Our Outlook for Consumer Cyclical Stocks

• Which retailers are best positioned to respond to the threat of e-commerce?
• Technological advances have affected not only consumer behavior but also retailing itself.
• Consumers' shift to e-commerce becoming apparent with holiday sales trends.

 

Which Retailers Are Best Positioned to Respond to the Threat of E-commerce?
It has always been difficult to establish an economic moat in the consumer cyclical space because of constantly changing consumer preferences, rapid speed to commoditization for many product categories, and low barriers to entry. The past several years have been a particularly challenging time for traditional retailers. Circuit City, Linens 'n Things, and Borders closed their doors, while names like  Barnes & Noble ,  Sears ,  Staples , and  Office Depot (ODP) have struggled to reverse deteriorating sales and profitability trends. We believe a number of factors are to blame for structural pressures facing traditional retailers, including a challenging macroeconomic backdrop, which has pushed consumers to price leaders like  Wal-Mart (WMT),  Costco (COST), and the dollar stores. At the same time, original-equipment manufacturers have increased their ability to take products directly to consumers and reduced their dependence on the traditional retail sales model. Nevertheless, we believe e-commerce has been the most disruptive headwind to traditional retailers over the past decade; players like  Amazon.com (AMZN) operate with more capital-efficient business models than traditional retailers and can pass these savings to consumers in the form of lower prices. E-commerce now represents more than 6% of U.S. retail sales and is up approximately 14% year to date, according to comScore, and we expect industry growth trajectories to remain in the low-double-digit range over the next several years.

Retailers are not taking the e-commerce threat lying down. Amazon's and  eBay's (EBAY) impressive user and revenue growth trends have forced many retail management teams to employ more tactical measures across all channels over the past year. Since the holiday season of 2012, we've seen traditional bricks-and-mortar retailers adopt more aggressive (and transparent) price-matching efforts as well as other promotional activities to remain competitive with online players. This list includes a number of retailers in commoditized categories where consumers will typically make their final purchase decision based on price and not the expertise level of a sales associate. We view this as an important step for these players to remain relevant in light of increasing online competition, where leading players like Amazon can price more competitively because of structurally lower overhead costs stemming from the absence of a physical store presence and a willingness to sacrifice margins in order to breed customer loyalty. However, as traditional retailers increasingly match prices, we expect to see downward pressure on their gross margins in the years to come.

We've seen management teams employ other creative defensive tactics to protect themselves from online retailers this past year. In 2012, the consensus opinion was that excess square footage was going to be a liability for most traditional retailers--waning in-store transactions would ultimately lead to operating deleverage and put downward pressure on margins. Nevertheless, we've seen a number of retailers turn their square footage from a potential liability into an asset this year by developing stores within stores with key vendors.  Best Buy (BBY) (with its partnerships with Samsung,  Microsoft (MSFT),  Google (GOOG), and even Amazon) has been one of the more notable names adopting this strategy, which should yield near-term revenue gains, even if it does carry some longer-term risks by providing vendors with a blueprint to develop longer-term direct-to-consumer plans where they become less reliant on retailers themselves and can capture a greater percentage of the economic profit from each sale. We've also been impressed that many retailers have turned their stores into fulfillment centers to expedite online orders or partnered with eBay to expedite same-day deliveries, though we believe some of this momentum may be stunted as Amazon continues to "get closer to consumers" by opening additional fulfillment centers.

Many retailers have also embraced mobile devices as a way to stay relevant. Consumers have been using smartphones and other mobile devices as a price-comparison tool for a few years now, but we've witnessed the creation of mobile apps by retailers in the past year or so that enhance in-store shopping trips. The more effective retailer mobile apps we've seen include features like detailed product information, in-store price comparisons, access to loyalty program balances and special promotional offers, and social media and interactive gaming tie-ins. In our view, embracing mobile technology is an important step for traditional retailers, as we believe those players who find ways to engage customers across multiple channels will be the best positioned to compete with e-commerce players over the long haul.

Which retailers are best positioned to respond to the threat of e-commerce? We believe retailers possessing brand intangible assets and scale cost advantages--two of the five criteria Morningstar uses to evaluate a company's economic moat--are best positioned to compete with Amazon and other large e-commerce players. First, scale allows retailers to purchase inventory at an attractive price and narrows Amazon's ability to undercut their prices. Second, scale allows for advanced shipping infrastructure and efficiencies. Third, a well-known brand aids in search engine rankings, eliminating the need for expensive search keyword purchases. Fourth, becoming a one-stop shop for all needs, with targeted sorting and data on payment method, shipping address, and past purchases, creates a switching cost to consumers.

To evaluate the competitive position of traditional retailers in the e-commerce era, we also believe it is critical to understand how pricing and service differentiation within a given retail category shape consumers' shopping and purchase decisions. In particular, we believe investors need to consider each retail category's price transparency and average ticket size, the shopping experience, expert help, immediate needs, shipping cost, and product assortment. We believe some retail business models, like home-improvement and auto-parts retail, have been largely insulated from e-commerce competition because of the specialized nature of the product assortment and need for sales associate help. Not surprisingly, the retailers that we believe are best protected from e-commerce players are also the ones that have established economic moats. On the other hand, industries such as consumer electronics, sporting goods, toys, and office products are more exposed given the commoditized nature of the product mix, reasonable shipping costs, and online pricing transparency. We believe these categories have been subject to product price compression as online choices have proliferated.

