Consumer Cyclical: Poised (and Priced) for a Strong 2017

• On a valuation basis, the consumer cyclical sector appears to be slightly undervalued, with a market-cap-weighted price/fair value estimate ratio of 0.94 as of Nov. 30.
• With the U.S. presidential election complete, some certainty has been restored to the U.S. consumer, leading to meaningful equity market gains. The Dow and S&P have risen 8% and 6%, respectively, since the election (through Dec. 15), boosting the wealth effect of spenders.
• International companies could be at risk from changes to trade policies that the new administration attempts to implement. However, domestic employment levels could benefit as previously relocated jobs return to the U.S.
• Wages are back on the uptick, helping to increase the average consumer's willingness to spend, and we believe that favorable demographics should continue to drive consumption, despite some potential volatility ahead as new policies take hold.

In our opinion, the consumer cyclical sector appears poised for strong performance in early 2017, fueled by consumer strength, global macroeconomic stabilization, and improved expense and inventory management. That said, much of this upside appears to be priced into the stocks, with a market-cap-weighted price/fair value estimate ratio of 0.94 as of Nov. 30, similar to the slight discount we experienced at the end of the last quarter. We would be strategic in locating stocks with an attractive margin of safety.

On average, consumer discretionary company performance appears to have benefited from positive sentiment following the recent presidential election in the U.S., with shares of cruise lines rebounding 10%, home improvement bouncing 14%, and powersports companies rising 8% post-election, for those names represented on our coverage list (through Dec. 15). We think the stocks of these businesses have benefited for two reasons. First, the tone of the new administration's rhetoric has been business-friendly (particularly surrounding the topic of lower corporate tax rates). Second, the new administration will likely make changes that benefit consumers on the tax front, upping the consumer's near-term willingness to spend.

However, we think several players in Mexico (and Latin America more broadly) that rely on heavy exports to the U.S. could be negatively affected by the new administration's policies--including heavily amended or outright repeals of current trade agreements or changes in immigration policies--though the full impact is not likely to be known for some time. However, our initial take is that we don't expect policy changes to have a material impact on brand intangible assets for the players heavily exposed to Mexico (for example,

Outside Mexico, those companies with high levels of manufacturing operations in China could be among the more immediate names affected by the election results, given Donald Trump's stance on existing trade agreements with China. While in recent years we've seen most of our consumer product companies diversify their manufacturing operations from China to India, other parts of Southeast Asia, and Latin America, some companies under our coverage still rely heavily on China-based manufacturing, including

But we also acknowledge that the enactment of more comprehensive trade barriers in the region could favorably affect U.S. employment levels and/or position U.S.-based firms to reclaim share previously lost to Chinese imports. From our vantage point, a reduction in imports from China could particularly stand to benefit home furnishing operators, toy manufacturers, and footwear firms (that have been disproportionately affected by Chinese imports). In this vein, we still view narrow-moat

On the wage front, after a long period of stagnation, wages are finally beginning to creep up again. Since pre-2008, nominal private-sector average hourly earnings growth has fallen from north of 4% to lows of just above 1%. Although the decline is less in real wage terms (falling from about 3.5% to just under 2%), the general trend remains. This downward trajectory is finally reversing itself but is still well below historical levels (7% nominal growth on average annually since 1948, using EPI's Charting Wage Stagnation data) and below the Federal Reserve Board's 2% inflation target, 1.5% productivity growth, and a stable labor share of income, showing that there is a long runway for potential future wage growth if the Fed eventually reaches its stated targets. With rising wages, there should be room for incremental consumer spending ahead.

Top Picks

Hanesbrands

HBI

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $39.00

Fair Value Uncertainty: Medium

Five-Star Price: $27.30

We see Hanesbrands as one of the best opportunities for investment in the apparel space. We think the shares' current discount is unjustified, given an underappreciated margin expansion opportunity, contributions from two recently announced acquisitions, and the fact that replenishment category sales correct more quickly than general apparel.

We believe the majority of Hanes' top-line growth deceleration is due to cyclicality and not competitive moat degradation. If we look at Hanesbrands' three largest retailers (

However, it is the margin expansion story that we think is most underappreciated by investors. Hanes has a history of achieving margin expansion through the pricing power attached to innovations as well as through cost efficiencies. Over the past three years, adjusted operating margin has increased from 9.7% to 15.0%. Hanesbrands has added $120 million in operating profit through acquisitions but then added an additional $170 million in operating profit through revenue, selling, general, administrative, and manufacturing synergies it achieved. We believe margin expansion is in the early stages, with a long runway for further improvement.

Bed Bath & Beyond

BBBY

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $64.00

Fair Value Uncertainty: Medium

Five-Star Price: $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 slightly 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.

Restoration Hardware Holdings

RH

Star Rating: 4 Stars

Economic Moat: None

Fair Value Estimate: $46.00

Fair Value Uncertainty: High

Five-Star Price: $27.60

No-moat Restoration Hardware's shares have fallen more than 60% over the past year, as product has failed to resonate with consumers and delays in the spring sourcebook (pushed back to the fall) delayed sales. In the longer term, we believe RH can reignite sales growth, and our model forecasts average top-line growth through the end of our forecast of 9% as square-footage growth averages nearly 10% over the same time frame. Here, as higher sales stem from new galleries (to the tune of 2 times legacy stores or more, according to RH), expenses should leverage. Our forecast includes gross margins that bounce back starting in 2017, and expense leverage of only 70 basis points over the next decade, as some new endeavors, like wholly owning the delivery process, are likely to weigh on profit growth. This could lead earnings to remain below last year's level ($2.72) until 2018. We also expect free cash flow to turn positive again in 2017, but it could turn negative further out, as the build-out and spend cycle could prove lumpy.

More Quarter-End Insights

Market Outlook: New Expectations Set the Tone for 2017

Economic Outlook: More of the Same Anemic Growth

Credit Insights: Global Rates on the Rise

Basic Materials: China-Led Rally of 2016 Rests on a Shaky Foundation

Consumer Defensive: Cooking Up a Bit More Value

Energy: OPEC Adds a Plot Twist, but Ending in Unchanged

Financials: What Will Really Drive Interest Rates?

Healthcare: What Does a Trump Administration Mean for Healthcare Stocks?

Industrials: Baking In Too Much Optimism

Real Estate: Through the Noise, Opportunities Exist

Technology: This Firm Is the Newest Software Empire

Utilities: Still High Even After Bonds' Withdrawal