Our Outlook for Consumer Stocks
How recovering consumer habits are playing out across the sector, and where opportunity still lies.
Quarter-End Insights
Valuations by Industry
The recent rally in the stock market has caused several of our favorite household & personal products companies to trade closer to our fair value estimates, but we think wide moat stalwarts like Procter & Gamble (PG) and Altria (MO) are worth keeping on the watch list.
Otherwise, the grocers, while not our favorite companies, are trading at attractive prices and are our most undervalued names. We would rather put our money in names like Kroger (KR) and Safeway , which have sufficiently healthy balance sheets, than some of the riskier names like SUPERVALU , which is attractively priced but carries a heavy debt load, or Whole Foods , which is much more sensitive to the economic cycle. Although we think grocers' margins will likely remain limited over the foreseeable future due to food deflation and price cuts, we think the market has overreacted, placing companies like Kroger and Safeway just above our consider buying prices.
Due to the stock market rally over the past few quarters, none of our media companies is currently rated 5 stars. In fact, most of our favorite companies have appreciated considerably, and now trade fairly close to our fair value estimate. However, we still think companies with strong competitive advantages like Disney, Google, and eBay (EBAY) are worth putting on a watch list.
| Consumer Industry Valuations | |||||
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| Star Rating | Price/Fair Value* | P/FV Three Months Prior | Change (%) | Uncertainty Percentile** | |
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| Alcoholic Beverages | 3.10 | 1.07 | 0.97 | 10.3 | 52.3 |
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| Apparel Manufacturing | 2.79 | 1.04 | 0.97 | 7.2 | 44.3 |
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| Apparel Stores | 2.97 | 1.06 | 1.16 | -8.6 | 72.7 |
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| Beverages - Soft Drinks | 3.00 | 1.08 | 0.99 | 9.1 | 3.4 |
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| Household & Personal Products | 3.55 | 0.87 | 0.81 | 7.4 | 1.1 |
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| Processed & Packaged Goods | 2.75 | 0.99 | 0.94 | 5.3 | 8.0 |
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| Restaurants | 3.12 | 0.95 | 0.86 | 10.5 | 4.5 |
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| Retail - Auto Parts | 2.87 | 0.88 | 1.04 | -15.4 | 10.2 |
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| Retail - Department Stores | 3.34 | 0.83 | 0.88 | -5.7 | 68.2 |
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| Retail - Discount Stores | 3.00 | 0.96 | 0.88 | 9.1 | 19.3 |
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| Retail - Grocery & Pharmacy | 3.17 | 0.93 | 0.88 | 5.7 | 6.8 |
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| Retail - Specialty | 3.78 | 0.84 | 0.87 | -3.4 | 33.0 |
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| Tobacco Products | 3.17 | 0.92 | 0.89 | 3.4 | 29.5 |
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| Travel & Leisure - Products | 2.01 | 1.16 | 1.10 | 5.5 | 30.7 |
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| Travel & Leisure - Services | 2.86 | 1.04 | 1.53 | -32.0 | 87.5 |
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| Data as of 12-14-09. |
In general, retail stocks look fairly valued if not slightly overvalued at this time, as the market appears to be pricing in a modest recovery in consumer spending in 2010. However, home improvement retailers Lowe's (LOW) and Home Depot (HD) remain out of favor with investors and are two of the most undervalued retail stocks we cover. Ongoing declines in same-store sales and worries about a housing market recovery continue to pressure both of these stocks, in our view. We believe increased consumer confidence will lead to more home upgrades, driving earnings growth for these two names over the next few years.
Although traditional department store chains are not among our favorite retail stocks, both Macy's (M) and J.C. Penney look modestly undervalued due to concerns around recent sales weakness. Despite trading below our fair values, neither stock is 5 stars at this time, and we believe investors may get a more attractive entry point should holiday sales come short of what the market is expecting.
Our Top Consumer Picks
| Top Consumer Sector Picks | |||||
| | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty |
| |
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| Safeway |  | $30.00 | None | Medium | |
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| Lowe's Companies |  | $36.00 | Wide | Medium | |
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| Kroger Company | | $26.00 | None | Medium | |
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| Yum Brands | | $46.00 | Narrow | Medium | |
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| Data as of 12-22-09 |
Safeway
We believe Safeway can weather any lingering effects from the downturn. The firm began the downturn with more of a premium position within the conventional supermarket space, but recent moves to lower prices on key items appear to be paying off, with volume and number of transactions up in the most recent quarter. We like Safeway because of its ability to generate cash despite weakness in the top and bottom lines. Even in a difficult 2009, the firm believes it can generate $1.1-$1.3 billion in free cash flow as it cuts back on capital expenditures. The firm is in decent financial shape, and though the environment should remain tough for the next few quarters, Safeway tends to throw off plenty of cash in good times and bad.
Kroger (KR)
The economic environment has proven to be extremely challenging for grocers. All operators in the space are fighting deflation in key categories, while continuing to be aggressive on pricing and promotions in order to drive traffic. However, despite the near-term headwinds, we like Kroger longer-term because of its size and scale, which we believe can help it weather macro and competitive pressures. As we expected, the company continues to lower prices, which has taken a toll on margins. However, as one of the largest retailers in the nation, we believe the firm should be able to use its scale to handle this environment better than smaller operators.
Lowe's (LOW)
Although both Lowe's and Home Depot look attractive at current levels, we prefer Lowe's because we think it is cheaper, and we expect it to take market share at a faster pace over the next several years. We think Lowe's has been able to compete with (and outperform on many measures) its larger rival by providing superior customer service, a critical point of differentiation, in our opinion. Lowe's also benefits from substantial buying power and efficient store operations, which should help it weather the current environment. We think its advantages are particularly meaningful over the large number of smaller regional competitors still around. Most of Lowe's revenue comes from maintenance spending on homes, leaving the top line less susceptible to weak consumer spending and residential real estate construction. We're convinced that Lowe's will emerge from the downturn in a stronger competitive position.
Yum Brands (YUM)
Yum Brands is well diversified in the global quick-service restaurant (QSR) industry. Several of the firm's brands--including KFC, Pizza Hut, and Taco Bell--occupy the leading market position in their respective domestic categories. We believe these brands have sizable international appeal, which should help Yum extend its leading market position to China and several other foreign markets. Although global weakness in consumer spending will probably weigh on operating results during the next few quarters, the firm has been able to preserve margins amid a challenging sales environment due to commodity cost deflation, fixed expense reductions and refranchising efforts. We expect the firm to emerge from the economic downturn as an even stronger player in the QSR industry.
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