, scale, and network advantages held by operators.
• The convenience and improved user experience of e-commerce continues to take steady share from brick and mortar retail. While we see department stores and the general apparel universe most at risk, newer startups have seen success through an ability to be nimble and to harness the power of technology to improve products and the shopping experience.

Consumer cyclical sector valuations remain a touch overheated, with a weighted average price/fair value ratio of 1.04, compared with last quarter's 1.03. We attribute this to historically high consumer and corporate confidence figures, implying consumers' willingness to spend remains robust.

Global consumer spend stands to benefit from favorable sentiment and demographic trends. U.S. consumer sentiment reached 99.7 in February 2018, the second strongest reading since 2004, and up from the 98.4 averaged through the fourth quarter of 2017. Meanwhile, the U.S. small business optimism index lifted to 107.6 this February, nearly matching the highest reading ever recorded of 107.7 in July 1983. We attribute a portion of this strength to added confidence around economic development resulting from the passage of tax reform late last year and reduced regulations.

In addition to favorable consumer and corporate confidence, we see demographic tailwinds aiding consumer spend globally. For instance, we estimate that the number of baby boomers moving into retirement years is set to rise at a double-digit clip (every five years) through 2030. Also, younger travelers (Generation X and millennials) are now entering their peak earning years, representing around 70% of the U.S. working population in 2015 but growing to roughly 90% in 2025. Additionally, we believe China’s rising middle class is set to roughly double to more than a 200-million-person opportunity over the next decade.

We see travel benefiting from favorable sentiment and demographic tailwinds, as it continues to see revenue and cost enhancing investments that stand to support long-term growth and brand, scale, and network advantages we award various operators. For instance, cruise line operators have recently launched wearable and mobile app technologies that allow travelers to more easily book events and food, while also being able to control room electronics. This technology effort should improve traveler experience through less time spent booking itinerary and more time vacationing, leading to opportunities for improving yields for operators.

Online travel operators are also investing into technology and platforms, aiding the network advantages we award leading industry participants. While all operators continuously look to refine the user experience on desktop and mobile apps, some are now beginning to invest aggressively in the cloud. And by moving capabilities from physical data centers to the cloud, operators are able to improve latency performance and foster innovation (quicker speed to market of new products), all at a lower compute cost. Online leaders are also continuing to invest in building out the supply side of their platform networks, by expanding reach in vacation rental and international markets.

Outside of travel, mall traffic continues to decline, and e-commerce is steadily stealing apparel market share (reaching over 25% in 2017 with the potential to reach over 40% in the next five years). Once-powerful competitive advantages, including a broad national brick-and-mortar footprint and the ability to garner economies of scale, not only no longer hold the advantage they once did but now can also be viewed as a disadvantage.

We see e-commerce and, more specifically,

Mattel

MAT

Star Rating: 4 Stars

Economic Moat: Narrow

Fair Value Estimate: $21.50

Fair Value Uncertainty: High

5-Star Price: $12.90

In our opinion, brand stabilization began at Mattel toward the end of 2016, as indicated by performance of key brands, including Hot Wheels and Fisher-Price, and entertainment (the majority of gross sales), which delivered solid and sustained constant currency results. We believe this was due to the focus on improving Mattel's brand equity under the management team, rather than shipping ahead of demand, which would have led to faster takeaway at retail as products had begun to resonate with consumers again. However, the last two holiday seasons along with the Toys 'R’ Us bankruptcy have proved Mattel's demand has waned a bit, leading to sales declines and margin pressure in 2017 and 2018, keeping shares at a significant discount and providing a wide margin of safety. We expect the Toys ‘R’ Us liquidation in the U.S. to be transitory, given the company’s decreasing reliance on the channel (Toys ‘R’ Us was a high-single-digit percentage of 2017 sales, but we surmise it has dropped to a mid-single-digit percentage more recently), resulting in our view that Mattel's long-term competitive advantages are intact. Aided by its competitive advantages and changes implemented under new CEO Margo Georgiadis' strategy, we see Mattel returning to low-single-digit revenue growth in 2019 that we believe will be sustained in following years.

Hanesbrands

HBI

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $29

Fair Value Uncertainty: Medium

5-Star Price: $20.30

We have a high degree of confidence in the defensibility of Hanesbrands' competitive position because of advantages that are difficult for others to replicate: the firm's large owned and controlled supply chain, core product positioning in a space where brand is more important than price, and economies of scale achieved through a growing portfolio of synergistic brands. We think the company is poised to post significant operating margin growth through recognition of synergies ($85 million in 2018 and 2019), $100 million in cost savings from Project Booster, and $30 million-$40 million in manufacturing efficiencies.

