Our Outlook for Consumer Cyclical Stocks
Top-line comparisons will become more difficult in the back half of 2012, but margin tailwinds and increased share repurchase activity set the stage for robust earnings growth.
Quarter-End Insights
- Consumer cyclical names enjoyed a better-than-expected first half for 2012, but several variables linger.
- Even if revenue growth slows, margin expansion is possible.
- Management teams are still targeting share repurchases to juice earnings.
Better-Than-Expected First Half 2012 for Consumer Cyclical Names, but Still Several Variables to Consider
Midway through 2012, our underlying thesis, which calls for a relatively slow and at some times volatile economic recovery in the United States, remains intact. We note that consumer cyclical companies have generally posted stronger-than-expected sales, margin, and earnings-per-share gains in the first half. Looking ahead, there are still some reasons for optimism, including the post-recession drop in U.S. unemployment, the rebound in the manufacturing and service sectors, and normalizing levels of inflation. However, concerns of slower business spending, contagion in Europe, and an uninspiring picture of U.S. consumer confidence have grabbed the headlines.
All-in, and consistent with our previously published view, we maintain our cautious optimism, as sluggish real wage growth, a lackluster housing market, and a wild-card political environment have created a choppy economic recovery. Excluding government-related factors, we generally forecast a mild deceleration in sales in the back half of the year, as much of our coverage universe faces some difficult year-over-year comparisons. However we project steady, if not expanding, margins as fixed-cost leverage and the reversal of last year's commodity-cost headwinds flow through the financials.
For better or worse, high-end consumers are still a driving force behind the U.S. recovery following the Great Recession, and we now find ourselves in a situation where the economy has become increasingly more dependent on a fairly narrow group of consumers. Notably, these are individuals that don't have to spend if they don't want to, and if the mood of the big spenders were to become more cautious, the tone of the economic sentiment could change in hurry. Despite a relatively strong market thus far in 2012, we're still closely watching the spending habits of high-end consumers, who tend to take their spending cues from equity and other asset market gains. We've built in modest revenue-growth deceleration for many of our high-end names primarily because of difficult comparisons, but we will continue to monitor market trends, particularly across Europe, which in many cases accounts for a meaningful slice of revenue. A material reversal in affluent consumer spending would have an adverse impact not only on the more discretionary names in our coverage universe, but also likely across much of the broader consumer cyclical sector.
At the lower end of the income spectrum, consumers generally appear to be on more solid footing, as the U.S. unemployment rate has steadily (though slowly) ticked down since early 2010. But with one in seven Americans (46 million) participating in the U.S. government food-stamp program in 2011, it still remains to be seen whether recent trends are sustainable or whether this demographic will continue to embrace frugality out of necessity. As employment levels have arguably improved and retail gas prices have come down, this acts as a silver lining and potential catalyst for spending. Still, elevated rent costs and the high number of underwater mortgages could take some of the wind out of the sails from household budgets over the course of the year.
Even if Revenue Growth Slows Into Fall, Modest Margin Expansion Is Possible
We remain comfortable with our mid-single-digit comparable-store sales growth assumption for 2012, which implies flat to a modest deceleration in growth trends relative to 2011 due in large part to more difficult comparisons. Given that consumer cyclical firms continue to operate under lean cost structures, mid-single-digit comparable-store sales trends should be more than enough to generate some selling, general, and administrative expense leverage for most firms in 2012, even with operating margins already sitting at or near peak levels. Although we're concerned about price competition and infrastructure investments designed to better position consumer cyclical firms in the years ahead (which may pressure margins), the reversal of last year's raw-material cost headwinds should begin to flow through financials, providing an incremental lift to profits later this year.
Taking a longer-term view, we still believe margins may start to show signs of structural decline in some retail situations: 1) We believe the retail sector is simply overstored, and price-leader Amazon.com (AMZN) makes the saturation problem worse; 2) retail is no longer fragmented for easy share gains against weaker local or regional players and remains far from a margin-neutral oligopoly structure, so we expect destructive price wars to develop; and 3) household and government deleveraging in Europe and the U.S. may limit consumer spending over the next decade.
