Consumer Cyclical Opportunities Still Exist

• Mixed macroeconomic signals, but better-run firms should still be able to pull levers in order to meet full-year expectations.
• Inflation is still a prominent headwind, but it's important to delineate secular and cyclical pressures.
• The market won't reward consumer companies for sitting on cash stockpiles, so expect share repurchases, dividends, and acquisitions to accelerate.

Mixed macro signals, but better-run firms should still be able to pull levers in order to meet full-year expectations
Our call for a relatively slow recovery among consumer cyclical firms in 2011 remains intact, but normalized growth prospects are generally reflected in valuation. Overall, firms within our consumer cyclical universe continue to perform relatively well, and there are several reasons to remain cautiously optimistic when looking into the back half of the year. Traffic, year to date, has been surprisingly strong, and most companies have seen only muted customer pushback to proposed selective price increases. Although some retailers have played the "limited visibility" card when outlining the next few quarters as they face increasing commodity and potential demand headwinds, with five months of mid-single-digit comparable store sales already in the books, many firms are still in good shape to meet if not exceed our top-line expectations.

After real gross domestic product growth slowed to a revised 1.9% in the first quarter (down from 3.1% in the fourth quarter of 2010), we wouldn't be surprised to see a headline second-quarter number which is (dare we say) only slightly positive, owing somewhat to hiccups in auto production. Bulls will cite other recent macroeconomic data such as falling initial employment claims, better restaurants sales, a positive hiring report from  ManpowerGroup (MAN), and improving (non-inflation-adjusted) incomes, as support for the view that retail spending is unlikely to crater when the second round of quantitative easing ends June 30. However, though we believe the economy is still on a measured path toward recovery, we maintain our balanced view and still project an incremental slowing in the back half of the year.

We expect there to be some trade-off between volume and pricing as the year progresses, which will place pressure on margins, particularly if inflation fears are realized. Costs of goods sold have undoubtedly risen (such as with transportation/freight, commodities, and wages) in recent quarters, and these increases are set to hit the financial statements in the next quarter. These concerns have been well-vetted by company executives and analysts alike, and though the execution of strategic plans and consumer acceptance of pricing actions are unknown, we generally haven't seen signs that firms are looking to accelerate pricing wars. Importantly, current inventories are ticking up, though not at an alarming rate, and demand, in the form of the holiday and spring 2012 order book, appears steady, which should reduce the urge to unduly slash prices.

With margins hovering at or near peak levels, there are only a handful of outcomes (at the company level, outside of renewed strength in the consumer) which would drive us to revisit our current stance: one, accelerating sales growth from higher-margin international and/or e-commerce business segments; two, sharp reverse in COGS, preserving margins; three, an aggressive pullback in expenses, and/or; four, a delay in larger-scale discretionary investments or capital-spending projects.

In summary, we still project mid-single-digit top-line growth for much of the sector, but we see early signs of incremental slowing and cost pressures which should drive modest margin compression in the second half of the year. Today our consumer cyclical coverage universe looks fairly valued, trading at a median price/fair value of 1.08 times. There are still selected pockets of value, including the home improvement retailers and for-profit education providers, but this list is small, and many subsectors remain overvalued. In short, we continue to focus on firms that we believe have established sustainable competitive advantages, or economic moats.

Inflation is still a prominent headwind, but it's important to delineate secular and cyclical pressures
During the last few months, many retailers and wholesalers have reported earnings and/or been on the road, speaking with investors and analysts. In most cases, the tone remains optimistic, despite the fact that almost everyone acknowledges that several commodity headwinds have been severe. A gradually improving U.S. economy and recent sales momentum supports a generally constructive view. At the same time, though we have become less concerned about achieving top-line growth, we continue to expect commodity costs to have more of a pronounced impact on firm's margins during the next two quarters.

Although we expect consumers to tolerate some price increases during 2011, we've also sensed overconfidence in many firms' abilities to pass on rising input costs in our recent conversations with management teams, especially with heightened sensitivity to prices among today's consumers. As such, we believe price increases could be a bitter pill for consumers to swallow, making 2011 margin-improvement goals more difficult for retailers and wholesalers alike.

Below, we frame the current situation for three of the most prominent cost headwinds facing the consumer cyclical universe as well as our expectations as to how firms will cope with these pressures.

Cotton
Current Situation: The rise in cotton costs has grabbed its fair share of the headlines (and more) during the last several months. At the beginning of the quarter, the price of cotton sat above $2.00 per pound, after doubling in six months following August 2010. Put in historical context, the recent spike is revolutionary, as the long-term (30-year) average cotton price is around $0.70. Although we expect that cotton prices could remain at elevated levels thought the next planting cycle, we didn't view the elevated prices as sustainable and haven't been surprised by the pullback to the $1.50-per-pound range in recent weeks. U.S. cotton producers intend to plant 12.5 million acres of cotton this spring (14% more than they did in 2010). On a global level, the International Cotton Advisory Committee projects that world cotton acreage will rise by 7% in 2011-12 (to 36 million hectares, the largest level in 17 years).

