Our Outlook for Consumer Cyclical Stocks
Channel diversification, infrastructure investments, and share buybacks should allow consumer cyclicals to see low-double-digit earnings-per-share growth in 2013.
Consumer Cyclical Sector Fairly Valued but Some Opportunities for 2013
It's true that we are concerned about lackluster economic growth in the United States and fears of fiscal austerity which could result in near-term volatility in sales and profits, but 2012 operating performance was modestly better than we originally projected. There have been hiccups along the way, particularly for consumer firms with exposure to continental Europe and those without an economic moat (which make them more susceptible to competitive pressures). Still, many management teams have done well to navigate a challenging environment. Closing in on year four of the U.S. recovery, we're thinking hard about whether the high-end consumer has the will and inclination to support the next leg of economic growth, while questioning the health of the traditional working-class citizen.
For some time we've held the position that the global macroeconomic recovery following the Great Recession of 2008-10 would be relatively slow and, at times, volatile. As 2012 comes to a close, we've been encouraged by the decline in U.S. unemployment, improving real wage growth, a rebound in the manufacturing and service sectors, an improved housing market outlook, and normalizing inflation. However, we maintain some caution, as fiscal austerity (domestic and international) and macroeconomic pressure in Europe could remain an overhang on equities over the short run. Even with continued government stimulus, we generally forecast a mild deceleration in both sales and operating margin expansion across much of our coverage universe against more difficult year-over-year comparisons in early 2013 (but with resilient earnings-per-share growth backed by new share-repurchase authorizations).
Despite the elevated uncertainty which has almost become the norm, we peg the average price/fair value ratio for our coverage cyclical universe at approximately 1.05. There are few outright bargains, though we continue to focus on factors such as value, brand ownership, and differentiated products/services, and later-cycle categories such as men's apparel and home, which may strengthen as the economy expands. We would become more interested if the market were to trade down another 10%, but we're quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand potential near-term volatility. Notably, we generally bake in a deceleration in retail sales in 2013 at this point--roughly consistent with U.S. gross domestic product trends--with stable pricing and selective promotional activity (amid lower comparable-store inventory levels) as a partial offset to slowing consumer spending.
E-Commerce Still Helping and Hurting Traditional Retail Business Model
Looking at the 2012 holiday season, doorbuster and heavy promotional ads were prevalent across retail (similar to prior years), which drove plenty of consumers into stores. Early signs suggest that overall sales could be up 3%-4% year over year, which would be encouraging, however we're still focused on the steady shift toward e-commerce, a channel which continues to gain steam (and take share from undifferentiated brick-and-mortar retailers). According to comScore, online holiday spending is up 13% year over year and the total number of billion-dollar spending days (through mid-December) has reached seven.
Sounding a familiar tune, we still see a number of secular headwinds plaguing traditional brick-and-mortar consumer electronics retailers going forward, driven by increased price competition from Amazon.com (AMZN) and other mass merchants and consumers' increasing comfort with digital media distribution. Amazon remains poised to be one of the big winners this holiday season and beyond. With fewer overhead costs and (currently) the avoidance of sales tax in many states, Amazon already enjoys structurally lower costs, so it is nearly impossible for physical retailers to compete at the same price point for comparable goods, especially because the company has shown a willingness to sacrifice margins in order to breed customer loyalty. Simply put, low prices, a rapidly expanding assortment, and timely delivery (facilitated by recent fulfillment-center investments) are a powerful combination in a value-conscious consumer environment which should help Amazon take even more share from traditional retailers.
We do see ways for the traditional retailer to actually benefit from the secular shift toward e-commerce and rise above the holiday noise and competition, but it's not easy. In short, we believe that a successful firm must be able to more actively: 1) control the distribution of its brand and/or 2) differentiate its product or service. For example, Williams-Sonoma (WSM) has created a unique multichannel model which includes enhancing the in-store customer experience and layering in exclusive products, while also embracing the Web (a channel which represents nearly 40% of consolidated sales), in part by limiting third-party distribution of its products. Other firms, like Polo Ralph Lauren (RL), VF Corp (VFC), Gap (GPS), and Vera Bradley (VRA) have launched country-specific international websites in an attempt to build brand equity and ultimately help the customer purchase "Whatever, wherever, and whenever" she wants. As the economics of a traditional store model become more challenging amid competition (both online and brick-and-mortar), higher-margin Web order and fulfillment has become one lever which has shown in recent quarters to be a modest tailwind to sales growth.
