Our Outlook for the Consumer Sector
What do the next few quarters look like for the U.S. consumer?
Quarter-End Insights
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The first quarter of 2008 turned out to be another shaky one for the U.S. consumer. Rising fuel prices, accelerating food inflation, an ongoing slide in home prices, a slight weakening of the job market, and continued tightening in the credit market all weighed on discretionary consumer spending. So what do the next few quarters look like for the U.S. consumer?
Not good, in our opinion.
Deflating home prices are still creating huge headwinds for consumer spending, as the beneficial effects of outsized home equity gains enjoyed throughout the first half of the decade have definitively reversed course. Unfortunately, home prices are probably in for yet more declines over the coming quarters, as the current inventory and affordability measures are still quite negative in most markets. Specifically, the latest Census Bureau data indicate the homeowner vacancy rate is about 2.8%, up from a rate of around 1.65% typical of a more normal environment. So where's the bottom in home prices, and when is it likely to arrive? It's anybody's guess, but if homes were to return to their respective long-term average mortgage payment-to-median income levels, there's still a ways to go. And with new homes being priced at a significant discount to existing stock in virtually every market, existing home prices will continue to feel pressure. If job losses accelerate significantly, however, price declines may be more severe.
None of this was a tremendous surprise, but the weakening jobs picture and a sharp acceleration in food inflation threw more fuel onto the fire. The job market deteriorated in the first two months of the year with the Bureau of Labor and Statistics reporting job losses in January and February. Additionally, the change in temporary employment, which is commonly looked upon as a leading indicator to total employment, continued to decline in the first part of 2008. Moreover, according to the USDA, food-at-home prices increased over 4% last year, the highest annual increase since 1990. It expects more of the same in 2008, with a projected increase of 3%-4%. Most of the packaged foods firms that we cover have announced mid-single-digit price increases on top of price increases passed through last year.
Valuations by Industry
Although some individual stocks have bucked the trend, we've seen further deterioration in the valuation of most of the industries and stocks within the consumer goods and services sector. Stocks directly tied to the housing industry (including home supply and homebuilding), and stocks depending on discretionary consumer spending (restaurants, clothing stores, casinos) are the cheapest within the sector, in our opinion. Unfortunately, the specter of a combination of inflation and slowing economic growth could continue to weigh on the sector. We're not looking for any material improvement in the consumer spending picture until 2009 at the earliest.
| Consumer Goods/Services Industry Valuations | |||
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| Segment | Current Median Price/Fair Value | Three Months Prior | Change (%) |
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| Alcoholic Drinks | 0.81 | 0.86 | -5 |
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| Apparel Makers | 0.81 | 0.82 | -2 |
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| Beverage Mfg. | 0.91 | 1.00 | -9 |
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| Clothing Stores | 0.75 | 0.85 | -13 |
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| Department Stores | 0.81 | 0.77 | 5 |
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| Discount Stores | 0.82 | 0.82 | -1 |
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| Food Mfg. | 0.91 | 0.96 | -5 |
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| Furniture Retail | 0.67 | 0.70 | -4 |
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| Gambling | 0.75 | 0.92 | -18 |
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| Groceries | 0.89 | 0.96 | -7 |
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| Homebuilding | 0.73 | 0.62 | 18 |
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| Home Supply | 0.60 | 0.65 | -9 |
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| Household/Personal Prod | 0.86 | 0.95 | -9 |
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| Jewelry/Accessories | 0.84 | 1.06 | -20 |
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| Restaurants | 0.63 | 0.77 | -18 |
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| Shoes | 1.00 | 0.79 | 26 |
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| Specialty Retail | 0.85 | 0.81 | 5 |
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| Tobacco | 0.93 | 0.99 | -5 |
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| Data as of 03-14-08. |
The decline within the consumer goods and services sector has been so broad-based that we don't think investors should be focused on one or two industries that have fallen from favor. Although we believe a portfolio of some of our lower-quality 4- and 5-star stocks would do well over the long term, we think that a more judicious approach for the individual investor would be to focus on higher-quality companies that have more exposure to consumer staples than to discretionary purchases. Given the strong effects that operating leverage can have on restaurants and retailers, and given that we aren't counting on a loosening of the credit markets, we'd also emphasize firms that have strong balance sheets and sufficient cash flows to meet their capital needs over the next couple of years.
