Consumer Cyclical: 4 New Realities for Retailers

• We believe the market has appropriately priced in consumers' current spending capacity across the globe. We've adopted a balanced outlook for consumer spending for the 2014 holiday season, acknowledging positives in the continued decline in unemployment trends and a relatively stable housing market in the U.S. but also questions about the macroeconomic environment across Europe and Asia Pacific.
• In our view, a fundamental shift in shopping behavior, highlighted in last year's holiday season, has resulted in increased value orientation among consumers, demand for convenience, market share competition from other categories, and volatility in demand for products. Companies that can meet these new realities likely have an economic moat, ultimately leading to better full-price sell-through and margin performance.
• We believe mobile devices are poised to be the next great disruptor in the retail space based on mobile penetration rates, retailers' use of mobile devices to enhance the in-store experience, and mobile payment developments.
• While we believe mobile devices will help to make retailers more competitive over a longer horizon, we ultimately believe that fulfillment is an area where retailers still have much ground to make up on  Amazon (AMZN). Despite retailers' increased emphasis on logistics and delivery speeds in 2014, only a few retailers can match its capacity and geographic reach, most retailers' fulfillment centers were not designed for e-commerce, and Amazon's inventory productivity across a wide breadth of products is unprecedented.

 

Broadly speaking, we view the consumer cyclical sector as fairly valued at current levels, trading at a median price/fair value estimate of about 1.01. Although there are a few pockets of opportunity across our various industry groups--including resorts and casinos (with a ratio of 0.69), home improvement stores (0.94), luxury goods (0.95), recreational vehicles (0.95), and department stores (0.95)--we generally believe that the market has appropriately priced in consumers' current spending capacity across the globe.

We've adopted a balanced outlook for consumer spending for the 2014 holiday season, acknowledging positives in the continued decline in unemployment trends and a relatively stable housing market in the U.S. but also questions about the macroeconomic environment across Europe and Asia Pacific. Although sentiment among affluent consumers appears to be relatively healthy across the globe, we continue to monitor changes in spending among higher-end consumers (who tend to take spending cues from asset market valuations). A meaningful reversal in asset market valuations would not only have an adverse impact on more discretionary names but would also have implications across the global consumer sector.

Among the industries that we find overvalued at current levels is apparel (price/fair value of 1.11) and specialty retailers (1.07). While we acknowledge that consumer spending capacity has improved in 2014--at least in the U.S.--we believe the market may be underestimating structural changes across the retail category brought about by the rise of e-commerce. We continue to believe that e-commerce--and more recently, mobile commerce--represent the most disruptive structural change in the retail sector since the rise of mass merchants and warehouse clubs in the early 1990s. However, we don't think that Amazon or other online merchants are necessarily a death sentence for all retailers; many players can adapt and thrive amid changing consumer expectations and rapidly evolving technologies.

We see four unique challenges confronting specialty apparel retailers in the modern retailing environment and think that differentiation in these areas will likely yield an economic moat and stronger, more consistent margins and top-line growth. Because of the high volume of purchases and universality of celebrations, it is highly likely, in our opinion, that company capabilities or deficits will be most pronounced during the holiday shopping season. As a reminder, the back half of the year has outsize importance in the retailing calendar, with 55%-60% of sales on average across our retail coverage universe occurring in the second half of the year.

The four themes that we consider essential to long-term success are as follows:

1. Value orientation. Although the Great Recession technically ended in 2009, we believe the magnitude of this downturn structurally changed shopping habits, with consumers exhibiting more pronounced price sensitivity. We believe companies that can provide customers with perceived value without taking a hit on margins will outperform competition.
2. Demand for convenience. Technology has shifted much of the power away from companies and to the consumer. Customers want to shop at any time of the day or week from any retailer worldwide. Fast delivery, free shipping, and easy returns have become the norm. We think companies that are investing in a seamless shopping experience will win both customers and their loyalty.
3. Market share competition from other categories. Millennials appear to be defining themselves more by their technology and their tech accessories than by their wardrobes. Their interests have also shifted from hanging out and shopping in malls to social networking, music, and exploring the restaurant scene. We think retailers that cater to these new interests will draw more visits, whether through foot traffic or online.
4. Volatility in demand. This economic recovery has been a series of fits and starts. With the political environment, weather, and global situation equally unpredictable, retailers that are able to quickly adjust product and inventory levels are much better suited to thrive.