Retailers have been successful driving better-than-expected store traffic in the past year, but it has largely come on the heels of increased promotional activity. In our view, only select retailers (with either defensible brands or services) have been able to secure sustained price increases, and we see few signs that consumers (particularly in the lower- to middle-income strata) will become any less focused on value in the months and years ahead. We believe the aforementioned forces create more downside, rather than upside, potential for margin expansion beyond 2012, absent a more meaningful economic recovery.
Sensing these competitive pressures, most consumer cyclical firms have responded by reinvesting in channel-diversification strategies, infrastructure and supply chain investments, and renovation of customer-facing assets. Growth in online and mobile-device sales continues to be a solid source of revitalization for mature retailers, most of which have seen year-to-date online sales increase at least in the high teens to low-20% range (though largely depending on where a given company is in its particular e-commerce strategy). Still, with Amazon's dominant position in online retail ($48 billion in 2011 revenue, roughly equal to the next six closest nonauction competitors combined), brick-and-mortar chains have a lot of catching up to do. With e-commerce sales at between 6% and 7% of total U.S. retail sales during the past several months (according to the U.S. Census Bureau), we expect ongoing investments in e-commerce by nearly every retailer given the high returns and increasing interest from consumers to shop online. In addition to being a viable distribution channel, the Web has proved to be an effective, low-cost tool to gauge consumer demand.
We've also witnessed a notable increase in infrastructure and supply chain investments among consumer cyclical firms, most designed to bring products to the market faster. Additionally, retailers and restaurants continue to invest in new point-of-sale technologies as well as interior and exterior upgrades to help store locations stand out from a crowded landscape.
Costs of goods sold (transportation, commodity, wages) spiked during 2011, but some, including cotton and oil, have retreated sharply from mid-2011 peak levels. Most management teams have acknowledged that buying prices have come down, which is encouraging, yet many chose to remain somewhat cautious in their raw-material purchases, opting to buy closer to demand and risk being out of stock, rather than be stuck with higher-cost inventory. The margin picture in the back half of 2012 could be much better, however, provided consumer cyclical firms don't shift to becoming overly aggressive with their purchases.
Management Teams Still Targeting Share-Repurchase Programs as Earnings Kicker
Fueled by aggressive cost-cutting efforts and conservative capital budgets, most consumer cyclical names have accumulated sizable cash stockpiles over the past several years. On average, we forecast that cash and equivalents will represent approximately 20% of total assets for our consumer cyclical coverage universe at the end of 2012, which we believe to be an all-time high.
We doubt the market is willing to reward companies for sitting on this cash, though having a sizable cushion isn't a bad thing in this environment, so it's not surprising that an increasing number of consumer cyclical companies announced dividend increases and/or expanded their share-repurchase programs as part of their midyear updates. This affirms our view that more retailers will opt to return cash to shareholders in the near term, even after fully funding domestic, international, and e-commerce growth initiatives. In our view, these trends will likely continue over the next year, and we wouldn't be surprised to see additional first-time dividends coming out of the consumer cyclical sector over the next several months.
Collectively, we're forecasting low-double-digit earnings-per-share growth across our consumer cyclical coverage universe in 2012, which might seem somewhat aggressive in the context of our industry expectations for mid-single-digit comparable-store sales growth, low-single-digit unit expansion, and muted operating margin expansion. However, we are confident that consumer cyclical firms will be able to support aforementioned channel diversification, infrastructure investments, and other asset renovations while simultaneously buying back shares, indicating another strong year of earnings growth. Although this would seem to suggest lower-quality earnings-per-share growth, it still may be sufficient to satisfy already-lofty market expectations and extend the category's recent stock price momentum.