Technological Advances Have Affected Not Only Consumer Behavior but Also Retailing Itself
Innovations in devices and Internet capabilities have redefined the way we communicate, seek information, access entertainment, and shop. In fact, these four activities, which were once distinct, are now thoroughly incorporated and accessible at all times, in all places, and across all devices. This has revolutionized the retail sector and disrupted the order of traditional players.

With the advent of social networks, gaming sites, streamed videos, and blogs, malls are no longer the social hub they once were. This is especially true for teens and young adults. Retailers that once saw their stores as social gathering places now are only destinations in the event a need crops up. Data from eMarketer indicates that adults in the United States spend more than five hours a day online. With so much of their time and activities tied up there, it is logical that purchasing behaviors would shift online, too.

Technological advances have affected not only consumer behavior but also retailing itself. Ease of website development, cheap payment processing options, and immediate global reach have removed almost all barriers to entry and flooded the retail space with competition. Research conducted by the National Retail Federation found that most retail companies are small businesses, with more than half of those in operation for an entire year having fewer than five employees. Retail businesses tend to be smaller or local-only operations, and 95% have only one location. Despite their limited physical footprint, they now have worldwide reach through the Web.

Over 1992-2011, U.S. online retailers and mail-order houses as a whole experienced a 19-year compound annual growth rate of 11%. To put that in perspective, over the same period, U.S. retail sales experienced a growth rate of 4% based on U.S. Census Bureau Retail Trade Reports. In our opinion, we are now at a significant inflection point as mobile devices and payment capabilities have matured and device prices have fallen, making them affordable and ubiquitous. We think e-commerce penetration will accelerate and grow from 6% today to more than 10% of all U.S. retail sales (including grocery and autos) by 2017.

While much hype revolves around U.S. figures, China is experiencing explosive e-commerce growth and Eastern Europe is seen as the next frontier for booming online economies. ITU ranked the U.S. only 24th worldwide in the percentage of residents who use the Internet. According to Internet World Stats, 45% of Internet users reside in Asia and 22% in Europe. North America comes in third, with 11%. We believe globalization is driven by increases in broadband penetration and smartphone adoption. Mobile device adoption and innovation has served to fuel worldwide Internet use growth. Once dependent on access to an expensive computer and broadband connection, consumers can now access the Internet through a relatively cheap smartphone. We estimate mobile broadband subscriptions are topping 2 billion worldwide. As a result, we estimate the global e-commerce market totals $585 billion, which is a 4% penetration of total retail sales. We think global e-commerce will grow at a five-year compound annual rate north of 15%, driven by increases in mobile and broadband penetration and e-commerce adoption.

Success in e-commerce is not as simple as opening an online storefront, however. In terms of market concentration, the U.S. has a clear market leader in Amazon, whose 2012 product sales ($51.7 billion, excluding services) roughly equal the next nine closest nonauction competitors combined, according to our estimates. We attribute this dominance to one of the widest economic moats in the consumer space, primarily derived from the company's low-cost operations and capital efficiency. Maintaining Amazon's impressive distribution network costs less than maintaining physical retail storefronts, leading to lower prices for customers and market share gains across a number of categories. Amazon also benefits from a network effect, as low prices and an expansive breadth of products attract millions of customers (active customers now total 224 million across the globe and have seen a 20% CAGR during the past five years), which in turn attract merchants of all kinds to Amazon.com, including third-party sellers on the platform and wholesalers/manufacturers selling directly on Amazon.

Consumers' Shift to E-commerce Becoming Apparent With Holiday Sales Trends
According to NRF surveys, more than 141 million people shopped Thanksgiving weekend in 2013, a slight increase from the 140 million last year. Black Friday remains the biggest shopping day of the weekend, accounting for 65% of the weekend's total shoppers participating on Black Friday. This represents approximately 92 million shoppers, or a 3% increase from 2012. However, there was a notable uptick in traffic on Thanksgiving Day, where earlier store hours and other promotional activity helped to drive a 27% increase in the number of shoppers compared with last year.

However, shoppers reported spending $407 million Thursday through Sunday on average versus $424 million last year, representing a 4% decrease year over year. We attribute much of this decrease to an intensely promotional environment, and view earlier store hours, layaway programs, and deeper Black Friday promotions as not just temporary pressures, but instead secular headwinds plaguing traditional bricks-and-mortar retailers. Generally speaking, the retail sector has become much less fragmented (which historically allowed larger retailers to post easy share gains against weaker local or regional players), and we expect price competition from Amazon and other mass merchants to remain a consistent theme in the holiday seasons to come. Additionally, consumers' increasing comfort with shopping online has fundamentally changed the way traditional retailers conduct business, and suggest that market share gains will be difficult to come by not only during the 2013 holiday season, but also for several years to come. The Internet also allows retailers to be more dynamic with respect to pricing, promoting an "everyday low price" business model and less one-time, limited-quantity, early morning offers in holiday seasons to come.

