Our Outlook for Consumer Cyclical Stocks
There are some signs that the U.S. economy is on the mend, but visibility is constrained.
Quarter-End Insights
- We continue to see signs that the U.S. economy is on the mend, but visibility beyond the summer months appears severely constrained.
- Consumer cyclical firms are still planning for top-line gains but are bracing for margin pressure, particularly in the second half of the year.
- Most luxury goods stocks are still expensive, even after the recent pullback, but some warrant a closer look.
We continue to see signs that the U.S. economy is slowly improving, and while our expectation for a modest recovery among consumer cyclical firms in 2011 remains intact, the group is by no means out of the woods.
On the positive side, retail sales continue to generally come in ahead of our expectations, and traffic growth has been impressive. Costs have remained in check, driving record corporate profits in some cases. The unemployment picture has also cleared up a bit, and many expect job prospects to become more favorable in the coming year.
However, we remain balanced in our view and note that the impact of holiday shifts, year-ago government stimulus, and mounting input cost pressures could lead to a couple of choppy quarters and, ultimately, margin compression as the year unfolds. As such, we still project mid-single-digit top-line growth for much of the sector, but we see early signs of incremental slowing in the second half of the year.
Within the consumer cyclical sector are a diverse group of industry categories, including advertising and marketing services, entertainment, publishing, restaurants, specialty and apparel retail, and travel and leisure. Each is unique, and below we've presented the prevalent themes for each industry during a period of gradual economic recovery:
Industry-Level Insights
Advertising and Marketing Services
Search Advertising: We think the continued growth of Internet usage, along with advantages inherent to search (its measurability and effectiveness) will lead advertisers to allocate more of their ad budget to search, resulting in solid growth prospects for the industry for several years. The U.S. search market is maturing, yet we think the real growth potential lies in untapped international markets. These growth opportunities bode well for all industry participants in 2011, especially Google (GOOG), which had 65% of U.S. market share in February 2011 according to comScore, and even higher market share in many European and Latin American countries.
Outdoor Advertising: The outdoor advertising market bottomed in 2009, and we project another recovery year in 2011. Unlike other old media--like newspapers or radio--that serve local advertisers, we think advances in technology will eventually expand the number of companies that use outdoor advertising, positioning these firms to take a larger share of local ad dollars from other media. Outdoor advertisers are starting to utilize new specialized features like digital billboards, which can be changed in a matter of minutes, allowing advertisers to pick specific times to display their messages. In turn, the outdoor advertising firms can charge a higher rate for peak traffic times like morning rush hour, making these billboards more profitable for the company. We believe that the industry is still in a relatively early phase of digital, and we would look for increased investment into (and profitability from) this channel in 2011.
Advertising Agencies: While ad growth rates vary by media sector, we think the results of marketing conglomerates such as Omnicom (OMC), WPP Group (WPPGY), and Interpublic Group (IPG) are a good barometer of broad-based spending on marketing services, as these firms provide a wide variety of services around the globe. We're optimistic that all three of these ad agency holding firms will continue to deliver high-single-digit revenue growth over the next few quarters, but we think year-over-year ad growth rates will peak later in 2011 as comparisons become more difficult.
Entertainment
Substitutes to the traditional pay television model--such as offerings from Apple (AAPL), Hulu, Netflix (NFLX), Roku, and others--have generated a substantial amount of buzz, but pay television remains a dominant industry. Roughly 90% of television households receive service from a cable, satellite, or phone company, according to Nielsen.
Considering the tough economic times and high unemployment rate in the United States, pay TV subscriptions have been exceptionally resilient. Compared to other cyclical categories, total pay television subscriber growth modestly increased in 2009 (partially a result of the digital broadcast transition that made it more difficult to get over-the-air programming and the aggressive price promotion among distributors) and remained essentially flat in 2010. We would not be surprised to see some modest subscriber losses over time, but we don't anticipate any precipitous subscriber declines given the lack of comparable substitutes.
A recent hiccup occurred in March, when some cable network owners such as Discovery Communications and Viacom objected to Time Warner Cable allowing its subscribers to view programming on an iPad while in the home. The cable network owners argue that such additional distribution requires additional content rights. We think it could take years for some of these content rights issues to get ironed out; however, we believe an authenticated system is necessary to limit the threats of cord-cutting and piracy in the long run.
Publishing
Following a rough 2008 and 2009, advertising trends at magazine and newspaper publishing industries have improved as advertising budgets steadily recover. We project more of the same in the near term as the U.S. economy expands. However, we maintain a more cautious longer-term outlook, as we don't expect the rebound in advertising to benefit all advertising-dependent companies equally, particularly given the ongoing secular shift in media consumption toward online companies like Google at the expense of newspaper and magazine publishers.
In response, several large magazine publishers have formed a consortium called Next Issue Media to jointly work on an electronic delivery business model for e-readers like the Kindle and iPad. The publishers want to make it easy for consumers to browse and buy content on the device of their choice, and plan to work with Amazon (AMZN), Apple, and other device manufacturers. However, we believe a significant challenge for the consortium will be retaining control of the customer relationship, as Amazon and Apple both have closed systems that control distribution. We think electronic reading devices, particularly Apple's iPad, could help increase readership of publications; however, the ad revenue model for digital content is unclear.
Restaurants
Restaurant traffic has steadily improved for most operators over the past few months, indicative of an improving consumer environment and supporting our mid-single-digit top-line growth forecast for the restaurant industry in 2011.