Our Top Consumer Cyclical Picks
Following the recent market run, we peg the average price to fair value for our consumer cyclical universe at 0.95 (implying the category is 5% undervalued). There are few outright bargains, though we continue to focus on later-cycle categories such as home improvement, which may strengthen as the recession cycles. We would become more interested if the market were to trade down another 5% or so, but we are quick to gravitate toward firms with established economic moats, which may be in a better relative position to withstand near-term revenue and operating margin volatility.
In general, we like companies possessing a combination of scale, pricing power in categories where perceived differentiation matters, exposure to emerging markets (particularly China), resources to extend brand reach, and strong dividend-growth potential.
| Top Consumer Cyclical Sector Picks | |||||
 | | | | | |
| Star Rating | Fair Value Estimate | Economic Moat | Fair Value Uncertainty | Consider Buying | |
 | |||||
| Las Vegas Sands |  | $74.00 | Narrow | Very High | $37.00 |
| |||||
| eBay | | $48.00 | Wide | Medium | $33.60 |
| |||||
| Time Warner | | $45.00 | Narrow | Medium | $31.50 |
| |||||
| Kohl's | | $61.00 | Narrow | Medium | $42.70 |
| |||||
| Guess | | $43.00 | None | High | $25.80 |
| |||||
| Data as of 6-20-12. |
Las Vegas Sands (LVS)
While we think that Sands' stock price may face further downturn pressure in the near term and acknowledge that there are considerable near-term macro risks for the stock, on a long-term basis, we view the stock as attractive and think it is likely to outperform the S&P 500 over the course of the next 24 to 36 months, due to: 1) the stock being undervalued on a discounted cash flow and relative basis, 2) Sands' position as the leader in the fundamentally attractive Asian casino market, 3) Sands' narrow economic moat, and a lack of new competition in its three principal markets, and 4) near-term catalysts that include the opening of a new casino in China and market share gains in the VIP market in China.
eBay (EBAY)
PayPal's in-store point-of-sale tests with several national retailers will renew the market's optimism for the company's payment-processing capabilities, while momentum should continue in the marketplaces segment. We believe investors should draw their attention to management's updated segment target ranges, which are increasingly looking conservative, including 2013 revenue and segment margin targets for PayPal of $6.5 billion-$7.0 billion and 25%-26%, marketplaces revenue and operating margins of $7.5 billion-$8.0 billion and 40%, and GSI Commerce revenue of $1.2 billion-$1.3 billion.
Time Warner
Time Warner will benefit most from our thesis that quality content is king, especially through HBO Go as a customer-retention tool and incremental licensing deals for its deep library of TV content. Time Warner has less earnings risk than its peers given its relatively low exposure to advertising, which we expect to decelerate in 2012.
Kohl's (KSS)
A return to positive comp-store sales and the demonstration that store openings can continue will drive the stock higher, though we believe it could be the second half of 2012 before the turn happens. Kohl's should benefit from input-cost pressures easing and middle-class employment improvement in the back half of 2012 and 2013, in our view. Other pressures on middle-class consumers such as gas prices, food-price inflation, and domestic fiscal worries should also ease at some point, taking pressure off Kohl's presently tepid comps. We also believe the market is underappreciating the impact of share buybacks, which could even accelerate if cash flow generation continues at the $2 billion-plus current run rate.
Guess (GES)
As the market continues to fixate on European macro risks (a region which accounts for more than 35% of Guess net sales), we believe that it is disproportionately penalizing Guess shares and overlooking the firm's long-term growth potential and earnings power. Our full-year 2012 EPS projection calls for a 13% year-over-year drop (to $2.63), driven by a combination of foreign exchange (cyclical) and softness in Italy and Spain (concerning, but cyclical). Guess sports a 2.7% dividend yield and carries no debt ($495 million, or $5 per share, in net cash), plus the business throws off roughly $200 million in annual free cash flow (7.4% yield). At 11 times forward earnings, (about 9 times excluding cash), and a well-defined international-expansion plan, we believe that these near-term headwinds are already reflected in the current share price.
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