Consumer Cyclical: Market Underestimating Apparel and E-Commerce

• The consumer cyclical companies under our coverage trade at a median price/fair value ratio of 0.93, and we believe the market is underestimating longer-term revenue growth and margin expansion opportunities from this group.
• We think we are at a low point in the apparel retail cycle and see future upside. We do not believe brick-and-mortar apparel retailing is dead, but rather think it will look significantly different in the future as retailers convert to modern responsive supply chains and the athleisure fashion trend winds down.
• We believe the market is overlooking the powerful network effect that many of the leading e-commerce companies have developed over the past several years, not to mention a host of other leading players in more nascent e-commerce markets that are successfully bridging the transition to a business-to-consumer from consumer-to-consumer marketplace through enhanced payment, financing, logistics, and branded store offering.
• We see the increased home-share laws as a small positive for hotels and as largely neutral for online travel agencies.

 

Our consumer cyclical coverage trades at an average price/fair value ratio of 0.93, reinforcing our views that the market is underestimating longer-term revenue growth and margin expansion opportunities from this group. Although we acknowledge the possibility of more-volatile consumer spending trends than we've become accustomed to across the globe--especially when factoring in Brexit-related uncertainty in Europe--as well as supply/demand inventory imbalances during 2016, we believe the market is now pricing in long-term cash flow assumptions that are more conservative than those baked into our longer-term consumer cyclical valuation assumptions.

Sentiment among affluent consumers generally remains healthy, even after recent market volatility, and we still expect growth out of our discretionary names, albeit at a decelerating pace. We continue to monitor consumption trends among high-end consumers, who take spending cues from asset/equity market valuations. A meaningful reversal in high-end spending not only would adversely affect discretionary names, but could have implications across the broader sector.

What We Make of the Near-Term and Long-Term Apparel Retail Environment
Given the recent negative performance of many apparel retailers and some calls that traditional apparel retailing is dead, we thought it would be useful to address our thoughts on these issues and discuss which subsectors and companies we see as positioned best for long-term success.

In our opinion, there has been a secular shift in apparel retailing that we see as a persistent force. We believe the current trend toward value over brand is here to stay. Unless a product can perform notably better than the competition (keep you warmer, keep you drier, perform better in athletic situations), the consumer appears unwilling to pay a premium simply to own a brand. We also think shifts in wallet share are here to stay, with experiences (travel, restaurants) valued over apparel and with other costs (including healthcare, education, and housing) rising in share. Finally, we think the shift in distribution channel toward digital will persist. As a result, we agree that apparel retail growth will probably not return to historical levels.

Having acknowledged that, we believe that we are at a low point in the apparel retail cycle and that there is upside in the future. We do not believe brick-and-mortar apparel retailing is dead; rather, we think that it will look significantly different in the future. We think there is a place for stores where consumers can touch fabrics, try sizes, and check fit.

However, the apparel industry has experienced much self-inflicted near-term malaise. Many management teams have been overly optimistic regarding inventory levels and have not converted to modern responsive supply chains. This has resulted in a highly promotional retail environment that has forced even well-run companies to discount in order to remain competitive.

Second, we think we are nearing the end of the athleisure fashion trend. With consumers having enough skinny and yoga pants to clothe themselves for a while and no new fashion must-have, nothing is driving discretionary purchases.

Therefore, in the near term, we see downside risk to many firms under our coverage, as company guidance for the full year may not have accurately reflected the unexpected decline in consumer demand for apparel that played out over the first quarter. We think these issues will take time to correct and are cautious on the space in 2016. That said, we do think there is long-term upside, as both inventory management and fashion newness can be corrected.

When we look at our coverage, we think the off-price, replenishment, and apparel manufacturers are best positioned for future success. We think traditional retailers and department stores are most at risk.

Off-price retailers are uniquely positioned to capitalize on consumer demand for value and a very responsive inventory-management system. This enables the companies to respond quite quickly to what the consumer wants, no matter how volatile the demand. Their buying system enables them to capitalize on overstock situations and to maintain their margin, no matter how promotional the environment. As a result of this and the benefit of scale in buying, we think these players are somewhat insulated to new competitors. In our coverage,  TJX (TJX),  Ross Stores (ROST), and  Nordstrom (JWN) fall into this category.

We also favor products that are replenishment-focused in nature and where brand is valued more than price. The innerwear category falls into this camp. Price is actually the fifth decision point for consumers in this category, making the customer much more brand loyal than the general apparel universe. In excess inventory situations, basic undergarments can often be stored and sold later at full price. Finally, consumers tend to replace these products as they wear out, making them slightly less discretionary in nature. We highlight  Hanesbrands (HBI),  Gildan Activewear (GIL), and  L Brands (LB) as companies under our coverage that fall into this camp.