However, we don't believe the magnitude of food inflation has been fully recognized by the market, and we would not be surprised to see cautionary revisions to full-year profitability assumptions from restaurant companies over the near term. Most restaurant operators have already started to raise prices in light of rising commodity costs (anywhere between a 1%-3% price increase), and several have locked in a portion of their commodity costs for the year, but we believe margin pressures will become much more apparent over the coming months.
Specialty and Apparel Retail
Traffic generally remained steady, despite inclement weather in some regions, as many retailers were able to sustain post-holiday gains into the first portion of 2011. The value-focused consumer is still in the driver's seat, but full-priced sell-through continues to improve, and many retailers have begun (or at least signaled a willingness) to turn the pricing knob as costs increase.
We wouldn't be surprised to see further margin gains in the first half of 2011, but we continue to look for incremental signs of mean reversion. All-in, we view the discretionary consumer space as slightly overheated, though as asset levels have held up, the majority of firms in our cyclical universe have exceeded expectations and pointed to a positive 2011. We remain selective with our picks, and highlight key subsectors in the following:
Apparel/Specialty Retail: A string of specialty apparel companies such as lululemon athletica (LULU), VF Corporation (VFC), and Limited Brands (LTD), as well as off-price chains like Ross Stores (ROST) and TJX Companies (TJX), appear positioned for incremental organic gains in 2011. However, mounting pressure from rising input costs (transportation, labor/wages, and raw materials) could prompt a more modest margin outlook as the firms cycle beyond the first half of the year. Aggressive price cuts are still required to boost traffic among the teen retailers Aeropostale , American Eagle (AEO), and Abercrombie & Fitch (ANF). Although these firms generally screen well from a valuation standpoint, we see few catalysts to push earnings meaningfully higher in the near term, although unemployment among 16-19-year-olds appears to be leveling off (albeit at historically high rates). Many retailers have become more transparent in outlining their international and e-commerce channel strategies, which we view as encouraging. As these firms execute to plan, this should lead to additional near-term sales momentum, providing an incremental boost to both sales and margins.
Auto Parts Retail: We expect favorable trends will continue to support demand for parts from Advance Auto (AAP), AutoZone (AZO), and O'Reilly Automotive (ORLY) over the next few quarters, though we recognize that industry tailwinds are becoming less prevalent as new car sales recover. Consumers are still looking for ways to extend the lives of their vehicles, but new car sales continue to tick up and could approach/exceed the 14 million unit tipping point in just a few years.
In the meantime, we are looking for signs of traction within the faster-growing commercial market, which sells automotive parts to professional installers and repair garages. We believe these national retailers should be able to leverage their expansive store network by adding the commercial program to existing stores, which should help boost returns on invested capital.
Department Stores: We are encouraged that many stores cycled past tougher comparisons. The higher end continues to outperform, a trend that we expect to continue short term but also to reverse as unemployment slowly improves. We believe clean inventories and healthy traffic have positioned Saks and Nordstrom (JWN) to have solid margins, as spring selling should not be inhibited by merchandise clearance. While the lower-end J.C. Penney and Kohl's (KSS) fared worse in sales, investors should be encouraged by improving margin trends, which in our view indicate tighter merchandise levels relative to demand. We see these trends continuing into 2011.
Home Improvement: Home Depot (HD) and Lowe's (LOW) enter 2011 with aspirations of margin expansion and double-digit earnings growth, despite common expectations for muted top-line performance. Both firms face more difficult year-over-year comparisons, particularly in the first half of the year as the industry laps "cash for appliances" and other government-supported stimulus programs that boosted 2010 performance. We still like shares of both companies, particularly as the U.S. economy and housing markets recover and normalize over the next few years, and we would use any pullback in the stock prices as an opportunity to add to positions.
General Merchandise Stores: Sales growth remained solid at Costco (COST) and BJ's Wholesale , further affirmation that the firms are retaining some incremental shoppers even as the economy continues its measured recovery. Trends at Target (TGT) remained "below" management expectations, led by a drop in TV, electronics, home, jewelry, and accessories categories. TV pricing remains under pressure across the industry, and some other electronics categories have yet to stabilize. A mid-single-digit comp for 2011 appears achievable for these firms, but the consumer remains focused on value, which could make a larger bounce difficult.
Luxury Goods: Firms like LVMH (FRA: MC), Tiffany , and Herm�s (FRA: RMS) are exhibiting similar patterns: strong top-line growth and even stronger cash flow generation in the fourth quarter. Growth and profits for the year broke records but are slowing sequentially on a quarterly basis. We highlight the fact that the first signs of a rebound in luxury demand appeared in late 2009, and companies are cycling past very strong 2010 increases. Stocks in the sector are generally trading above our fair value estimates and, in our view, the high valuations are dependent on the continuation of rapid growth in China and related emerging markets, which has been a positive catalyst for most names. Many luxury firms now face the toughest comparisons (in percentage terms) during the first and second quarters of 2011, and it will be difficult to maintain the current pace of organic growth.
Travel and Leisure
The travel and leisure industry remains in the midst of a robust recovery, as the average RevPAR growth (a measure of same-location sales growth in the industry) is up nearly double-digits this year. While still in the early stages of a rebound, we think improved supply conditions could still lead to upward revisions in the near term as occupancy and rates continue to rise. Vehicle miles driven and global air passenger enplanements have both improved, foretelling positive trends in other travel spending such as cruise vacations, rental car bookings, hotel bookings, or leisure activities.
The macro environment remains a critical component, and while early indications point to another successful year in 2011, we think that this upside is already priced into many stocks. Although continued strong results for the industry may present opportunities for short-term momentum investors, we think that long-term value investors are likely to find more attractive value investing opportunities elsewhere, and we'd remain extremely selective, even amid a pullback.
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