Our Outlook for Consumer Stocks

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• Retailers square-off against consumer packaged-goods firms.
• Buyouts (rumored and actual) gain momentum as credit markets loosen.
• Cyclical laggards--restaurants and grocers--begin to stabilize.

In the text that follows, we address a wide variety of consumer themes in detail (including those listed above) with individual examples from the various industries followed by our top overall picks in the consumer markets. But first, let's set the macroeconomic scene.

The U.S. economy is on the mend. Credit markets have eased materially, home prices have stabilized, and businesses are catching up on overdue investment and selectively investing for the future. The contribution from consumers, on the other hand, has been mixed and for good reason---the unemployment rate is still near 10%, nearly half a million people are lining up weekly to file unemployment insurance claims, and wages are stagnant.

Still, it appears that we've reached a base of income from which to grow. But the question remains: What's our potential? In aggregate, we continue to believe that consumer spending will remain sluggish during the next year, as companies try to retain outsized productivity gains (a headwind to employment), consumers balance spending desires with servicing debt obligations and plugging holes in their balance sheets (elevated savings rate), and myriad government supports fade.

What does this mean for consumer stocks? At the moment, we think they're slightly overvalued on average. (However, we still have some good picks at the end of this article). We arrive at this overvaluation opinion by forecasting mild recoveries in both revenue and profitability in many of our discounted cash-flow models. This leads us to prefer firms with sustainable competitive advantages ("economic moats") which also tends to coincide with pricing power--a great quality to have when volumes are constrained. It also causes us to recommend a couple of out-of-favor industries (namely restaurants and grocers), as we're essentially calling the bottom and forecasting a recovery when the market mostly seems to believe otherwise. Now let's dig into the details.

Industry-Level Insights

Consumer Packaged Goods
Consumer products companies are supposed to be among the most recession-resistant firms, as they tend to post resilient sales and margins in both good times and bad. However, the industry is not bullet-proof, as the recession has demonstrated. Many of the CPG firms we cover have reported lost market share to private labels and consumer down-trading. As the economy stabilizes, however, questions remain whether these companies will regain their lost share and be successful in implementing price increases. Overall, we have concerns that retailer pressure via private-label development and a persistently promotional retail environment could limit the potential upside in developed markets for the world's leading CPG firms.

In the United States, the depth and severity of the recession has led to private-label share gains across a number of categories. We would normally expect this to reverse once economic conditions improve, but the improved quality of private-label products plus higher margins could solidify, if not increase, retailers' own-label market shares in the future. We think categories such as dairy, where  Kraft (KFT),  Groupe Danone (BN), and  Dean Foods (DF) have leading presences, could be especially vulnerable if branded players fail to differentiate themselves in such a commoditized category. However, many personal-care categories, such as oral care where  Procter & Gamble (PG),  Colgate (CL), and  Church & Dwight (CHD) compete, tend not to have strong private-label penetration and are more insulated from such pressures.

In addition to private labels, we have concerns that ongoing promotional activity could recondition the consumer to expect these specials on a regular basis. At the recent Consumer Analyst Group of Europe conference,  Reckitt Benckiser's (RB.) CFO Colin Day stated, "The biggest risk we face today is the persistence of promotion." Although most promotions today are supplier-funded, CPG firms run the risk that such deals become fixtures in generating sales. Many companies in the industry have indicated that they will cut pricing to generate volume growth, and we expect this to be the case in the coming quarters.

Having spouted the negatives, here are the positive attributes of this industry. Many of these firms have strong pricing power for a large percentage of their branded portfolios, particularly if those brands are number one or two in their categories. For example,  McCormick & Company (MKC), Procter & Gamble,  PepsiCo (PEP),  AmBev (ABV),  Avon (AVP),  Coca-Cola (KO), Colgate-Palmolive,  SABMiller (SBMRY),  L'Oreal (OR),  Diageo (DEO), and others are wide-moat companies that can price their products profitably, while smaller peers are more likely to struggle in a lower-demand environment. On average, we're willing to recommend these firms at smaller discounts to our fair value estimates--which we did for many of these during the last year--because we can be more confident in each firm's true intrinsic value.

Media
During the first quarter, we've seen content owners maneuver to better monetize assets as the media landscape evolves. For instance, there were a few high-profile disputes regarding affiliate fees between content owners and pay-TV distributors. Negotiations over retransmission fees for  Disney's (DIS) local ABC station in New York became public when Disney threatened to cut off  Cablevision's (CVC) ability to carry the station the day before its popular Oscars broadcast, if a deal was not reached. This was the first time Disney asked Cablevision for direct payment for its ABC station, as prior agreements bundled the station in with affiliate fees for Disney Channel and ESPN. The two parties finally reaching an agreement 15 minutes into the Oscars broadcast. Earlier in the quarter,  News Corp. (NWSA) and  Time Warner Cable (TWC) also reached a last-minute agreement on retransmission fees for local stations.

