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Quarter-End Insights

Consumer Cyclical Investors: Shop Carefully in 2015

Those firms with moats will continue to take share, despite near-term uncertainty about foreign exchange, European spending, and Asia Pacific regional growth.

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  • We believe the market has appropriately priced in consumers' current spending capacity across the globe, and the consumer cyclical sector is slightly overvalued. We believe that many companies in this sector have become increasingly lean over the last five years, leading to decelerating operating margin expansion in years ahead.
  • Globally, investors and analysts are pressing for more transparency from management of companies, leading to better clarity on capital allocation and operating margin goals across many firms.
  • Foreign exchange remains the broadest near-term risk for companies we cover, with both the euro and the Canadian dollar weakening materially against the dollar over the last few months. We expect this to reverse over the long term.
  • While foreign-exchange risk will probably not affect a company's moat rating, the ability to pursue operational excellence within an industry and continue to drive expense leverage could change the cost structure of a business, improving a company's moat, while affecting peers negatively. We expect to see best-in-breed businesses emerge as those companies that consistently drive on the importance of low cost and brand equity segregate themselves from the rest of the group.

Broadly speaking, we view the consumer cyclical sector as slightly overvalued at current levels, trading at a median price/fair value estimate just above 1. Although there are a few pockets of opportunity across our various industry groups--including resorts and casinos, home improvement stores, luxury goods, recreational vehicles, and leisure--we generally believe that the market has appropriately priced in consumers' current spending capacity across the globe.

Among the industries that we find overvalued at current levels are lodging and auto-parts manufacturers. Although we expect U.S. consumer spending to continue to improve moderately in 2015, we remain concerned that European spending could tick down and that China will continue to have positive spending trends, albeit lower than in the past.

However, we believe a number of companies in the consumer discretionary industry are operating more competitively thanks to increased investor scrutiny and  incentives to capture incremental consumer spending, which has become consistently more difficult to achieve since the last recession.

On the investor side, firms have appeased investors by laying out concise financial and capital allocation goals, which should lead to better operating leverage and returns on invested capital as the teams attempt to grow the business. Stating specific metrics the company hopes to achieve holds management accountable to reaching such goals (or attempting to), and facilitates clarification on how each company can achieve its medium- to long-term goals, be it by gross margin expansion; selling, general, and administrative leverage (cost control); or faster revenue growth. These metrics help ensure that the business is being developed properly to support the company's long-term competitive position and economic moat (if it has one).

In turn, many of these goals should be achieved by firms offering products better-tailored to consumer wants, driving demand from a wider customer base, which should help the company close more transactions, driving higher revenue and operating leverage. Many companies have developed their omnichannel strategies in response to support of individual consumer demands, developing capabilities in seamless inventory, supply-chain efficiencies (leading to faster turns), and speed in point-of-sale data, all lending to faster responsiveness by consumer companies.

Despite companies becoming leaner in operations and smarter at generating faster revenue growth (due to restructurings after the last economic downturn and an increase in collecting the data of consumer preferences), domestic companies selling abroad have been plagued by foreign-exchange headwinds, as the dollar has strengthened and currencies like the euro and Canadian dollar have weakened dramatically. We do expect currency headwinds to eventually abate, but the next year looks particularly difficult for U.S. firms selling abroad, and we would prefer either U.S. firms selling products in the U.S. or international firms selling into the stronger dollar or into their own currency, avoiding translation volatility.

Although we see some cyclical uncertainty across our discretionary coverage, we still believe there are solid, strong ROIC-generating companies in the sector. A number of these companies that we would expect to succeed have already developed their brands into products that customers are willing to pay a premium for, which has already offered the business an economic moat. This generally leads to a return on invested capital that is above the company's cost of capital.

Over time we expect the leaders in each segment to take share from peers through both continuous operational excellence initiatives and brand-building awareness, leading to improved top- and bottom-line growth, despite near-term uncertainty about foreign exchange, uncertain European spending, and decelerating Asia Pacific regional growth.

Top Consumer Cyclical Sector Picks

Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
Priceline
$1,860 Narrow High $1,116
Swatch $31 Wide High $18.60
Wynn Resorts
$180 Narrow
High $108
Data as of 03-26-2015

 Priceline (PCLN)
Priceline is the world's largest online travel agency, offering booking services for hotel rooms, airline tickets, rental cars, restaurant reservations, cruises, and other vacation packages. Transaction fees for online bookings account for the bulk of revenue and profits. We expect Priceline's global online travel agency leadership position to expand over the next decade at a much faster rate than that of primary competitor Expedia, driven by a superior position in China, continued leadership in Europe, and expanding presence in the U.S. We see the firm's global share of online bookings reaching high single digits in 2019 from 3.7% in 2013, project a midteens 2015-19 earnings CAGR, and view the current 19 times non-GAAP 2015 earnings multiple as providing an attractive margin of safety for new money allocations.

 Swatch (SWGAY)
Swatch Group is one of the world's largest manufacturers and distributors of timepieces. With a portfolio of 20 brands, including ultraluxury Breguet, Omega, Longines, midrange Tissot, and entry-level Flik Flak, Swatch is as much about fashion and design as it is about accuracy and dependability. We view Swatch as one of best ways to gain exposure to the global hard luxury market, long-run European recovery, and emerging-markets middle-class growth simultaneously. We believe new products and technologies for mechanical watches could be growth drivers for the watch industry, increasing consumer awareness and shifting preferences further toward Swiss mechanical watches. Technologies will necessitate a further retail build-out for Swatch brands and enable increased automation in production, both driving long-term margins. In addition, Swatch's watch components business has high barriers to entry and should increase margins over the long term, aided by Swiss Competition Authority rulings.

 Wynn Resorts (WYNN)
The Macau gambling region (which makes up the majority of Wynn's revenue) has suffered in recent months because of a slowing Chinese economy and government efforts to stem corruption-related issues, but we think the market's reaction to these near-term pressures has been overblown. We continue to believe the geography's push toward mass gaming, which offers higher margins than related VIP gamblers, combined with Wynn’s upcoming Cotai Strip casino will support higher revenue growth and profitability for the company. We also see steady improvement in the firm's Las Vegas revenue and profitability, and ultimately believe the stock offers a sizable margin of safety at current levels.

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Jaime M. Katz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.