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Quarter-End Insights

Our Outlook for Consumer Stocks

Consumers' confidence hasn't reached their wallets yet.

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As we remarked in our second-quarter outlook for consumer stocks, consumer confidence is a "nice-to-have" and income is a "need-to-have" for a sustainable economic recovery. According to the Conference Board, consumer expectations have improved markedly, but those same consumers believe present conditions are bouncing along the bottom.

Granted, there are reasons to think the future is brighter than the past: Home prices have stabilized, Institute for Supply Management indexes have recovered sharply, and employment is shrinking at a slower rate. However, we hesitate to extrapolate the latter point to a positive. Slower job losses are losses just the same, which means fewer dollars in the consumer's pocket.

Without increased employment, wallets are likely to remain locked. We can see this in the personal income and spending figures, as they have improved only fractionally from their bottoms. Looking forward, year-over-year comparisons get dramatically easier through the rest of calendar 2009 as we lap "deer in the headlights" consumer behavior in the fourth quarter of 2008. Still, easy comps can only last so long. Eventually, we need the positive signs in other parts of the economy to generate increased aggregate wages if the recovery is going to be palpable for consumers.

Therefore, our high-level consumer outlook remains subdued. Clearly we're past the worst, as downside risks have been minimized by unprecedented stimulus and capital raising, but we don't see signs for strong consumer spending, let alone a V-shaped bounce. For most consumer firms, from retail to casinos, we expect modest growth over the next couple of years. In the sections below, we discuss consumer-dependent firms at the micro level.

Consumer Products and Travel & Leisure
Although the worst may be behind us, consumers continue to be laser-focused on price, allowing cheaper private-label goods to gain share over branded products. Even in categories where there is little to no private-label presence, like alcoholic beverages, consumers are trading down to lower-priced alternatives, as Jack Daniel's maker  Brown-Forman (BF.B) recently noted in its latest quarter. Additionally, traditional grocers, in the hopes of remaining competitive with price leaders such as  Wal-Mart (WMT), have increased promotions and discounts to generate store traffic, often to the detriment of earnings, as consumers continue to take their business where they can get more bang for their buck.

Consumer products companies continue to face head winds, but there are some signs of stabilization. True, private label continues to gain market share over branded products, but it is at a decreasing pace. Additionally, many packaged foods companies are reporting volume gains on top of price increases. For example,  McCormick (MKC), which dominates both private-label and branded spices and seasonings in North America, reported in its latest quarter that volumes rose 3% despite price increases of 3%-4% (in local currency). Even  Del Monte (DLM), which is heavily exposed to private-label threats, increased sales an impressive 12%, due to both price increases and volume gains. Finally, while not all consumer packaged goods companies are seeing both volume and price gains, most are benefiting from lower commodity costs and cuts in operating expenses, boosting margins.

We are hopeful that consumers will return to buying their favorite branded products once the economy improves, but one industry that we expect to remain weak for some time is Travel & Leisure. Consumers have significantly pulled back from big ticket purchases, like boats, motorcycles, and vacations. Without significant improvement in personal income, we don't see a large snapback in spending in this area anytime soon, and revenues for most of these firms continue to drop at steep double-digit rates. We expect trading up to occur in low-ticket purchases like consumer goods before we see it in high-ticket discretionary goods.

Despite signs of an improving economy, consumers continue to trade down and spend cautiously on discretionary goods. Discount chains such as Wal-Mart,  Costco (COST), and  Dollar Tree (DLTR) are performing well given their rock-bottom prices and merchandise mix, which is heavily skewed toward everyday goods. As for sales of more discretionary goods, value players like  Kohl's (KSS),  TJX (TJX), and  Aeropostale (ARO) are handily outperforming premium-priced peers such as  Saks (SKS) and  Abercrombie & Fitch (ANF). Although we see few catalysts that would drive a significant bounce in consumer spending in the near term and expect sales of discretionary goods to remain weak, a stabilizing economy and recent stock market gains bode well for consumer sentiment as the all-important holiday season approaches. We expect retail sales will start to improve in the next few quarters as retailers start to lap easier comparisons.