Response: Although cotton prices have retreated somewhat, they remain well above 30-year average prices. While we've probably entered a so-called new normal with respect to cotton pricing, we think that the larger and more established consumer firms possessing economic moats are better-positioned to offset these higher commodity costs through a number of potential levers. One lever is that selective price increases are still "inevitable," according to several management teams, and appear to be in the mid-single-digit range, on average. A second lever is that selective promotional activity might continue, though most retailers appear to be holding clean inventory positions and have been conservative with their orders. A third lever is that e-commerce and faster-growing regions, such as Asia, are expected to shoulder more of the burden this year, as these channels can drive growth. A fourth lever is that product mix is shifting towards wool, polyester, sportswear other non-denim (lower cotton content) material, in an attempt to preserve overall margins.

 

Chinese Manufacturing Wages
Current Situation: Chinese manufacturing wages are still very low compared with those in advanced countries and lower than those in many other Asian emerging nations, including the Philippines and Taiwan. As the Chinese economy expanded, wages and productivity gains closely followed. For example, monthly minimum wages in China increased by more than 300% between 2005 and 2010, surpassing total gross domestic product growth (115%) during this same period. Reports of manufacturing labor shortages are commonplace, and the issues are set to compound as China's working population (ages 19-65) peaks in the next few years. Although we note that labor productivity has increased (up 10% annually since the early 1990s), which has helped to somewhat slow overall manufacturing expense growth, Chinese wage inflation remains a key concern of ours both in the near and medium term.

In its latest attempt to damp high inflation, the People's Bank of China announced another key interest rate hike on April 5 (the fourth since October 2010). The 25-basis-point increase lifts the one-year lending rate to 6.31% and the rate for one-year bank deposits to 3.25%, presenting yet another headwind for footwear and apparel firms that import a significant amount of products from China.

Response: Retailers are still taking steps to minimize these pressures. Industry stalwart  Wal-Mart Stores (WMT) has moved some of its sourcing from China to India, while apparel retailers and shoe manufacturers such as  Adidas,  Collective Brands , and  Kohl's (KSS) have already started moving manufacturing facilities to inland regions of China, or are relocating to low-cost alternatives in other parts of Asia such as Indonesia, India, Cambodia, and Vietnam. Additionally, we project wage hikes in China will have a smaller impact on retailers and manufacturers such as  Gap (GPS) and  Nike (NKE) which already have a more diversified sourcing portfolio (only one third of their products are sourced from China). Furthermore, we believe premium-priced companies with well-established brands like  Hermes and  Polo Ralph Lauren (RL) will fare better than value players like Children's Place and  Carter's (CRI), as they could easily pass these price increases on to their customers who tend to be more affluent and less price-sensitive.

Freight/Transportation
Current Situation: The price of bunker fuel, after remaining in a relatively tight band through last summer, is up 27% year-to-date to more than $648 per metric ton. We acknowledge that geopolitical unrest in the Middle East, an improving macroeconomic backdrop, and the March 2011 earthquake in Japan (among other factors) have added volatility to the price of oil. However, even in a more normalized environment, market characteristics (balance of supply and demand) remain constrained, limited production is scheduled to come on line during the next few years, and emerging-markets consumption of fossil fuels continues to grow. In short, we see few reasons why the price of West Texas Intermediate crude oil should dip below the forward strip, which averages right around $95 per barrel through 2012.

Response: We project that larger retail/wholesale firms like  VF (VFC), with in-country Asia product sourcing offices and a solid (and expanding) China sales base, should fare well. Additionally, those companies that have steadily invested in supply-chain capacities, such as Inditex, should be (on the margin) more adaptable to change and more profitable in the long run.  Williams-Sonoma  is another firm that appears well-positioned operationally, despite its relatively small size. The firm changed its furniture sourcing infrastructure to add expertise and efficiency, completed an East Coast distribution center consolidation that will result in lower rent, utility, and labor costs, and added new IT systems that cut inventory, transportation, and shrinkage expenses.

The market won't reward consumer companies for sitting on cash stockpiles, so expect share repurchases, dividends, and acquisitions to accelerate.
Fueled by aggressive cost-cutting efforts and conservative capital budgets, most consumer cyclical names have accumulated sizeable cash stockpiles the past two years. On average, we forecast that cash and equivalents will represent 17% of total assets for our consumer cyclical coverage universe at the end of 2011, an all-time high.

We doubt the market is willing to reward companies for sitting on this cash, so it's not surprising that a slew of consumer cyclical companies announced dividend increases and/or expanded their share-repurchase programs in recent months, affirming our view that more retailers will opt to return cash to shareholders in the near term, given fewer attractive domestic investment opportunities.

