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Quarter-End Insights

Consumer Cyclical Stocks for Your Radar

Consumer cyclical firms are still planning for top-line gains but are bracing for margin pressure, particularly in the second half of the year.

As we detailed in our consumer cyclical industry-level analysis, we still see signs for near-term optimism as it relates to the first half of 2011, and we recognize further signs of an improving economy. Today we are somewhat less concerned about sustainability of the top line, and instead believe there could be downside risk to operating margins in the back half of the year.

Most, if not all, retailers have expressed some level of awareness surrounding rising input costs in recent months, hoping to set (lowered, yet achievable) expectations without raising the fear level among investors. Transportation, labor, and raw material cotton costs remain at the center of these conversations. Put into perspective, the price of cotton has doubled since August 2010, and the cost of WTI crude oil is up nearly 40% over the same time period. Shipping rates, in tandem with the recovering global economy, are up 30% year-over-year. For example  Vera Bradley (VRA), a small-cap firm that sells cotton handbags and accessories predominantly manufactured in China, expects a 30% increase in its cotton costs for the year.  Guess (GES), another global fashion retailer is seeing "double-digit increases" in apparel. The not-so-comforting news is that even the large-cap consumer sector firms such as  Nike (NKE) are experiencing rising costs, which suggests that the impact is being felt at all levels. Since the lead time for apparel manufacturing is typically about six to nine months, apparel retailers will start to see the impact of higher cotton prices hit financials in mid-2011, with further sourcing cost pressures projected for the fall season.

We expect the restaurant category to also face inflationary cost pressures in 2011. Despite our outlook for solid top-line growth, restaurant operators continue to contend with higher food prices across a number of commodities, including beef, wheat, dairy, and coffee, which could stunt operating income growth this year. And while the stabilizing U.S. economy is a net positive for restaurant chains, we also project that these firms will need to invest in labor and in-store upgrades this year to satisfy increasing consumer demand.

The good news is that despite the magnitude of the recent inflation, the increases still appear manageable in the near term and should ultimately level off (if not normalize) over time. In the meantime, firms are taking a number of steps to help offset rising costs:

  1. Planned price increases appear to be "selective," weighted toward the back half of 2011, and in the mid-single-digit range.
  2. Although promotions may continue, most retailers appear to be holding fairly clean inventory positions, suggesting that markdown activity in 2011 should be slightly less than last year. Discounting will also remain a key theme in restaurants, but we believe competition will be more rational than it was in 2010.
  3. Companies will place additional advertising and marketing emphasis behind faster-growing and more profitable products/brands and channels (including Internet and international) in an attempt to take incremental share.
  4. Product design and mix shifts toward wool, polyester, sportswear, and other non-denim (high cotton content) are also on the docket, as retailers attempt to preserve overall margins.

Despite our concerns, we believe that several companies can break through current peaks and add sustainable growth in the near term by attracting post-recession consumers with a constant flow of new and differentiated merchandise, made possible through industry-leading product-allocation and supply-chain systems. For example,  Limited Brands (LTD) has managed to string together an impressive run, consisting of double-digit same-store sales growth for five out of the last seven months. We don't expect this trend to continue, particularly as comparables become more difficult, but the retailer appears to have weaned consumers off of the deep discounts that they had grown accustomed to in late 2008 and 2009.

Separately,  BJ's Wholesale  and  Costco (COST) each continue to see steady increases in consumer traffic, an encouraging sign at this point in the cycle. Our view has long been that the warehouse clubs offer a compelling value proposition for consumers, particularly during the downturn, but that these firms can continue to outperform as the economic environment normalizes. We certainly recognize risks associated with commodity inflation and rising health-care and payroll costs in 2011, but we view both firms as well-positioned as we look ahead.

In particular, Costco appears to have found a delicate balance in its current pricing strategy, despite rising costs in some areas--yet we believe that management remains willing and able to pull this lever (which could result in better gross margins) should inflation continue in the coming months. Taking a step back, the fact that Costco continues to drive traffic, manage its expenses, and deliver earnings growth while leaving the membership pricing lever untouched to this point is a sign of a solid operator, in our view. We still believe there's plenty of runway for growth (domestically and abroad), which, when combined with solid free cash flow generation and a conservative capital structure, make this a name that we keep on our watchlist.