Yet, with high unemployment rates and little wage growth on the horizon, we think retailers will remain cautious as they plan for next spring. Inventory levels at department store chains as of the second quarter were down in the high-single to low-double-digit range year over year. While the move to align inventory levels with current demand has resulted in gross margin improvement for department store chains such as Kohl's and  J.C. Penney (JCP), we're probably near the bottom in terms of inventory cuts. We expect flat to modest growth in inventory levels next year for most discretionary retailers as consumer spending for non-essential goods comes back online at a muted pace.

In addition to tightening inventory levels, retailers have been diligent about cutting costs, resulting in lower selling, general, and administrative expenses. While the reduced spending has helped offset margin pressure from weak sales, we continue to see some deleveraging as sales have deteriorated at a faster pace than costs have been cut. We believe a number of retailers are in a position where they need to see some top-line growth for margins to improve as future cost-cutting efforts are limited. Home improvement retailers  Lowe's (LOW) and  Home Depot (HD) fall in this category, and we don't expect much margin improvement until consumer spending in this area starts to grow.

Valuations by Industry
The table below shows that most consumer industries are closer our fair values than they were a quarter ago and a few are overvalued. In the paragraphs below, we discuss our outlook for several industries.

 Consumer Industry Valuations
   Star Rating Price/Fair
P/FV Three
Months Prior
Change (%) Uncertainty Percentile**
Alcoholic Beverages 3.11 0.97 0.89 9 13
Apparel Manufacturing 2.63 0.97 0.86 13 13
Apparel Stores 2.79 1.16 0.97 20 15
Beverages - Soft Drinks 2.86 0.98 0.92 7 7
Household & Personal Products 3.07 0.81 0.76 7 6
Processed & Packaged Goods 3.11 0.91 0.84 8 9
Restaurants 3.35 0.90 0.78 15 10
Retail - Auto Parts 2.80 0.88 1.11 -21 14
Retail - Department Stores 3.00 0.99 0.84 18 10
Retail - Discount Stores 2.83 0.86 0.83 4 8
Retail - Grocery & Pharmacy 3.19 1.49 0.78 91 15
Retail - Specialty 2.88 0.88 0.92 -4 12
Tobacco Products 3.20 0.90 0.80 13 11
Travel & Leisure - Products 2.00 1.09 0.99 10 11
Travel & Leisure - Services 2.60 1.49 1.21 23 17

Data as of 09-14-09.
*Market-Weighted Harmonic Mean
**Ranks the industry's fair value uncertainty (most uncertain =100) based on the aggregate market-weighted uncertainty ratings of all industries under coverage.

We believe that the most stable industries are the most undervalued. Namely, household & personal products, processed & packaged goods, and tobacco appear cheap. The HPP firms we like, such as  Procter & Gamble (PG),  Colgate-Palmolive (CL), and  Clorox (CLX), own top brands in their categories and are less susceptible to trading down. We think the market is not giving these moaty firms credit for their robust and steady cash-flow generation. The PPG industry is also trading below our estimate of the industry's fair value, and we think many of these firms will benefit from the consumer's increasing preference for eating meals at home. We have been impressed with companies like McCormick,  General Mills (GIS), and  Kellogg (K), as their leading portfolios and economic moats have allowed them to maintain a solid bottom line throughout these bad times. In tobacco, trading down to lower-priced brands continues in the U.S., but we think the market is undervaluing these firms' profitability, especially for domestic behemoth  Altria (MO). Outside the U.S., we think the market is not giving enough credit to the growth prospects of firms like  Philip Morris International (PM).

Retail stocks have had a nice run in the last few months, and we believe most of the sectors are fairly valued. However, we see still some bargains in the discount store sector with Wal-Mart being the most undervalued of the bunch. While most sectors look more fairly valued than they did three months ago, auto parts retailers are more undervalued, in our view. We attribute this change to new car sales coming back online driven by the Cash for Clunkers stimulus program. This program has a negative impact on demand for replacement auto parts, which has resulted in a deceleration in comparable store sales growth at retail chains like  AutoZone (AZO). While this may provide some near-term pressure on sales, we think ongoing consolidation in this industry should provide a long-term tailwind to national players like AutoZone.

