Our Outlook for Consumer Cyclical Stocks

 

• We're cautiously optimistic as consumers are still spending, but growth rates are slowing and macro concerns linger.
• A strong U.S. dollar has hit margins, but underlying volume growth is generally OK.
• Management teams are routing free cash toward share repurchases and dividends to boost total returns.

 

Cautiously Optimistic as Consumers Still Spending, but Growth Rate Is Slowing and Macro Concerns Linger
As we look toward the Holiday 2012 season and take an initial peek at 2013, our overarching thesis, which assumes a relatively slow and at some times choppy economic recovery in the United States, remains intact.

Although there have been a few slips, year-to-date performance among consumer cyclical companies has been slightly better than our original projections. Some of this was initially due to seasonal factors (warm, early spring), an unexpected uptick in bigger-ticket discretionary purchases, and continued robust sales trends at off-price retailers.

Although we maintain a cautiously optimistic bent, slower business spending, contagion in Europe, and an uninspiring picture of U.S. consumer confidence have grabbed the headlines. On the plus side, inflation is in check, unemployment levels are slowly coming down, and there are signs of life in the U.S. housing market. Still, with the prospect of a new round of quantitative easing, the upcoming presidential elections, and fiscal cliff concerns, politicians and economists generally agree that the current situation isn't ideal.

Excluding government-related factors, we generally forecast a mild deceleration in sales growth this holiday season. Still, while foreign exchange headwinds have hit some firms this year, adjusted margin performance has been good, as fixed-cost leverage and the reversal of last year's commodity-cost increases trickle through the financials.

It is still our view that the high-end consumer fills an important role today, as the U.S. economy has become increasingly more dependent on this fairly narrow cross-section of consumers. These are individuals who 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 swiftly change. There are concerns that the market may have topped out (the S&P 500 is up about 18% year to date), and we're closely tracking the spending habits of high-end consumers, who tend to take their spending cues from equity and other asset market gains. We've heard grumblings of a modest pullback, notably in tourist cities for some of the higher-end retailers, but some of this is due to difficult comparisons, and the general view is that, all things considered, the consumer is better off today than he or she was a year or two ago.

We 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.

Consumer spending trends at the low end hasn't changed all that much in 2012, and we're anticipating more of the same next year. The U.S. unemployment rate has steadily--though slowly--ticked down since early 2010. But with 46 million Americans--one in seven--participating in the U.S. government food-stamp program, and gasoline prices on the rise again, it remains to be seen whether recent trends are sustainable, or whether this demographic will continue to embrace frugality out of necessity. 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 coming year.

Strong U.S. Dollar Has Hit Margins, but Underlying Volume Growth Generally OK
We remain comfortable with our mid-single-digit comparable-store sales growth assumption for the remaining months of 2012, and we're building a case for additional top-line growth (though slowing) in 2013 as well. 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. However, just as many firms are looking for growth beyond the U.S. border, which is a long-term positive, the strong U.S. dollar has created a stiff foreign exchange headwind this year. So while underlying operating margins are sitting at or near peak levels, currencies have become a source of risk to near-term results. We view this as cyclical, rather than structural. 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 is now providing an incremental lift to profits.

Our long-term view hasn't changed. 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. 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 underlying margin picture heading into holiday 2012 could be good, provided consumer cyclical firms haven't shifted back to becoming overly aggressive with their purchases.​

Management Teams Are Routing Free Cash Toward Share Repurchases and Dividends to Boost Total Returns
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, although having a sizable cushion can convey benefits 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 quarterly 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 during 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're 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 1.05 (implying that the category is modestly overvalued). 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 10% or so, but we're 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		$65.00	Narrow	Very High	$32.50
eBay		$53.00	Wide	Medium	$37.10
Time Warner		$45.00	Narrow	Medium	$31.50
Kohl's		$61.00	Narrow	Medium	$42.70
Weight Watchers		$74.00	Wide	High	$44.40
Data as of 09-18-12.

Las Vegas Sands (LVS)
While we think that Sands' stock price may come under continued pressure in the near term. We also acknowledge that it carries considerable near-term macro risks. However, on a long-term basis, we view the stock as attractive, and we 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 the second half of 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 this occurs. 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 lowballing the impact of share buybacks, which could even accelerate if cash flow generation continues at the $2 billion-plus current run rate.

Weight Watchers (WTW)
A series of company-specific missteps, combined with difficult year-over-year comparisons drove a meaningful sell-off in the first half of 2012. We see an opportunity for this wide-moat firm to get back on track, and take share both in its meetings and online businesses as the business environment normalizes. While we don't expect much of a top-line rebound, either in 2013 or beyond, we like the firm's long-term positioning in the global weight loss management market. The shift to mobile adds a higher margin growth driver, and the potential for corporate and health-care market penetration would represent upside to our base case model.

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