Our Outlook for the Consumer Sector
Investors need to separate near-term business trends from valuation.
Quarter-End Insights
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The second quarter of 2008 was another difficult one for the U.S. consumer, and we expect ongoing weakness to persist through year-end. Strained by skyrocketing fuel prices, rising food inflation, and higher unemployment rates, today's consumer is forced to make choices. Companies such as Wal-Mart (WMT) and McDonald's (MCD) are gaining share of consumers' wallets in this challenging environment, and we expect those trends to continue in the near term.
However, we think long-term investors need to separate near-term business trends from valuation. In the case of Wal-Mart and McDonald's, we think the market has already priced these tailwinds into their stocks.
Conversely, there are still a number of high-quality consumer names that are trading at attractive valuations, in our opinion. Although we think there could potentially be further weakness in the stocks of fundamentally strong firms in the near term due to persisting economic head winds, we continue to believe that high-quality consumer stocks will fare well over the long haul.
May marked the fifth consecutive month of job losses in the U.S., and the unemployment rate rose by half a percentage point to 5.5%. The housing market also continues to deteriorate, and the latest Census Bureau data indicate the homeowner vacancy rate is about 2.9%, up from a rate of around 1.65% typical of a more normal environment. In addition, the USDA expects food-at-home prices to rise between 5% and 6% in 2008 on top of the 4.2% increase recorded in 2007. Combined, these economic head winds have come together to create a perfect storm, and as a result, consumers are faced with tough decisions when it comes time to spend.
Mass merchant retailers, particularly Wal-Mart and Costco (COST), have made spending decisions easier for many consumers, as these firms offer a wide range of everyday products at attractive prices--all under the same roof. Consumers seeking to stretch their paychecks are exploring different product categories and allocating a greater portion of their dollars to these big-box retailers. This trend was evident in the latest retail monthly sales results, as Wal-Mart and Costco reported impressive May comparable-store sales growth of 4% and 9%, respectively. Another firm that is bucking the trend is McDonald's, which reported that global comparable sales rose 7.7% in May, which was up from 5% in April and on top of 8.7% growth in the prior-year May period. Although our outlook for these three dominant companies' businesses remains positive, we think investors are fully aware of the strength of these firms, and the stock prices have already appreciated to reflect solid future prospects.
While we can't predict when the perfect economic storm will subside, we think investors looking for exposure to the consumer sector should focus on the retailers, restaurants, and consumer goods manufacturers that possess scale and buying power, as well as strong balance sheets. In our opinion, companies that meet these criteria should emerge from the current downturn in consumer spending relatively unscathed.
Valuations by Industry
Although some individual stocks have performed well despite the weak economic environment, we've seen a fairly broad-based decline in the market valuations of most of the industries and stocks within the consumer goods and services sector. That said, we think the classically countercyclical alcoholic drinks industry is almost fairly valued. Discount stores, which continue to benefit from consumers trading down in an effort to combat rising inflationary pressures, are also approximately fairly valued, in our opinion. On the other hand, stocks related to the housing market (home supply, homebuilding, furniture retail), and stocks depending on discretionary consumer spending (including casinos and restaurants) remain the cheapest within the sector, in our opinion. However, because we don't believe relief for the U.S. consumer will arrive until 2009 at the earliest, we think it is particularly important for investors to take a more judicious approach when selecting consumer-related stocks, given the current combination of inflation and slowing economic growth, which could continue to weigh on the sector.
| 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 | 0.91 | 0.81 | 12 |
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| Apparel Manufacturers | 0.87 | 0.81 | 8 |
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| Beverage Manufacturing | 0.88 | 0.91 | -3 |
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| Clothing Stores | 0.77 | 0.75 | 2 |
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| Department Stores | 0.78 | 0.81 | -4 |
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| Discount Stores | 0.91 | 0.82 | 11 |
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| Food Manufacturing | 0.93 | 0.91 | 2 |
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| Furniture Retail | 0.62 | 0.67 | -8 |
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| Gambling/Hotel Casinos | 0.77 | 0.75 | 3 |
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| Groceries | 0.84 | 0.89 | -6 |
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| Homebuilding | 0.73 | 0.73 | -1 |
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| Home Supply | 0.63 | 0.60 | 5 |
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| Household and Personal Products | 0.82 | 0.86 | -4 |
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| Jewelry/Accessories | 0.89 | 0.84 | 6 |
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| Restaurants | 0.61 | 0.63 | -3 |
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| Shoes | 0.70 | 1.00 | -30 |
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| Specialty Retail | 0.85 | 0.85 | 0 |
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| Tobacco | 0.88 | 0.93 | -5 |
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| Data as of 06-13-08. |
Even though we don't think these trying times for the U.S. consumer are over, we still believe there are plenty of compelling opportunities available for long-term focused investors. We reiterate the importance for investors to narrow their shopping list (no pun intended) to firms that have developed strong competitive positions. In fact, we think well positioned retailers and consumer goods manufacturers with strong balance sheets stand to actually strengthen their competitive positions, as they pick up market share left behind by weaker rivals that lack the resources to survive the downturn. Moreover, we'd prefer to focus on firms that have a large mix of consumer staples and/or substantial overseas exposure.
