Our Outlook for the Consumer Sector
Market jitters about the consumer have made some stocks attractive.
Stock Strategist
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Over the last three months, economic uncertainty due to a deteriorating housing market and a tightening credit environment sent consumer-related stocks into a tailspin. These macro events on top of high prices at the pump and food inflation have investors worried about the fate of consumer spending. While we do believe there is more uncertainty today surrounding the consumer's ability to spend on discretionary items than there has been in the recent past, we don't foresee the current headwinds lasting indefinitely.
At this point, we think some pessimism regarding the consumer has been priced into the market. Outside of the homebuilders and home supply companies, average star ratings of most of the industries that constitute the consumer goods and services sectors fall into the 3- to 4-star range. Additionally, the average price/fair-value ratios of these industries are between 0.8 and 1.0, with the two aforementioned exceptions and online retail. Overall, we think that consumer goods and services stocks are modestly undervalued.
We think the recent market jitters have left several high-quality consumer stocks with favorable long-term prospects in 5-star territory. Best-in-class companies like Wal-Mart (WMT), Home Depot (HD), Bed Bath & Beyond , and Staples look attractively priced, in our opinion. We also like stocks with an international angle, including Diageo (DEO) and Cadbury Schweppes (CSG), for investors looking to diversify outside of the domestic market. While we expect pockets of weakness from the consumer in the back half of the year and into 2008, we think there is value in the consumer goods and services sectors for long-term investors.
Valuations by Industry
Within the consumer goods and services sectors, we think the most undervalued segments are home supply companies (Home Depot and Lowe's (LOW)) and restaurant firms. We also see a lot of value in the following groups: clothing stores (including narrow-moat company Chico's ), alcoholic drinks (especially Constellation Brands (STZ)), and shoes (including K-Swiss and Timberland ). The only segments that look expensive to us are jewelry/accessories and online retail, although we still see a few buys in the latter group.
| Consumer Goods/Services Industry Valuations | |||
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| Segment | Average | Median Price/Fair Value | Stocks Covered |
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| Apparel Makers | 3.1 | 1.0 | 10 |
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| Clothing Store | 3.5 | 0.9 | 21 |
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| Department Stores | 3.2 | 0.9 | 6 |
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| Discount Stores | 3.8 | 0.9 | 12 |
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| Food Manufact | 3.0 | 1.0 | 31 |
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| Groceries | 3.2 | 1.0 | 13 |
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| Homebuilding | 4.4 | 0.7 | 18 |
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| Home Supply | 5.0 | 0.8 | 2 |
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| Hotels | 3.2 | 1.0 | 9 |
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| Jewelry/Accessories | 2.2 | 1.1 | 5 |
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| Online Retail | 2.3 | 1.3 | 10 |
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| Restaurants | 3.8 | 0.8 | 19 |
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| Specialty Retail | 3.7 | 0.9 | 18 |
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| Data as of 09-19-07. |
With a large number of 5-star stocks, the restaurant industry looks particularly cheap to us. Despite the current headwinds facing the consumer, we believe that spending at restaurants should get a boost in the long run from baby boomers entering their peak earning years, a rise in dual-income families, and a growing desire for convenience in a time-pressed society. Our Consider Buying list includes one wide-moat company, Starbucks (SBUX), and one narrow-moat company, Darden (DRI), both of which hit 5 stars for the first time last summer.
In addition to Darden, several other casual dining restaurant stocks look attractive to us, including Brinker (EAT), Cheesecake Factory (CAKE), and P.F. Chang's . We think Panera and Ruth's Chris , both of which are leaders in their respective industry segments, are the two most undervalued companies on our restaurant coverage list. Most of the fast-food companies do look fairly valued to us, with the exception of 5-star rated CKE Restaurants .
We also believe the cruise industry, namely Carnival (CCL) and Royal Caribbean (RCL), present attractive investment opportunities. Both of these firms should benefit from favorable long-term demographic trends as well as expansion to Europe and other parts of the globe.
