Consumer Cyclical: Near-Term Concerns Over China Create Buying Opportunities

• Our consumer cyclical universe trades at a median price/fair value of 0.95 after spending much of the year modestly overvalued. Although we acknowledge the possibility of more-volatile consumer spending trends than we've become accustomed to across the globe throughout the balance of 2015 and into 2016, we believe the market now appears to be pricing in more conservative long-term cash flow assumptions than baked into our longer-term consumer cyclical valuation assumptions.
• Most of the market's global macro fears are derived directly from China, where we've heard cautionary statements from a number of consumer-facing companies. Consumer spending trends may take time to stabilize, but we continue to take a constructive view on companies with exposure to China's growing middle class due to favorable wage growth and job creation/urbanization trends.
• Although we admit that the long-run health of the Chinese economy is significant to our luxury coverage universe, we believe these names are well-positioned to weather the highs and lows of the annual sales trends given the strength of their powerful brand intangible assets, many of which have endured for several decades and provide the foundation for our sectorwide wide- and narrow-moat ratings.

After trading at a median price/fair value above 1 for the better part of the year, Morningstar's consumer cyclical universe has pulled back in recent weeks and now trades at a median price/fair value estimate of 0.95. We attribute much of the recent weakness to concerns about slowing economies across the globe, which we believe have triggered a rotation into less discretionary categories.

Sentiment among affluent consumers appears relatively healthy even after recent market volatility, and we still expect growth out of our discretionary names (albeit at a decelerating pace). We're keeping a close eye on consumption trends among high-end consumers, who tend to take spending cues from asset/equity market valuations. Although we acknowledge the possibility of more volatile consumer spending trends than we've become accustomed to across the globe throughout the balance of 2015 and into 2016, we believe the market now appears to be pricing in more conservative long-term cash flow assumptions than our consumer cyclical models assume.

Most of the market's aforementioned macroeconomic fears are derived directly from China, where we've heard cautionary statements from a number of consumer-facing companies following China's decision to devalue the yuan in early August and the recent stock market volatility. China e-commerce giant

These comments are among the earliest regarding the slower pace of consumer spending in the region, but aren't likely to be the last. While we recognize that spending trends may not inflect until equity markets stabilize--something that could certainly take several quarters--we believe the slowing pace of consumption has more to do with consumer sentiment and less to do with consumers' inability to spend. We continue to take a constructive view on companies with exposure to China's growing middle class, including Alibaba, JD.com,

Not surprisingly, luxury names--many of which have heavy exposure to China--have also been hit hard by China macro concerns and now are trading at a median price/fair value of 0.82. Although we admit that the long-run health of the Chinese economy is significant to our luxury names and their corresponding valuations, we believe the firms are well-positioned to weather the highs and lows of the annual sales trends given the strength of their powerful brand intangible assets, many of which have endured for decades or even centuries (which also provides the foundation for our sectorwide wide- and narrow-moat ratings).

Among the most attractive names in the luxury category are

With Ralph Lauren, current cyclical and near-term headwinds are present, but we believe the recent sell-off amid worries over the firm's largest customer,

Wynn Resorts

WYNN

We believe Wynn is well-positioned for the long-term growth we see in the Macau region (70% of Wynn's 2014 EBITDA), driven by its intangible gaming concession asset. We remain constructive on long-term growth in Macau, which is supported by the heavy investment occurring in infrastructure, Hengqin Island, and new casino projects (Wynn's Cotai casino is set to open March 25, 2016, and increase the company's Macau room share to 9% from 6%) that should support the large population in near proximity. That said, shares have been pressured due to the government's ongoing anti-corruption measures, which have resulted in declining industry gaming growth in the Macau region. Additionally, Chinese economic data has weakened recently, which has provided some additional pressure on share performance. We believe the near-term slowdown is presenting an attractive margin of safety for investors with shares trading at a significant discount to our fair value estimate.

Gap

GPS

With investor attention focused on what we perceive to be near-term, fixable product issues within the core Gap brand, we think that Gap's larger and more important margin expansion story is being overlooked. Having invested heavily in a seamless inventory model (expected to be fully integrated by 2016); omnichannel capabilities including ship-from-store, find-in-store, reserve-in-store, and order-in-store; and responsive supply chain initiatives including fabric platforming, vendor-managed inventory, rapid response, and test and respond, we think Gap is poised to close the disparity between its low-double-digit operating margin and the high-teens margins of fast-fashion competitors.

All these initiatives reduce lead times and allow the company to read demand and react to color, size, or silhouette that customers are purchasing. In total, these initiatives should reduce volatility in performance, increase full-price sell-through, and fulfill previously missed sales, putting Gap well on track to matching fast-fashion core competencies. The company expects to increase the percentage of assortment on the responsive model to 50% by the end of 2016. If successful, we see no reason Gap could not reduce the operating margin gap between itself and other fast-fashion retailers and further distance itself from other no-moat companies.

We continue to view near-term product misses at the Gap and Banana Republic brands as fixable and think the brands are on track to post positive comparable sales growth in 2016. Although we do not think new products will hit the shelves until the end of the fourth quarter or early 2016 given current lead times, we think the company is on track with its turnaround efforts. In our opinion, management and brand teams have correctly identified the source of prior product misses--namely fit, quality, and design--and new products will resonate better.

As the stock is currently trading at a discount to our fair value estimate, given product challenges and an underappreciation of the margin expansion opportunity, we think that this is an attractive entry point for investment.

Ralph Lauren

RL

Ralph Lauren possesses a portfolio of brands that can be priced at a premium to competitors, and the firm's solid returns on capital are testament to the power that 50 years of image-making have instilled in the Ralph Lauren name. Yet despite a solid track record of growth and profitability, headwinds ranging from currencies to changes in tourist flows to increased infrastructure spending, combined with slower growth, have caused the stock to trade at a wide discount to our fair value estimate.

Although we rate Ralph Lauren only a narrow moat, and we note that some of the firm's derivative sub-brands are positioned at less-exclusive price points, we believe the current discount in the stock overestimates the depth and duration of the company's current difficulties.

We believe that the brand's relatively low penetration in China and emerging markets leaves it significant growth opportunities. In addition, Ralph Lauren can continue to take share in accessories, where it has less than 10% of its sales, and in the women's categories, which unlike most luxury goods firms, is smaller than men's.

More Quarter-End Insights

• Stock Market Outlook: Minor Correction Not Enough to Make Stocks Cheap
• Economic Outlook: As World Growth Falters, the U.S. Consumer Rolls Along
• Credit Markets: Plummeting Commodity Prices Take Their Toll
• Basic Materials: U.S. Construction Activity Provides Shelter From the Storm
• Consumer Defensive: Upside in Staples Companies With Long-Term Cost-Cutting Opportunities
• Energy: No Rapid Rebound for Oil Prices
• Financial Services: Re-Analyzing Banking Systems and Bank Moats
• Health Care: Recent Pullback Opens Door to More Compelling Valuations
• Industrials: High-Quality Industrials Are on Sale
• Real Estate: For the Strong Stomached, Commercial Real Estate Looking More Attractive
• Tech and Telecom: Still Watching Foreign Exchange Headwinds and the Cloud
• Utilities: Low Rates Keep the Sector's Lovefest Raging