Each side of the pay-TV business model has negotiating leverage, but these recent examples indicate that compelling content is valuable. We believe the pendulum has swung even further to the content side as telecom companies like  Verizon (VZ) and  AT&T (T) are aggressively competing for video customers. This makes it harder for the traditional cable and satellite providers to push back on programming costs, which generally get passed along to subscribers.

Another dispute in the media industry was settled during the quarter when  Time Warner (TWX) reached agreements with Redbox and  Netflix (NFLX) in which new-release DVDs will be available only after a 28-day window. In exchange for remaining idle, the two leading distributors will pay less per movie. We think the other movie studios will follow suit and look to establish similar windows with the rental companies. Time Warner hopes the deal will rejuvenate high-margin DVD sales, which declined 13% in 2009 according to Adams Media Research. While the movie studios will milk DVD sales as long as possible, digital distribution of content is on the upswing. Due to low barriers to entry, we expect a plethora of competition from the likes of Netflix,  Apple (AAPL),  Amazon (AMZN), YouTube, and Hulu. Additionally, pay-TV distributors such as  Comcast (CMCSA) and Verizon, already have relationships and set-top boxes with a majority of U.S. households.

 

Retail
We see encouraging signs in the retail sector as easy year-ago comparisons and improving demand for discretionary goods drives positive sales growth across most categories. Although we believe the worst is over, we expect caution to linger among low- to middle-income consumers during the next couple of quarters amid a murky job market. This bodes well for value players such as  Wal-Mart (WMT),  TJX Companies (TJX), and  Dollar Tree (DLTR), which continue to show strength.

However, we expect sales growth to slow among most value chains as they begin to lap more difficult comparables midway through the year and consumers slowly begin to trade up to other retailers in categories such as groceries and apparel. At the higher-end of the consumer spectrum,  Saks (SKS),  Nordstrom (JWN), and  Macy's (M) continue to report improving sales trends. We believe that affluent consumers, who are less sensitive to fluctuations in the job market, will maintain current spending patterns as long as asset values are at least stable.

Retailers are investing cautiously and appear intent on managing the business with less inventory going forward. Apparel manufacturers such as  VF (VFC) and  Ralph Lauren (RL) recently commented that they are not seeing signs of restocking, as many retailers learned during the economic downturn that they can effectively operate with less inventory. We view this as a positive for retailers, as it requires less upfront capital and tends to lead to less discount and clearance activity, resulting in higher margins. While there may be some restocking in certain categories, such as women's apparel where we expect more of a bounce back in sales because of pent-up demand, we generally project inventory levels to be flat to modestly up in 2010 as a gradual recovery in spending ensues.

Amid modest investment in the business and improving fundamentals, many retailers ended the year with excess cash on hand. As a result, dividends and share buybacks are on the rise. A slew of firms across different retail categories announced dividend increases and/or new share-repurchase programs as part of fourth-quarter earnings, including  Gap (GPS),  Home Depot (HD),  Tim Hortons (THI), and TJX Companies. We thought it was especially noteworthy that firms such as  Chico's (CHS) and  P.F. Chang's (PFCB) decided to initiate a dividend, as opposed to investing excess cash to expand their store base, affirming our view that retailers will grow conservatively in the near term. Additionally, several companies, such as Wal-Mart,  Lowe's (LOW),  Target (TGT),  Sears (SHLD), and  Chipotle (CMG) bought back shares in the past quarter and reiterated their commitment to repurchases this year. Given the excess cash available at some of these firms, we wouldn't be surprised if more retailers provide a positive update on this front in the coming year.

Another popular use of cash is investing in overseas growth. A significant number of retailers such as  American Eagle (AEO),  Abercrombie & Fitch (ANF), Gap,  Gymboree (GYMB),  Limited (LTD), and  Urban Outfitters (URBN), recently announced or reaffirmed plans to expand internationally. This did not come as a surprise, given lower consumer demand and the subsequent lack of commercial real estate development in the U.S., as well as rising growth potential in emerging markets. Consistent with our expectations, most specialty apparel retailers, such as American Eagle and Gymboree will be expanding conservatively through low-cost avenues such as franchise or joint-venture arrangements, or smaller-store formats.