One of the most overvalued sectors, in our view, is jewelry/accessories, which includes two 1-star stocks ( Tiffany and Blue Nile ) that seem to defy gravity. We also think quite a few online retail companies are significantly overvalued, including Amazon.com (AMZN), Drugstore.com , 1-800 Flowers.com (FLWS), and Priceline (PCLN). Still, there are some attractive buys in that segment. For example, eBay (EBAY), Expedia (EXPE), and IAC/InterActiveCorp (IACI) are all rated 5 stars.
Consumer Goods/Services Stocks for Your Radar
The following table presents several consumer stocks to consider:
| Stocks to Watch--Consumer | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | Price/Fair Value |
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| Diageo |  | $105 | Wide | Below Avg | 0.83 |
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| Cadbury Schweppes | | $60 | Wide | Below Avg | 0.76 |
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| Home Depot | | $44 | Wide | Below Avg | 0.75 |
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| Starbucks | | $36 | Wide | Average | 0.75 |
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| Staples | | $30 | None | Average | 0.72 |
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| Data as of 09-25-07. |
Diageo (DEO)
Diageo has continued to deliver strong margins in mature markets such as North America and Europe, while delivering strong growth in emerging markets such as China and Brazil. Management recently boosted its earnings outlook for fiscal 2008, and senior analyst Matt Reilly thinks that his long-term assumptions of about 4% revenue growth and very modest operating margin expansion are very attainable. The company continues to put its ample free cash flow to shareholder-friendly uses such as dividends and share buybacks, and he thinks long-term shareholders will be rewarded as Diageo should continue to capitalize on the trend toward premium spirit consumption throughout the world.
Cadbury Schweppes (CSG)
A prolonged and uncertain sales process for this company's North American beverages business and disappointing confectionery margins in the first half of the year have weighed on Cadbury's ADRs but analyst Mitchell Corwin believes the weakness provides long-term investors a nice entry point in the largest worldwide confectionery firm. Cadbury has plenty of avenues for growth. Just half of the global confectionery market is in the hands of large players, and the company's participation in all three confectionery categories (chocolate, sugar, and chewing gum) gives it a distinct advantage over many of its peers. While turbulence in the credit markets and disappointing early bids for the beverages business have cast doubt as to the potential for an outright sale, he thinks it is more likely than not Cadbury will find a buyer during the second half of this year.
Home Depot (HD)
This firm has had to sell its supply business at a discount given the deterioration in the credit markets, but analyst Brady Lemos is encouraged that Home Depot was able to complete a deal and can now focus on reinvesting in its core retail business. He believes Home Depot has one of the widest economic moats in retail, thanks to its scale advantages and prime real estate portfolio. So, while the slowing housing market could pressure the company's sales over the next few quarters, he expects this retailer to weather the storm and emerge as a more dominant force in the home-improvement market over the long run.
Starbucks (SBUX)
We believe that Starbucks is still in the early innings of growth. With one of the most recognized and respected brands, this leading specialty coffee retailer could ultimately expand to 20,000 domestic stores, nearly double its current base. We think the chain could also match its domestic potential in foreign countries (which currently account for just a little over 4,000 stores). The myopic market, however, is giving Starbucks very little credit for its long-term growth potential and high returns on invested capital, presenting a rare opportunity to buy shares of this wide-moat company at an attractive price.
Staples
Analyst John Gabriel thinks Staples' focus on business customers as well as its international exposure helps insulate the company from many of the headwinds faced by retailers selling more-discretionary items. Despite being the industry leader in selling office supplies, he thinks Staples still has plenty of opportunities to expand through entering new metropolitan markets in the U.S., beefing up its services offering, and growing its footprint abroad. Having just scratched the surface in international markets, Gabriel thinks the retailer's investment in China, India, and Brazil bodes well for its long-term growth prospects.
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