A common thread across each of the aforementioned themes is an attachment to mobile devices. In fact, there are a few factors indicating that mobile devices are poised to be the next great disruptor in the retail space. First, mobile phones have achieved a penetration rate significant enough to justify general retail investment--no longer just for the wealthy or technologically sophisticated, smartphones have reached the masses. Second, retailers are approaching mobile devices creatively. In fact, we think actual purchasing on mobile devices is one of the least-used capabilities. Instead, companies have been very creative in using mobile phones for marketing, conversion, information purposes, and even to drive brick-and-mortar traffic. Third, mobile payment developments are likely to bridge the divide between brick-and-mortar and online channels, as well as once again crossing the divisions among communication, information-seeking, shopping, and entertainment. All in all, we think mobile initiatives are poised to make their debut in the retail world.

However, we expect the impact to differ dramatically from the growth of e-commerce. When e-commerce exploded onto the retail scene, traditional retailers seemed dismissive and caught off guard. Instead of immediately exploring and investing in the new technology, most appeared to hope that it was a fad that would never make it to the mainstream. After all, who would ever order shoes without trying them on? In our opinion, it was precisely this attitude that allowed a slew of pure e-commerce players to enter the competitive market and steal share. By the time traditional broadline players tentatively launched websites,  eBay (EBAY), Amazon, Zappos, and others had solidified themselves as leaders, with strong and trusted brand intangible assets and powerful network effects.

Retailers' early reaction to mobile commerce and apps has been noticeably different. Retailers appear to be embracing the technological innovations and approaching potential functionalities with excitement and creativity. Unlike with e-commerce, we don't foresee new pure-play mobile competitors resulting from the technology. Instead, we think existing retailers will use it to differentiate themselves and increase their competitive position, especially with mobile device ownership reaching critical mass across developed and emerging markets. Even more important, consumers are using the device for a multitude of functions other than simple communication. Given the device's ubiquity, we think that it is poised to be the most attractive channel through which to reach consumers no matter their geographic location or time of day.

Despite widespread mobile adoption, it's important to point out that the device accounts for only about 10% of e-commerce visits and that only roughly 1% convert to purchasing. However, we do not view purchasing as the only use of the mobile device for retailers. In fact, we think that this functionality may be the least attractive to consumers in the long run given the small screen size and the lack of time sensitivity to purchasing products. Instead of making a purchase on a phone, we think consumers are more likely to wait until they have access to a computer or tablet to purchase the product. We think that apps providing product information, store layout, store location, rewards details, coupons, and other benefits will be more appreciated.

While we believe mobile devices will help to make retailers more competitive over a longer horizon, we ultimately believe that fulfillment is an area where retailers still have much ground to make up on Amazon. In our view, 2013 was the year of price-matching for many retailers, emphasizing their ability to match prices as a way to end "showrooming" (where consumers would evaluate products in-store but make final purchases online or through mobile devices) and better compete with Amazon. However, this strategy backfired for many retailers--particularly during the 2013 holiday season--as delivery speed proved to be equally critical in consumers' purchasing decisions.  Best Buy (BBY) CEO Hubert Joly summed up the situation nicely when he said that Amazon "completely shocked" the retail industry in 2013 by guaranteeing delivery through the Monday ahead of the Wednesday Christmas date, when the rest of industry cut off guaranteed holiday orders before the weekend. This effectively extended Amazon's holiday selling window by several days during an already shortened holiday shopping season.