The company operates 50 manufacturing facilities, mostly in Asia, Central America, and the Caribbean Basin. In 2017, approximately 73% of units sold were from finished goods manufactured through a combination of owned and operated facilities and third-party contractors that perform some steps (cutting/sewing). When Hanes can internalize high-volume styles, we estimate that it saves as much as 15%-20% and view this as a sustainable cost advantage.

Using this manufacturing platform, Hanesbrands has been successful in making acquisitions to drive earnings growth. Through acquisitions, the company has increased operating profit by $120 million, then added $170 million in synergies over the past couple of years.

Hanesbrands' top line has come under pressure, partly from what we view as short-term headwinds (the basics category experienced a low-single-digit decline in 2017) and partly from secular trends to online sales (only 11% of U.S. revenue was e-commerce in 2017, and retailers were hit with bankruptcies and downsizing). However, Hanesbrands is distribution channel agnostic, and we think these trends affect only the near term and create an attractive entry point for investors. The company continues to gain market share, with 2017's flat basics revenue topping industry growth, and the transition to e-commerce is proceeding well, with the online revenue growth hitting 22% during the fourth quarter of 2017. As online sales increase as a mix of business (we model penetration topping 20% in three years), we think total company growth will rebound to low-single-digit growth.

L Brands

LB

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $69

Fair Value Uncertainty: Medium

5-Star Price: $48.30

Although wide-moat L Brands still has work ahead, we believe that improving comparable sales growth throughout fiscal 2017 (from a 9% decline in the first quarter to 2% growth in the fourth quarter) and easing gross margin pressure (from a 280-basis-point decline to 37.1% in the first quarter to a 100-basis-point decline to 42.3% in the fourth quarter) point to a recovery in progress. We continue to believe that L Brands can return to comparable sales growth in fiscal 2018 and that gross margin pressure will ease with the comping of swim and apparel exits and mix challenges.

In our opinion, L Brands has a wide economic moat, with brand strength in a category characterized by high levels of consumer brand loyalty and prioritization of quality and fit over price. In the near term, we see multiple catalysts for an inflection point in sales and margin performance with discontinued categories being comped, bralette penetration stabilizing, Victoria's Secret Beauty improving, and new structured bra introductions. Further, we believe the company has a healthy long-run growth opportunity in China. With recovering comparable sales pointing to intact brand strength, we think the current discount to our $69 fair value estimate is unjustified and view this as an attractive entry point for investment.

Quarter-End Insights

Stock Market Outlook: Stocks Look Slightly Overvalued Today 4- and 5-star stocks are harder to come by in today's market, but a few values are still out there.

Credit Market Insights: A Decidedly Negative Quarter for Fixed-Income Markets Rising rates and widening credit spreads took their tool in the first quarter of 2018.

Basic Materials: Still Overvalued Despite Protective Tariffs Our bearish view on the mining and metals sector means the basic materials coverage universe trades at a market-cap-weighted 30% premium to our fair value estimates.

Communication Services: The Most Undervalued Sector We Cover We see value in several firms as consumers migrate away from traditional TV bundles and Europe invests in fiber and 4G.

Consumer Defensive: Looking to M&A, Online Sales for Growth We see a few values for long-term investors amid intense competition.

Energy: Looming U.S. Shale Supply Should Temper Optimism Huge output decline boosts near-term fundamentals, but lofty prices likely to trigger dangerous shale growth later.

Financial Services: Regulations and Interest Rates Remain in the Spotlight for 2018 We see financial services stocks across the globe as fairly valued today.

Healthcare: Values Among Drug, Biotech, and Supply Chain Firms Innovation, consolidation, and a mixed regulatory picture for healthcare stocks in the first- quarter.

Industrials: Healthy Demand, But Few Values Among a mostly fairly valued industrials sector, some good values remain.

Real Estate: Rising Rates Won't Derail Strong Fundamentals REITs have focused on strengthening their portfolios, deleveraging, and capital recycling in the face of higher bond yields and new construction.

Technology: Shift to Cloud Computing Most Important Story The sector looks modestly overvalued as a whole, but there are some attractive firms in enterprise software and IT services.

Utilities: Under Pressure in Early 2018 Utilities sell-off presents opportunities for long-term investors.

Venture Capital Outlook: Despite Slow Volume, Liquidity Prospects Remain We expect ample opportunity in the VC-backed IPO market as alternative liquidity routes gain popularity.

Private Equity Outlook: Carveouts on the Rise as Fundraising Slows As dealmakers look to innovate their origination process, we anticipate a continued rise in take-privates and corporate divestitures.