Finally, we think apparel manufacturers can be strong performers, provided that there is solid management execution. Although apparel manufacturers are more exposed to the cyclicality of the industry than the above subsectors, they are channel-agnostic, which provides defense to online trends. In fact, we think many will benefit from this, as they can now do business directly with consumers instead of being reliant on other retailers' merchandising and foot traffic. For example,  VF (VFC)'s channel exposure is only 4% department stores, 4% midtier, 12% mass, 25% direct to consumer, and 55% specialty stores.  Ralph Lauren (RL), in contrast, is over 50% direct, but nearly 25% of its wholesale is  Macy's (M).

Therefore, we think well-positioned brands that deliver either value or technological innovations that outperform competitive offerings will survive and grow. From our coverage, we would highlight Gildan, Hanesbrands, and VF in this category. Our thesis on Ralph Lauren is that longer-term growth in international, particularly Asia, and growth in accessories and its own stores can offset the department-store issues.

We think department stores are most at risk in the long term. As these retailers carry many of the same goods as online retailers, we think they are often forced to compete on price, which puts margin at risk. Furthermore, the sector continues to underperform the general apparel retail environment, and we think it is in a state of secular decline, as the format has become tired compared with new retailers. Of our coverage (Macy's,  Kohl's (KSS), and Nordstrom), we think Nordstrom is best positioned in the long term because it carries many smaller brands that cannot move direct to consumer, and it provides real value in carefully curating a selection of products for a very defined niche consumer, almost like a large boutique.

Many of the Leading Global E-Commerce Players Still Trading at Discounts
Broadly speaking, Morningstar's global e-commerce coverage--home to some of the widest economic moats in the consumer space--continues to trade at a discount to our fair value estimates. Although we acknowledge the possibility of more-pronounced economic headwinds for consumers across the globe in 2016 and the implications for discretionary consumer spending, we believe the market is overlooking the powerful network effect many of these companies have developed over the past several years, not to mention a host of other leading players in more-nascent e-commerce markets that are successfully bridging the transition to a business-to-consumer from a consumer-to-consumer marketplace through enhanced payment, financing, logistics, and branded store offerings.

 Amazon (AMZN) remains our favorite company in the North American e-commerce space, and we regard as unlikely the market concerns over the firm potentially embarking on a major logistics investment cycle after posting solid profitability gains this year. We anticipate some investment for incremental fulfillment-center capacity--especially given the greater-than-expected Fulfillment by Amazon, or FBA, demand from third-party users this past holiday season--but not a massive transformation into an independent third-party parcel carrier. Besides, we think some of the incremental fulfillment capacity would probably be offset by FBA price hikes, reinforcing Amazon's pricing power among sellers.

Additionally, although they face slowing or contracting economic conditions in their respective regions, we believe  Alibaba (BABA) and  MercadoLibre (MELI) are receiving insufficient credit for recent platform enhancements for buyers and sellers alike--including improved logistics capabilities, a vastly branded product selection, and payment innovations--which we believe will solidify their leading e-commerce positions for years to come.

Moreover, looking at the past decade, we've found economic downturns can actually be conduits for e-commerce adoption rates, given their competitive pricing, the rapidly expanding product selection, and the convenience of expedited shipping these platforms generally offer, something we don't believe is reflected in current stock prices across the group. Although e-commerce volume trends typically slow during the onset of a recession, we believe value-seeking consumers flock to these marketplaces as economic headwinds persist; in turn, these firms recover before other consumer cyclical companies. Additionally, with online grocery expected to be one of the fastest-growing e-commerce categories over the next several years, we expect the mix of consumer purchases online will become more defensive in nature, further insulating many of the leading e-commerce marketplaces from potential recessionary conditions.  

Once e-commerce players amass more than 10% of their operating regions' population as active users, it becomes very difficult for competitors to unseat them, potentially leading to a multidecade period of excess economic returns. With several e-commerce players enjoying well-entrenched network effects in key markets, these players have more recently taken steps to lock in these customers through membership and other subscription-based services, while leveraging their network effects into new growth categories such as mobile payments, cross-border trade, third-party fulfillment, and online-to-offline services such as restaurant delivery. Although some of these business extensions are already meaningful cash flow contributors--Amazon Prime in particular--we believe many of these other endeavors are natural extensions of these companies' network effect moat source, and that they should drive improved profitability over an extended horizon.

Stricter Enforcement of Home-Share Laws Supports Long-Held View
That Airbnb Is a Manageable Risk
We have long held the view that Airbnb is a manageable risk to hotels and online travel agencies, or OTAs, and that it could also face increased regulation at some point. This stance is supported by recent enforcement of existing home-share laws that restrict use in Berlin and San Francisco. We see the increased regulation as a small positive for hotels, while it is largely neutral for OTAs.

Berlin and San Francisco face tight housing markets that have aided a high-cost-of-living environment, driven in part by the year-round rental of units to visitors versus residents. As a result, Berlin passed a law in April 2014 stating that one could only rent out rooms that are less than 50% of total square footage of the unit, and that those who break the law could face a $113,000 fine. The law gave owners two years to adjust before being implemented May 1.