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 | P/FV |
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| Wal-Mart |  | $60 | Wide | Below Avg | 0.85 |
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| Diageo PLC | | $112 | Wide | Below Avg | 0.71 |
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| Walgreen | | $50 | Wide | Average | 0.73 |
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| Campbell Soup | | $42 | Wide | Below Avg | 0.78 |
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| Yum Brands | | $49 | Narrow | Average | 0.74 |
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| Data as of 03-17-08. |
Wal-Mart Stores (WMT)
Wal-Mart sells everything from apples to televisions, but a large percentage of its revenue comes from nondiscretionary goods that people buy regardless of the state of the economy: food, personal care, medicine, and household consumables. Wal-Mart's biggest advantage over other retailers selling the same products is in its hefty economies of scale. Its fixed cost ratio is one of the lowest of any retailer, which means it can scale back its costs easily if its sales start to dip. Because the firm is typically the price-leader on a large percentage of the items that it sells, it also has the ability to pass a good portion of rising costs on to consumers. Although Wal-Mart stumbled in recent years when it tried to attract more affluent consumers, the company's return to a low-price strategy couldn't have come at a better time. The stock currently trades at about a 15% discount to our fair value estimate of $60 per share.
Diageo PLC (DEO)
Spirits behemoth Diageo currently trades at a 29% discount to our fair value estimate, and we think the company has what it takes to shine during a U.S. economic downturn. Alcoholic beverages are classically defensive, since people don't stop drinking during recessions. In fact, alcoholic consumption per capita in the U.S. has remained relatively flat over the last 50 years, despite numerous periods of economic downturn. Diageo is arguably the incumbent of large liquor producers, as it boasts eight out of the world's top 20 brands, including Guinness, Smirnoff, and Tanqueray. Not only is Diageo a good industry play, but we like the firm's tremendous international growth potential. A third of its sales come from Europe, where consumers are trading up to its premium brands from other lower-priced competitors. We also think the company will see tremendous revenue growth in emerging markets, as it expands its distribution in India, Africa, and Russia. Diageo has unparalleled access to those developing countries, and because its Western brands appeal highly to consumers there, we think the company's sales in those regions have nowhere to go but up.
Walgreen Company (WAG)
Walgreen should hold up well in tough economic times, because it offers unmatched convenience for purchasing everyday necessities. No matter how difficult the economy, consumers don't give up what they truly need and will pay a small premium for the convenience of the corner drugstore. Although discount chains sell the same necessities, including prescriptions, they can't offer the same number of well-located stores that Walgreen can. The company also has some protection against the effects of inflation on consumer spending, because 95% of the prescriptions its pharmacies dispense are reimbursed to some extent by third parties. And with a large chunk of the U.S. population aging into retirement, we see decades of growth in prescription drug spending outpacing growth of the rest of the U.S. economy. Shares of Walgreen currently trade at a discount of about 27% to what we think they're worth.
Campbell Soup Company (CPB)
Controlling nearly 70% of the U.S. soup market, Campbell dominates this category, yet the firm's shares currently trade at a 22% discount to our estimate of their fair value. Campbell has an extremely wide economic moat based on the dominance of its soup business, and with little private-label competition in the category, as well as a commitment to product innovation and marketing, the firm shouldn't have much trouble passing inflationary price increases on to consumers. If anything, the consumer's lighter pocketbook will also mean less dining out and more dining in, so we don't see demand waning anytime soon for this company's staple grocery store brands.
YUM Brands (YUM)
With more than 35,000 units in more than 100 countries, Yum (the parent company of KFC, Pizza Hut, and Taco Bell) is the world's largest fast-food restaurant company. We believe that fast food has become much more of a consumer staple, which makes leading companies, such as Yum, resistant to, although not entirely immune from, the recessionary environment present in the United States. Yum also generates more than half of its profits in foreign markets, making it less dependent on the U.S. consumer. We believe that China, in particular, represents a huge opportunity for the company. KFC is already China's leading fast-food brand, with around 2,600 restaurants in more than 450 cities. Yum also has a leading position in casual dining with Pizza Hut, which has 480-plus restaurants in more than 80 Chinese cities. Given the size of the opportunity, the restaurants' attractive unit economics, and strong competitive advantages, Yum could ultimately expand to more than 20,000 restaurants in China alone. The firm's shares currently trade at a 26% discount to our fair value estimate.
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