Our Top Consumer Picks
The five stocks below are cheap enough to purchase, in our opinion, as each of them is trading near or below our consider buying price. We believe the downside risk to the U.S. economy has been dramatically reduced over the last couple of quarters, but it still seems prudent for most investors to stick with companies trading at reasonable discounts instead of the riskier, less-certain investments that may still be available.

 Top Consumer Sector Picks
   Star Rating Fair Value
Fair Value
Sysco $35.00 Wide Medium 0.72
PetSmart $30.00 Narrow Medium 0.73
Procter & Gamble $77.00 Wide Low 0.76
Kroger $30.00 None Medium 0.69
Jack in the Box $32.00 None Medium 0.64
Data as of 09-28-09.

 Sysco (SYY)
In our opinion, Sysco is attractive at its current valuation. The firm is the dominant player in the highly fragmented North American foodservice industry, controlling about 15% of the market. While the foodservice industry is plagued by high fixed costs and low levels of profitability, Sysco's expansive distribution network and stringent cost management have enabled it to generate returns that are around three times the level of its peers. Although its results have come under pressure recently as consumers are increasingly opting to eat more meals at home rather than frequent Sysco's main customers (restaurants), we contend that its unparalleled scale, the breadth of its products and services, and a continued focus on reducing costs should keep it generating fairly impressive returns and strong cash flows for shareholders over the longer term.

 PetSmart (PETM)
PetSmart appears well positioned to gain market share in the $43 billion domestic pet supplies industry. Although we recognize that easing pet food commodity costs and sluggish hardgood category sales could have a negative impact on short-term fundamentals, we expect an increased emphasis on private-label offerings and a leaner cost structure to drive profitability higher as macroeconomic conditions stabilize. Pet services such as grooming, boarding, and training represent $4 billion in annual sales, presenting the firm with additional avenues of growth. Mass merchant competition is a concern, but we doubt that these rivals can provide the same level of product diversity or devote retail space for service offerings.

 Procter & Gamble (PG)
Procter & Gamble is the largest consumer products manufacturer in the world with 23 brands generating over a billion dollars a year in sales. With its broad product platform and extensive global reach, we think P&G has sufficient resources at its disposal to reposition its offerings for more value-centered customers in mature markets and trade consumers up in developing and emerging markets. Over the past year, the company struggled to respond to the downturn in consumer spending, focusing on protecting its businesses from rising input costs and fluctuating exchange rates and pushing through too many price increases. Management is already dialing back some of these price increases and has increased the value messaging in its advertising. New CEO Robert McDonald is also stepping up efforts to improve productivity and streamline operations. With the savings from these efforts, the firm is reinvesting back in its businesses by repositioning brands and expanding into underpenetrated markets. P&G has managed through periods of crisis before, and while slow out of the gate this time around, we don't believe that's indicative of the company's prospects longer-term. Investors can also sleep well knowing P&G generates a ton of cash and preserves an impeccable balance sheet and credit rating.

 Kroger (KR)
Although Kroger's recent results have been weakened by continued pressure on the consumer, we like the firm because it continues to outpace its peers. The company has been able to keep identical store sales growth in positive territory while other traditional grocers have delivered declines in store productivity. We believe the company can continue this trend, thanks to its best-in-class private-label offering, as well as tailored merchandise selection. We expect that Kroger will continue to lower prices to drive traffic to its stores, but the company should be able to use its scale to handle this better than smaller chains.

 Jack in the Box (JACK)
Although we anticipate that near-term top-line results will be pressured by higher unemployment levels and aggressive promotional activity, we believe ongoing efforts to move to a more franchised business model have been underappreciated by the market. Jack in the Box remains on track to refranchise 70%-80% of its restaurant network by the end of fiscal 2013. With fewer capital requirements under this model, we expect operating margins and returns on invested capital to improve over the coming years. These transactions will also provide Jack in the Box with ample cash proceeds, which can be used to pay down debt or other shareholder-enhancing initiatives. Qdoba, the firm's fast-casual Mexican chain, provides differentiation from other quick-service restaurant rivals.

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Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.