Management Teams Continue Using Cash for Share Repurchases and Dividends
Several consumer cyclical names have accumulated sizable cash stockpiles coming out of the downturn, aided by aggressive cost-cutting efforts and conservative capital budgets. In a near-zero interest-rate environment, we doubt the market is willing to reward companies for sitting on this cash, though having a sizable cushion can convey benefits in this environment. As a result, it's not surprising that an increasing number of consumer cyclical companies announced dividend increases, one-time payouts, and/or expanded their share-repurchase programs as part of their quarterly updates.
Collectively, we're forecasting low-double-digit earnings-per-share growth across our consumer cyclical coverage universe in 2013, which might seem somewhat aggressive in the context of our industry expectations for mid-single-digit comparable-store sales growth, negligible overall unit expansion, and modest operating margin expansion. However, we're comfortable with the notion 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 year of earnings growth. If realized, more retailers may opt to return cash to shareholders, even after fully funding domestic-, international-, and e-commerce-growth initiatives. In our view, we wouldn't be surprised to see additional first-time dividends coming out of the consumer cyclical sector during the next several months.
Our Top Consumer Cyclical Picks
After a choppy yet impressive ride (the S&P 500 is up double digits year to date), we peg the average price/fair value ratio 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 and furnishings, 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 might be in a better relative position to withstand near-term revenue and operating margin volatility.
In general, we like companies possessing a combination of brand ownership, 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 |
| Economic |
| Fair Value |
| Consider |
|MGM China||HKD 29.00||Narrow||Very High||HKD 14.50|
|Weight Watchers Int'l||$74.00||Wide||High||$44.40|
|Data as of 12-18-12.|
MGM China Holdings (02282)
The market is effectively pricing in flat revenue and cash flow for the next five years, with the stock trading at a next-year P/E ratio of approximately 12 times. We expect, over the long term, positive Macau gaming growth and sustainable long-term growth by MGM China to drive the stock toward our fair value estimate, though the stock faces near-term headwinds of slower economic growth in China, and a slowdown in VIP gambling in Macau.
A return to positive comp-store sales and the demonstration that store openings will continue should still drive the stock higher, though we believe the 2012 fourth quarter will be important to indicate the start of the turn. 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.
Weight Watchers (WTW)
Shares of Weight Watchers could remain in the penalty box for some time as investors absorb the early 2012 modified Dutch tender offer and recent operational missteps which have hurt meeting attendance. There is plenty to like in the firm's long-term story including current obesity trends around the world, the upgrade of its current North American locations, and penetration of the more profitable online business. Meanwhile, we think that even though growth stagnated in 2012, the firm's program upgrade, further corporate account gains, and a renewed marketing campaign at year-end could spur a nice rebound in enrollments, which should drive margins and free cash flow generation.
Starbucks possesses tremendous long-term product, channel, and geographic expansion opportunities, with more potential sources of cash flow than much of our consumer coverage universe. In particular, we're confident that channel-development efforts (VIA, K-Cups, and Verismo), emerging-markets expansion (namely China, India, and Brazil), and a complementary brand portfolio (Evolution Fresh, La Boulange, and Teavana) provide the company with an exceptionally long runway for growth. We believe the current share price offers an attractive entry point for a name that is uniquely positioned to capture share in the retail and wholesale specialty coffee categories for years to come. Although the first quarter will be a heavier-than-normal investment period to facilitate the Verismo launch, we expect continued same-store-sales momentum in the United States and China and easing coffee cost pressures to provide a positive near-term stock catalyst.
NetEase relies mostly on organic growth, and we think catalysts in the near term include the new release of several in-house games with new graphics and features as well as the launch of more World of Warcraft games following the extension of licensing agreements with Blizzard. Although the overall gaming market remains volatile and increased scrutiny over the structure of Chinese ADRs are a concern, we expect investors to build more confidence in steady top players such as NetEase given its strong and balanced portfolio of in-house and licensed games, unrivaled research capabilities to keep the gaming experience fresh and exciting, and operational expertise in managing the gaming platforms.
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Peter Wahlstrom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.