Consumer Cyclical: Assessing Disruptions in Restaurant, Retail, and Travel

• Our consumer cyclical universe trades at an average price/fair value of 1.02, suggesting that market valuations are generally aligned with our longer-term revenue growth and margin expansion forecasts. Sentiment among affluent consumers appears relatively healthy, although we continue to take a more balanced view of the spending power of lower- to middle-income consumers.
• We believe the market continues to overlook the longer-term growth prospects of the online travel industry, particularly those players with international exposure.

Our consumer cyclical universe trades at an average price/fair value of 1.02--a shade below Morningstar's overall coverage universe at 1.03--suggesting that market valuations are generally aligned with our longer-term revenue growth and margin expansion forecasts. Although sentiment among affluent consumers appears relatively healthy, and we expect growth out of our discretionary names (albeit at a decelerating pace), we're monitoring spending among high-end consumers, which tend to take spending cues from asset and equity market valuations. A meaningful reversal in high-end spending would not only have an adverse impact on discretionary names, but it would also have implications across the broader consumer sector.

That being said, we've adopted a more balanced outlook for spending among lower- to middle-income consumers, acknowledging positives in the continued unemployment declines, general housing market improvements, and lower gas prices but also negatives in real wage growth trends and elevated cost-of-living expenses such as rent, utilities, and health care. We're more cautious about Europe consumer spending trends amid persistent unemployment but remain generally upbeat about the longer-term potential of China's middle-class through wage-driven wealth creation.

From a valuation perspective, one of the most intriguing categories is restaurants, with fast-casual chains such as Chipotle and Panera increasingly becoming disruptive forces for both traditional quick-service and casual-dining restaurant chains. In our view, fast-casual restaurants have adjusted better to changes in consumer behavior during the past several years, including increased spending power among minority groups and millennials (which has created demand for a wider variety of flavors, better-for-you products, and locally sourced food), evolving views about in-restaurant experiences (resulting in consumer calls for customizable menus and faster throughput), and widespread advances in consumer-facing technologies (leading to mobile-based ordering, payment, and loyalty programs as well as in-restaurant wireless offerings).

More important, consumers aren't just willing to visit fast-casual chains more frequently; they're also willing to pay premium prices for the product and restaurant experience. The companies that have stayed ahead of changing consumer preferences have also experienced a meaningful increase in average checks during the past five years, while the increase for traditional quick-service restaurants, or QSRs, has been more muted. In our view, the increase in average check suggests greater pricing power, and by extension, a strengthening of the brand intangible asset source that we consider when evaluating economic moats among retailers and restaurants.

The growth of the fast-casual restaurant industry coincides with a major structural shift within the retail space: greater adoption of online and mobile commerce. With fewer retailers operating in relatively insulated categories offering meaningful long-term growth opportunities in the United States, we believe the commercial retail real estate market has found itself with excess supply. In our view, commercial landlords are eager to fill this real estate, and between the overlap with changing consumer views about dining out and the strong unit economics for operators, fast-casual restaurants have become the one of the preferred ways to fill this excess real estate capacity. Coupled with fewer high-growth opportunities across the traditional retail sector and the lack of a major disruptive presence like Amazon, we believe this has attracted investors to the restaurant category, resulting in inflated valuations in many cases (though we still see opportunities in names like

Although we believe pressure from e-commerce led to structural changes across the retail industry and has indirectly driven up valuations in the restaurant category, we still find several instances of retailers that are better insulated from e-commerce competition than others. Tractor Supply is a perfect example, offering a unique competitive position relative to peers that focus on one segment of the market. Tractor Supply's breadth across categories--including livestock and pet (44% of sales); hardware, truck, towing and tool products (22%); seasonal products (20%); work/recreational clothing and footwear (9%); and agriculture (5%)--provides a one-stop solution for those looking to fill multiple needs in a number of outdoor categories. While consumers are able to acquire similar merchandise at peers such as

We believe that Tractor Supply's product offerings will allow the company to maintain its market leadership position in the $400 billion outdoor lifestyle market (which encompasses home improvement, pet supplies, and apparel) for two reasons. First, despite its leading position in certain categories, we think the firm possesses the ability to continue to benefit from scaling its operations, as it builds out its store footprint (we expect Tractor Supply to add about 100 stores annually over our 10-year explicit forecast). We think another rural lifestyle competitor would need to get to more than 1,000 locations to begin to capture similar vendor pricing as Tractor Supply, particularly in some of the specialized categories such as equine or livestock.

Second, if competitors were to arise, we still think Tractor Supply could offer better pricing thanks to its established scale, possibly driving the new entrant out of business in key markets (or could even prevent entry). We have seen numerous small hardware and pet supply stores close their doors over the last few decades as larger competitors such as Home Depot, Lowe's, and PetSmart have entered local markets. We don't view Tractor Supply's competitive positioning much different from either the home improvement and pet supply sectors, which remain relatively insulated from e-commerce threats, as many of the more sizable items Tractor Supply stocks are costly to ship (generators, safes, animal feed). The company also captures vendor benefits from its sizable volume in certain categories, which it can pass on in everyday low prices, which would put it on equal pricing footing versus an online retailer.

Online travel is another area exposed to rapid technological changes that the market continues to overlook, particularly those players with international exposure. The online travel market has been a fast-growing space the past five years (with a 13.1% annual growth rate since 2010), and we see several industry growth drivers--including emerging markets, in-destination services, vacation rentals, mobile usage, and hotel service software--that will support solid (although slightly slowing) bookings growth the next several years.

This industry growth, which we forecast at a 9.8% annual clip through 2019, should benefit both

Wynn Resorts

WYNN

We view Wynn Resorts as a well established high-end iconic brand that is positioned to participate in the attractive long-term growth opportunity of Macau (70% of EBITDA), as the company expands its room share to 9% from 6% through the Cotai Palace opening in 2016. The offset to this expanded room presence is the continued shift away from VIP and gaming revenue (where Wynn has an outsize exposure) toward nongaming and mass play, as well as its existing Macau property being located on the peninsula, where traffic has lagged Cotai. In our view, it is not unreasonable to expect Macau visitation and revenue to reaccelerate to above a mid-single-digit pace in a few years, as new casinos open in 2015-17 (increasing Macau room supply toward 43,000 from 28,000 currently), infrastructure is built out in 2017 and beyond (easing overcrowding and accessibility issues), and nearby Hengqin Island is developed over the next decade (3 times the development area of Macau). This increased supply should easily be matched with demand, as the population within a few hours of Macau is seven times that of Las Vegas, yet the number of Macau rooms and visitors were only one-fifth and three-fourths that of Las Vegas in 2014. With Wynn holding one of only six gaming licenses it stands to benefit from this growth.

Priceline Group

PCLN

We think that Priceline's narrow economic moat, derived from a powerful network effect, is becoming stronger over time, and expect the company to increase its global market share of all travel bookings from mid-single digits currently, to high-single digits in the next five years. With more than 85% of bookings derived from less penetrated international markets, we expect the company to grow significantly faster than rival Expedia. We view valuation as attractive, with the stock trading at a P/E ratio of only about 16 times our estimated 2016 non-GAAP earnings, an unduly low multiple given our outlook for roughly 16% EPS growth the next five years.

Swatch Group

SWGAY

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. The sudden appreciation of the Swiss franc is a short-term negative, but revenue related to U.S. dollars will partly offset franc-based costs, and the strength in the franc should normalize in the long run. While the potential of the

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