Consumers' shift to e-commerce for holiday shopping is supported by recent industry data. Forty-two percent of NRF survey respondents shopped online on Black Friday Weekend versus 44% in 2012. However the average person spent $178 online, which was 44% of their total weekend spending, up from 41% last year. Additionally, ChannelAdvisor, which tracks gross merchandise volume activity on major online shopping platforms, reported that third-party volumes for sellers on Amazon and eBay's marketplaces increased 42.1% and 28.0%, respectively, for the holiday-to-date period (Nov. 28 to Dec. 8, 2013). These reinforce our favorable long-term outlook for e-commerce players like Amazon and eBay, and add support to our cautious for traditional retailers operating in commoditized categories.

Our Top Consumer Cyclical Picks
After an impressive run during 2013, we peg the average price/fair value ratio for our consumer cyclical universe at 1.07 (implying that the category is moderately overvalued). There are few outright bargains, though 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 (but not overly dependent on these regions), resources to extend brand reach, and strong dividend-growth potential. We've highlighted five of our top consumer cyclical stock picks below:

Top Consumer Cyclical Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Swatch		CHF 700	Wide	High	0.81
eBay		$63	Wide	Medium	0.82
Urban Outfitters		$43	None	High	0.83
Ross Stores		$82	Narrow	Medium	0.87
Coach		$61	Narrow	High	0.91
Data as of 12-17-13.

 Swatch Group (UHR)
We believe recent concerns about increasing competition from smartphones and smartwatches, changes in China gift-giving rules, and uncertainty about new technologies have been overblown. In fact, we view several of Swatch's new products and patented technologies (more than 150 in the last two years alone) as a competitive strength that has not been fully appreciated by the market. Innovations range from automation of component-making functions that have traditionally been by hand to introducing nonferrous or even nonmetal movement parts. We also identify several other positive catalysts on the forefront, including the Swiss Competition Authority's decision to allow Swatch to keep more of the watch components it makes for its own brands. Swatch should also benefit from the Sochi Olympics in 2014. We also believe Swatch's middle-range brands are picking up in Europe and continue to gain recognition in emerging markets and China.

 EBay (EBAY)
We view the current share price as an intriguing entry point for eBay, given our view that the company is well-positioned to capitalize on favorable, sustainable long-term trends in commerce online (via site enhancements, adjacent formats, increased PayPal acceptance) and offline (through mobile shopping and payments, in-store PayPal tests, same-day delivery services for retailers). With an extremely capital-efficient business model and a wide economic moat grounded in a solid network effect, eBay's role as a global commerce facilitator should translate into excess economic profits over the next several years. We also believe management's goal of $300 billion in enabled commerce volume by 2015 (which compares to $175 billion in 2012, and includes approximately $75 billion in mobile enabled commerce) offers several potential sources of upside to our current estimates. In our view, the current share price understates the company's long-term growth opportunities.

 Urban Outfitters (URBN)
With only 500 global locations, we believe Urban Outfitters still has room for location growth, especially in Europe, and longer term in Asia as the brands expand. In our opinion, the eclectic selection of merchandise Urban Outfitters offers insulates it from direct e-commerce competition, as it would be difficult to comparison shop prices for apparel, home goods, accessories, and trinkets all in one easy location. Additionally, the higher-income consumer that both Anthropologie and Free People cater to tend to spend more consistently through economic cycles, supporting a more stable revenue stream if the merchandise is right. We see a longer-term opportunity in the Free People brand entering more wholesale relationships, which could grow quickly. In the near term, the stock could be waylaid by headwinds across the apparel sector, but we see the business as relatively better positioned than numerous other bricks-and-mortar apparel businesses, especially thanks to the success of its e-commerce channel (which had grown double digits annually over the last five years).

 Ross Stores (ROST)
Because of incomplete merchandise assortments, frequent inventory turnover, and low prices, the off-price retail model is hard to replicate in a profitable way online. We believe Ross’ merchant force of 600 buyers, financial ability to offer vendors attractive terms, and well-developed relationships with more than 8,000 vendors are difficult and time-consuming to build, providing the foundation for our narrow moat rating and protecting the company from online threats. We think the flexibility of store layout and ability to vary store merchandise to match local preferences allows the store to work in any geography and to serve any demographic. The treasure hunt aspect of shopping the store, along with frequent inventory turnover, keeps customers coming back. These attributes should allow the company to meet our expectation for 8% revenue growth in 2014 and our $82 fair value estimate.

 Coach (COH)
We believe Coach is suffering from the shift from logo bags to more subdued and traditional leather fashions. We also believe there is a cyclical shift away from accessories as consumers move to bigger-ticket purchases after having added extra handbags to wardrobes in the past four years. Among short-term negatives, North America store traffic is soft, inventory is up, and clearance is expected in factory channels. While the company hasn’t given investors much to cheer about for the next nine months, there are signs that the new lifestyle strategies are beginning to gain traction, as China trends remain strong and European expansion is in the very early stages. The men's business continues to grow and is underserved in the market, in our view.

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