Among the more prominent names announcing dividend increases or new share-repurchase authorizations include  Costco (COST) (a $4 billion stock-repurchase authorization and a 17% quarterly dividend increase to $0.24 per share),  Best Buy (BBY) (a $5 billion authorization and a 7% quarterly dividend increase to $0.16 per share),  PetSmart  (a $450 million share-repurchase program and a 12% increase in its quarterly dividend to $0.14 per share), and Wal-Mart (a $15 billion share-repurchase authorization) Other names such as  Bed Bath & Beyond , VF, and Williams-Sonoma also chipped away at existing buyback programs in recent weeks. In our view, these trends will likely continue during the next year, and we wouldn't be surprised to see additional first-time dividends coming out of the consumer cyclical sector during the second half of 2011. Companies such as  J.C. Penney ,  Kohl's (KSS), and  Macy's (M), which suspended share-repurchase initiatives during the past year due to financial commitments and an uncertain consumer-spending environment, are likely to reinstate these programs during the next few years as their obligations lighten and business fundamentals improve.

We're also wary that some consumer cyclical companies might become too dependent on share-repurchase programs and not allocate sufficient cash flow to improving their competitive position at a time when low-priced warehouse clubs like Costco and dominant online retailers continue to take share from traditional specialty retailers. Best Buy is a prime example, as funding set aside for share repurchases and dividend increases could be more prudently used for optimizing its store portfolio, improving e-commerce initiatives, or international expansion.

With so much cash sitting on the sidelines right now, we also believe that the consumer cyclical industry is poised to be a hotbed of merger and acquisition activity. Coming off a year featuring robust M&A activity across a wide variety of consumer-related industries, 2011 has been off to a relatively slow start with very few notable deals announced. We believe this pause was likely the result of the meteoric rally across most consumer cyclical categories from September 2010 to March 2011-- the S&P Retail Index appreciated 25% during that period--leading potential target companies to rethink their own internal intrinsic-value assumptions and takeover firms to reassess internal rate-of-return thresholds.

 

However, that trend started to change during the second quarter, as  LVMH Moet Hennessy Louis Vuitton purchased Italian luxury goods maker Bulgari for EUR 4.3 billion,  PPR offered EUR 400 million for activewear-apparel brand Volcom, and VF announced its intentions to acquire footwear and apparel company  Timberland  for $2 billion. We believe these announcements were just the tip of the iceberg, as we've identified more takeover candidates in Morningstar's consumer cyclical coverage universe than almost any other sector, largely because so many retailers and restaurants meet the typical profile of a leveraged buyout candidate (strong cash flow and minimal debt) and are many are small enough that credit market and regulatory issues really don't enter the fray.

Not surprisingly, we've identified a number of small- to mid-cap retail names as potential takeover targets, particularly those in categories where cyclical headwinds have lingered longer than in the broader industry, including teen-apparel retailers and office-products distributors. However, many companies in our consumer cyclical universe are still trading near their 52-week highs (despite a recent pullback), suggesting deals will not come cheap. However, if valuations continue to come down as a result of inflationary cost pressures or concerns about general macroeconomic slowing, we would expect a continuation of the acquisition activity we've seen in recent weeks. Additionally, if there are additional hints of interest-rate increases on the horizon, private equity firms could overpay for target firms rather than letting the window of cheap funding close. We wouldn't be surprised to see the average forward enterprise value/EBITDA multiple in the low-double-digit range for forthcoming consumer acquisitions.

Consumer Defensive Stocks for Your Radar
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Las Vegas Sands		$69.00	Narrow	High	0.57
Staples		$25.00	None	Medium	0.62
American Eagle Outfitters		$20.00	None	High	0.64
Lowe's		$36.00	Wide	Medium	0.64
Under Armour		$41.00	None	High	1.76
Data as of 6-23-11.

 Las Vegas Sands (LVS)
The market is underestimating the growth potential for the company's operations in Singapore, similar to when the market significantly underestimated the size of the Macau casino market when it was still a nascent market. In addition, a corruption probe in Macau has created an unnecessary overhang on the stock. Our research indicates that similar probes have resulted in fines of less than $10 million, and even if there is a larger fine, the company has nearly $4 billion in cash and can adequately reserve for a higher fine..

 Staples 
High unemployment and small-business budget constraints have weighed on results, but we believe the market is underestimating the 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.

 American Eagle Outfitters (AEO)
Aggressive price cuts at rivals and elevated teen unemployment have pressured recent results. However, current sourcing initiatives, better inventory management, and improvement in teen unemployment, which will likely pick up in the back half of 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 during the next few years. Given a debt-free balance sheet and strong cash-flow characteristics, American Eagle could attract interest from financial buyers.

 Lowe's  (LOW)
Despite a shaky macroeconomic 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 home-buying 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 macroeconomic concerns subside.

 Under Armour (UA)
We like Under Armour's brand and products, but the stock price currently implies 25% annual operating profit growth for the next decade without interruption. Its recently launched cotton product has been gaining traction but still represents a very small percentage of sales; we remain concerned about cannibalization. The stock price also assumes a steep growth curve in international markets and success in newer categories, such as basketball footwear, which directly compete against larger players like Nike that are less likely to cede market share.

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