In San Francisco, the law was passed 18 months ago, allowing short-term apartment rentals for up to 90 days each year if the unit was registered. In order to be registered, an owner could post only one unit, which would be set as his or her primary unit. Since then, just 20%-25% of Airbnb's listings in the city have been registered, and third-party analyses have concluded that the majority of revenue generated on the platform is from multiple-owned units renting out to visitors year-round. As a result, the city board of supervisors voted 10-0 this month to begin charging platform operators penalties of up to $1,000 per day for listings that don't comply.

The increased focus on having Airbnb listings comply with existing laws is likely to slow its listings and overall growth, which should provide a marginal tailwind for hotels that have seen some impact during compression events. We never viewed Airbnb as having much effect on either  Priceline (PCLN) or  Expedia (EXPE), and we see recent events as having largely neutral implications for these OTAs, as a potentially smaller Airbnb network is offset by the vacation rental presence the two have, which would also stand to be affected by enforcement of apartment-sharing laws.

It seems likely that other cities could increase enforcement of laws similar to those in Berlin and San Francisco. We also expect home-sharing operators to fight these laws by saying that they unfairly support hotels, and that home-sharing has a positive impact on a local economy, as it generates income for individuals and tourism for cities.

Top Picks

 Bed Bath & Beyond (BBBY)
Star Rating: 5 Stars
Economic Moat: None
Fair Value Estimate: $64.00
Fair Value Uncertainty: Medium
Consider Buying: $44.80

No-moat Bed Bath & Beyond's shares have fallen in tandem with many softline retailers as consumers have shifted their spending in recent periods to more-durable categories. However, we think the firm still has a defensible business model as a best-in-class merchandiser in the home, baby, and beauty goods spaces. Although we think the cadence of couponing is unlikely to slow over the near term, we believe Bed Bath & Beyond's improving omnichannel presence, disciplined real estate expansion process, and still-robust international opportunities will help offset the company's inability to price at a premium, ultimately leading to lower operating margins over the next decade (11.6%) from 2015 levels. Incorporating 2% top-line growth (supported by Morningstar's mid-single-digit outlook for spending in the repair and remodel market through the end of the decade) with moderate selling, general, and administrative expense leverage over time underlies our fair value estimate. We believe the shares have become attractive and are out of favor as a result of consumers' temporary shift away from lower-price discretionary items.

Swatch Group (SWGAY)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Estimate: $28.00
Fair Value Uncertainty: High
Consider Buying: $16.80

Headwinds continue for the Swiss watch industry despite lapping the 2014 Hong Kong protests and China's anti-gift-giving laws of 2013. Exports to Hong Kong, one of the main retail trading areas for Swiss watches, are still down. Apple Watch worries have subsided (for now), but as Swatch has just introduced a number of new products, from Sistem51 to its partnership with UnionPay in China, it remains to be seen if sales growth can be rekindled.

Although other luxury companies' stock prices have fallen mostly on worries over the macroeconomy in China, and the watch industry appears to be highly exposed there, we continue to prefer Swatch Group for its discount to our fair value estimate and the value of the portfolio of brands and technologies it holds.

While the Apple Watch launch has underwhelmed, the number of other fitness and smart devices is accelerating as sports and health companies enter the market. We believe interest in new wrist products will benefit the whole watch industry, especially for microbatteries and low power use where Swatch has significant know-how. We are also of the opinion that Swatch's partnership with UnionPay in China may be underestimated and that NFC payments are the one application for smartwatches that might catch on. In the long run, we believe new products and technologies could be growth drivers for the watch industry, and even though the United States is the largest single consumer, mechanical watches are still proportionately underpenetrated there.

Swatch enjoys a dominant position as the leading manufacturer of watch parts, where there are high barriers to entry. Technologies will necessitate a further retail buildout for Swatch brands and enable increased automation in production, driving long-term margins. Currencies remain a risk to demand and profitability, but stabilization should work its way in consumer purchase decisions and cost and pricing strategies. Although weakness in global equity markets creates uncertainty for high-end spenders and risk to near-term sales figures, a rebound in retail sales would reverse destocking and risk aversion at wholesale.

 Ralph Lauren (RL)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $150.00
Fair Value Uncertainty: Medium
Consider Buying: $105.00

Ralph Lauren possesses a portfolio of brands that can be priced at a premium to competitors, and its solid returns on capital are testament to the power that 50 years of image-making has instilled in the Ralph Lauren name. Yet despite a solid record of growth and profitability, headwinds ranging from currencies and 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.

Despite share price improvement and further bad news from U.S. department stores, we still see Ralph Lauren's stock as undervalued. Although the risks remain, we don't believe the current short-term domestic headwinds for wholesale clients are harbingers of pending economic malaise in the consumer sector.

We believe the brand's relatively low penetration in China and emerging markets leaves 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 its women's categories, which (unlike at most luxury goods firms) are smaller than men's.

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