Others, such as  J. Crew (JCG), are testing market demand via retail websites prior to building out physical stores. These steps are prudent, in our view, and should help limit downside risk given the inherent challenges of expanding overseas. That said, we believe expansions abroad could be a growth driver for many chains in the near term. In our opinion, retailers such as Abercrombie, Limited, and Urban Outfitters, will likely have the most success, as a result of their ability to provide consumers with new and differentiated products not readily available in some regions.

Takeover rumors among consumer stocks are getting louder. On the heels of Thomas H. Lee Partners' proposed takeover of  CKE Restaurants (CKR) and  Phillips-Van Heusen's (PVH) plans to purchase Tommy Hilfiger, merger and acquisition rumors continue to rise. We believe these transactions could represent the first of several acquisitions in the consumer industry, as potential acquirers look to make a move before the window for securing low-cost debt closes. Potential suitors could range from private-equity sponsors looking to get back into the market after several years on the sidelines to strategic buyers looking to enhance their competitive positions by acquiring smaller rivals.

Strategic acquisitions are still more likely than leverage buyouts, but the latter could surface sooner rather than later, aided by increasing credit availability and lower equity contribution requirements from lenders. Thus far, takeout valuations appear reasonable from a historical perspective, with Phillips-Van Heusen paying about $3 billion (roughly 8.1 times trailing earnings before interest, taxes, depreciation, and amortization, presynergies) for Tommy Hilfiger and Thomas H. Lee offering $928 million (6.3 times trailing EBITDA) for CKE.

Although economic conditions showed signs of stabilization throughout the past quarter, most domestic quick-service restaurant operators and grocer stocks have languished amid prevailing concerns over price competition. Currently, grocery stores and quick-service restaurant categories are both collectively trading at about 0.9 times our fair value estimates. As the economic downturn progressed and prices for key commodities such as meat, dairy, and produce plummeted, several restaurants and grocers reacted by aggressively lowering prices to retain traffic.

 

We expect price competition to remain to remain a key theme throughout the first half of 2010, as these firms will likely be reluctant to raise prices amid the specter of higher unemployment rates (particularly among lower-income consumers). However, we expect some top-line relief during the back half of the year in the form of moderating food deflation, which is consistent with our thoughts of these categories as late-cycle economic recovery plays.

Travel & Leisure
There is no doubt that one of the hardest-hit industries in this economic downturn has been the travel and leisure industry. Consumers have continued to forgo big-ticket expenses as budgets remain tight. However, there is a glimmer of hope that we may be reaching a bottom. In the hotel industry, for example, year-over-year revenue per available room declines are decelerating. Furthermore, we project RevPAR to increase during the next few years, though at a modest pace as big-ticket discretionary spending will likely remain tight until excess room inventory built during the prerecession boom can be absorbed.

Our Top Consumer Picks

Top Consumer Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/Fair Value
Lowe's Companies		$36.00	Wide	Medium	0.68
MolsonCoors		$59.00	Narrow	Medium	0.73
Sonic		$15.00	None	Medium	0.68
Energizer Holdings		$80.00	Narrow	Medium	0.79
The Home Depot		$40.00	Wide	Medium	0.81
Data as of 03-22-10.

 Lowe's (LOW)
Despite negative comparable-store sales, Lowe's has remained profitable and continues to generate significant cash from operations. The market's pessimism is likely because of persistent fears over housing and consumer spending. However, catalysts should arrive in 2010 as consumers gain confidence and resume investing in their homes, relieving overblown market fears on the stock.

 Molson Coors (TAP)
Molson Coors' earnings growth potential is strong with the MillerCoors joint venture in the U.S. in its fold, but the market continues to be spooked by lackluster top-line growth at the firm. We don't expect Molson Coors to generate robust sales growth in the near future, but its two-year earnings growth potential is being undervalued by the market, placing the shares at attractive prices.

 Sonic (SONC)
Near-term restaurant traffic and margins will likely be plagued by high unemployment and aggressive pricing, but we're optimistic about Sonic's long-term prospects. We find the firm's growth opportunities, profitable menu mix, and low capital requirements particularly compelling. Same-store sales trends should start to improve during the back half of the year. 

 Energizer (ENR)
Excessive fears about eroding sales of household batteries have decimated Energizer's stock. We think the market's overly pessimistic view fails to account for the trade-up to alkaline batteries that much of the developing world has yet to realize, and Energizer's household products business, at 40% of sales and operating profits, offers a sufficiently solid foundation to navigate current category challenges.

 The Home Depot (HD)
Home Depot's share price continues its recovery on the back of improving comparable-store trends and housing market news. With the sale or closing of all concepts other than the core Orange Boxes, the firm is now focused on sales productivity and profitability. Significant operational investments (supply chain and IT infrastructure upgrades) should drive margin expansion, leading to solid earnings growth during the next three years.

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