Consumer Goods/Services Stocks for Your Radar
| Stocks to Watch--Consumer | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Price/ |
| |||||
| Darden Restaurants |  | $52 | Narrow | High | 0.61 |
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| Walgreen | | $50 | Wide | Medium | 0.70 |
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| Kraft | | $40 | Narrow | Low | 0.73 |
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| Target | | $65 | Narrow | Low | 0.77 |
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| PepsiCo |  | $77 | Wide | Low | 0.85 |
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| Data as of 06-20-08. |
Darden (DRI)
Darden's flagship brands have held up very well in a challenging macroeconomic environment. This is especially true for Olive Garden, which increased its sales by 9.7% in the first nine months of the fiscal year, thanks to 40 net new restaurants and 4.6% same-restaurant sales growth. We believe that this popular chain, which generates roughly $3 billion in sales per year, is strengthening its leadership position in Italian casual dining. Red Lobster also dominates its segment, with $2.6 billion in sales per year. The seafood chain's sales rose 1.6% in the fiscal year-to-date, largely due to an increase in same-restaurant sales. On the back of this top-line growth, Darden has been able to boost both earnings and cash flow, while many other restaurant companies have struggled. We attribute Darden's superior performance to its brands' strong guest loyalty and compelling value-oriented offerings, which still provide a good margin. Management has also carefully controlled expenses. We think the recent addition of LongHorn Steakhouse to the portfolio provides another growth vehicle for the company.
Walgreen (WAG)
Walgreen is focused on being the most convenient drugstore chain. The firm has shunned a tie-up with a large pharmacy benefits manager PBM (like its rival CVS Caremark (CVS)) and instead is targeting other pharmacy services and platforms for serving consumers and health plan providers through small acquisitions. The firm has become the largest home infusion provider and fourth largest purveyor of specialty drugs. Through its new Health and Wellness division, Walgreen will increase its own services with clinics in its stores and at corporate campuses. Walgreen is attempting to redefine convenience for a new age, delivering prescriptions and convenient care wherever they are needed, as efficiently as possible. We like that Walgreen is sticking to its core strengths as an outstanding retailer, and we expect its store base to double in the next decade.
Kraft (KFT)
Although commodity cost inflation continues to be a major headache at Kraft, the company has leveraged its strong brand equity and seems to have picked up enough pricing lately to offset a fair amount of its rising input costs. Since Irene Rosenfeld took the helm nearly two years ago, the firm has overhauled its product portfolio. We believe that the acquisition of Danone's global biscuit business, as well as the divesture of Post and Veryfine will not only increase the firm's focus but also enhance its growth profile in the longer term. We also think that Kraft has a compelling opportunity to take advantage of its underleveraged balance sheet and repurchase shares in the near term. Given the solid stream of cash flows Kraft generates from its operations, we believe the company could create shareholder value by increasing its debt load and using the capital to buy back shares.
Target (TGT)
Target has remained true to its long-term strategy: differentiation through style and shopping experience. Target's attention to a more affluent customer base and its differentiation through merchandising and store experience have historically allowed the company to buck some of the negative trends that have hurt other discounters and department stores over the past couple of years. While same-store sales have suffered due to the company's relatively high sales mix of home goods and apparel, strong sales of consumables have partially picked up the slack. Though the weaker economy could put Target through a rough patch over the next few quarters, we think the company will eventually emerge with its competitive advantages intact.
PepsiCo (PEP)
With a portfolio full of strong brands, a solid track record of product innovation and differentiation, and a direct-store-delivery network that has few peers, we believe PepsiCo is prepared to weather the storm of economic head winds and rising commodity costs better than its peers. One of PepsiCo's main competitive advantages is the strength and positioning of its brands. The company's portfolio of 16 mega-brands (including Pepsi, Mountain Dew, Gatorade, Tropicana, Lay's, Doritos, and Cheetos) generate roughly half of the firm's annual sales and profits and are market leaders in their categories. The real key differentiator for PepsiCo, however, is the firm's extensive direct-store delivery system. Frito-Lay became the dominant seller of snack foods in North America because its direct-store delivery system allowed it to work much more closely with retailers than many of its peers--many of which could not afford to build out such extensive networks.
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