Competitive pricing has always been central to our wide moat rating on Amazon. We believe the cost to maintain its fulfillment network is lower than maintaining a large physical retail presence, allowing Amazon to price below its brick-and-mortar peers. However, we believe a somewhat underappreciated offshoot of Amazon's pricing advantages is the sophistication of its fulfillment infrastructure, something that we believe has led to changes in consumer expectations across many developed markets over the past several years. In our view, a traditional retailer offering similar or even modestly lower prices than Amazon will ring hollow among consumers if that order can't be fulfilled within a few days (particularly as Amazon Prime memberships have surged to around 30 million members globally as of the most recent quarter).

Amazon's fulfillment infrastructure represents a considerable challenge to traditional retailers. Despite retailers' increased emphasis on logistics and delivery speeds in 2014, only a few retailers can match its capacity and geographic reach, most retailers' fulfillment centers were not designed for e-commerce, and Amazon's inventory productivity across a wide breadth of products is unprecedented. It's clear that many retailers have taken 2013's lessons to heart, with 2014 shaping up to be the year when retailers attempt to take the fulfillment fight more directly to Amazon by pushing deadlines for online orders later into the holiday season. We believe  Wal-Mart (WMT),  Target (TGT), and Best Buy are better prepared for expedited shipping this year, while eBay Now and  Google's (GOOG) Express should also benefit from increased consumer demand for same-day deliveries. Nevertheless, outdated distribution center designs and technologies, a lack of integrated physical and online inventory management systems, and higher parcel shipping costs still pose barriers for traditional retailers.

Top Consumer Cyclical Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Wynn Resorts		$245	Narrow	High	0.62
Swatch Group		$36	Wide	High	0.63
Kingfisher PLC		$14	Narrow	Medium	0.75
Data as of 12-23-2014

 Wynn Resorts (WYNN)
Although we believe a demographic shift toward millennial and Generation X consumers, who gamble less, will present long-term secular challenges to the Las Vegas Strip market, we remain constructive on Wynn's Chinese operations--which have driven more than 71% of adjusted EBITDA through the first nine months of 2014--based on longer-term wealth-creation tailwinds in the region and favorable industry supply/demand trends. Additionally, we expect Wynn's upcoming Cotai Strip casino (scheduled to open in 2016) should drive substantial top- and bottom-line growth for the company.

Swatch Group AG (SWGAY)
Swatch Group is one of the largest manufacturers and distributors of timepieces. With 20 different brands, Swatch is as much about fashion and design as it is about accuracy and dependability. Despite current exchange rate headwinds and fears over China demand and coming smartwatches, we continue to believe shares are undervalued. We believe that Swatch still has long-run margin improvement opportunities, and that Swiss mechanical watches will further capture consumers' imagination in an increasingly digital world.

 Kingfisher PLC (KGFHY)
Kingfisher is Europe's largest home improvement retail group, with almost 1,150 stores in nine countries in Europe and Asia. Performance of the French business has depressed overall performance, but comments by President Francois Hollande indicating that France will take measures to kick-start the construction industry should provide some support to Kingfisher's Brico Depot business. We still believe a return to positive housing-price growth in France would be the true catalyst for the stock, which we view as undervalued at current levels.

More Quarter-End Insights

• Stock Market Outlook: Volatility Creates Pockets of Opportunity
• Economic Outlook: Stop Watching the Fed, Start Following the Consumer
• Credit Market Outlook: Tailwind From Declining Interest Rates Has Likely Run Its Course
   
• Basic Materials: Iron Prices Swoon on Weaker China--Copper Is Next
• Consumer Defensive: Only a Handful of Values Left
• Energy: Oil Price Collapse Takes Center Stage
• Financial Services: Bargains Still Hard to Find
• Health Care: A Strong Run, but Some Stocks Still Look Undervalued
• Industrials: Macroeconomic Tailwinds Lift Market Valuations
• REITs: Tread Carefully in This Low Interest Rate Environment
• Tech and Communication Services: Gravitate Toward the Moats
• Utilities: Repeating a Stellar 2014 Performance Will Be Tough