Most luxury goods stocks are still expensive, even after the recent pullback, but some warrant a closer look. The recent Japan disaster provoked a sell-off in several luxury goods companies. Shares of European-based  LVMH (FRA: MC),  Herm�s (FRA: RMS), Richemont (CFRUY), and PPR (FRA: PP) fell between the mid- to high-single digits following the event. U.S. based competitors were also affected, as  Tiffany & Co.  and  Coach (COH) also traded down over 10% and 9%, respectively. While Japan is a large market for luxury goods, it has been weak for some time, and the area affected by the disasters is away from the city centers such as Tokyo, where the largest portion of glamorous luxury stores and customers are located. LVMH derives just 9% of its revenue from Japan, and we estimate PPR's Japanese revenue accounts for less than 8% of total sales. While the other firms are more dependent on Japanese revenue--Hermes (16%), Richemont (12%), Tiffany (18%), and Coach (20%)--we believe that the financial impact is likely to be small.

While most names in the sector are still trading above our fair value estimates--the group has a median price/fair value of 1.4 times and a range between 0.9 times and 2.0 times--equity prices have at least come out of the stratosphere, and on a relative basis, some stocks are now looking more attractive than others. The most compelling luxury name, in our opinion, is PPR. Shares are slightly undervalued, trading at 0.9 times our fair value estimate. Following the divestiture of lower-margin Conforama, we have more confidence in the firm's ability to generate cash flow. Additionally, we believe opportunities to sell the remaining business that management deems less attractive (Fnac and Redcats) should surface as the economy improves. Acquisitions that improve PPR's global competitiveness will likely follow, but our concern is that management will overpay, as we think it did for Puma.

Top Consumer Cyclical Stocks for Your Radar

 Consumer Cyclical Stocks for Your Radar
   Star Rating Fair Value
Fair Value

Price/ Fair Value

American Eagle Outfitters $20.00 None High 0.77
Lowe's $36.00 Wide Medium 0.75
Melco Crown Entertainment   $11.00 Narrow Very High 0.69
Staples $27.00 None Medium 0.73
OpenTable $28.00 Narrow Very High 3.40
Data as of 03-23-11.

 Melco Crown Entertainment (MPEL)
The market is overly fixated on the short-term hurdles created by new--and intense--competition that we don't believe will have much of an impact on this casino operator's strong growth prospects over the longer term. Potential near-term catalysts include a continuation of the strong monthly gaming figures for Macau as well as the possibility of outperformance in the first half of the year due to the benefit from an imbalance between supply and demand in the Chinese casino market.

 Lowe's (LOW)
Despite a shaky macro environment, Lowe's has remained profitable and continues to generate significant cash from operations. The market's pessimism reflects persistent fears surrounding housing and consumer spending uncertainty. The removal of homebuying stimulus and higher interest rates could remain downside risks in the short term; however, we expect shares to recover as U.S. economic growth normalizes and macro concerns subside.

 American Eagle Outfitters (AEO)
Aggressive price cuts at rival  Abercrombie & Fitch (ANF) have pressured recent results. However, current sourcing initiatives, better inventory management, as well as improvement in teen unemployment (which will likely pick up by mid-2011) could be near-term catalysts. Additionally, we think growth in the aerie lingerie concept and international expansion will boost American Eagle's sales and profits over the next few years. Given a debt-free balance sheet and strong cash flow characteristics, American Eagle could attract interest from financial buyers.

High unemployment and small-business budget constraints have weighed on results, but we believe the market is underestimating this company's ability to deliver a strong performance as the economy improves. Staples is the dominant retailer of office products, and continues to see an uptick in customer traffic while rivals have seen declines. Corporate Express continues to have a positive impact on international and North American delivery segment profits, and we remain optimistic about the long-term synergies.

An exceptional business model and strong growth potential are not enough to justify an excessively lofty valuation. Even under our most optimistic forecasts, the stock appears expensive at more than 75 times our forward EPS estimate. To justify the current share price, we believe OpenTable would need to capture at least 90% of the addressable market in North America (50,000 restaurants), add another 40,000 restaurants overseas, seat more than 500 million diners annually by 2020, grow ancillary businesses by more 50% annually over 10 years, and raise operating margins to greater than 50%.

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Peter Wahlstrom has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.