Consumer Cyclical: Still Opportunity in a High-Confidence Environment

• On a valuation basis, the consumer cyclical sector is fairly valued, trading at a median price/fair value of 1.00 as of Feb. 1, 2017.
• Bolstered by an improving job market and demographics, the travel industry remains one of the most resilient consumer cyclical categories, despite uncertainty surrounding President Trump's proposed travel ban and its impact on the economy.
• Brick-and-mortar apparel continues to face headwinds from the shifts to e-commerce and lack of enticing new fashion.
• The continued global shift to online purchases continues to aid players with leading networks.

We believe that the consumer cyclical sector is poised for growth again in 2017, as consumers have become increasingly confident following the November U.S. election, and given the continuation of an improving job market. Although the consumer cyclical universe is fully valued at a median price/fair value estimate ratio of 1.00, we still see opportunities for investors in stocks with an attractive margin of safety.

Following the U.S. presidential election, consumer confidence has remained high, and many discretionary companies have benefited from positive sentiment. The Consumer Confidence Index reached multiyear highs of 114.8 in February, while the S&P has risen another 6.5% in the year to date through March 15.

One industry that has remained resilient is travel. To illustrate, shares of hotel operators have gained 6% and 18% in the year to date (through March 15) and since the U.S. election, respectively, while cruise lines have rebounded 18% and 25%, respectively. We believe stocks of these businesses have risen due to rhetoric around lower corporate tax rates, deregulation of the financial sector, and infrastructure spending, all of which could lift consumers' willingness and ability to spend.

Further, the continued expansion of China's traveling consumer class, which we believe currently numbers around 100 million individuals, will more than double over the next decade, aiding global travel. That said, the timing and magnitude of actual policy remains difficult to predict, and the economic impact from President Trump's proposed travel ban creates some uncertainty, in our opinion.

Mainstream apparel retailers continue to report slowing traffic to stores and excess inventory in the market. We think this is due to a few factors. First, there is no compelling new fashion trend to draw shoppers into stores. Second, the shift to online purchases continues to take traffic away from physical units. Third, department stores and mass-merchant subsectors still look overstored. Fourth, off-price retailers have benefited from both a multitude of buying opportunities, given excess inventory and demand increases as consumers have remained price-sensitive.

While the idea of e-commerce as a disruptive force is not exactly a new concept, consumers continue to become increasingly comfortable making everyday purchases online or through mobile devices across many developed economies. This global shift to online consumption continued to benefit leading networks in the first quarter. Shares of consumer and travel network companies have increased 19% on average in the year to date through March 15.

Top Picks

Hanesbrands

HBI

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $34.00

Fair Value Uncertainty: Medium

5-Star Price: $23.80

We have a high degree of confidence in the defensibility of Hanesbrands' competitive position, given advantages that are difficult for competitors to replicate: the firm's large owned and controlled supply chain, core product positioning in a space where brand is more important than price, and economies of scale achieved through a growing portfolio of synergistic brands. We think earnings per share can increase about 50% in the next five years on pricing premiums, further leverage of the global supply chain, and additional acquisitions synergistic to core products.

The company operates 52 manufacturing facilities, mostly in Asia, Central America, and the Caribbean Basin. In 2016, approximately 72% of units sold were from finished goods manufactured through a combination of owned and operated facilities and third-party contractors that perform some steps (cutting/sewing). When Hanes can internalize high-volume styles, we estimate that it saves as much as 15%-20%, and we see the company moving toward producing 85%-90% internally over time, providing a significant operating margin driver.

Using this manufacturing platform, Hanesbrands has succeeded in making acquisitions to drive earnings growth. Through acquisitions, the company has increased operating profit by $120 million, with the addition of $170 million in synergies over the past couple of years.

Recently, Hanesbrands' top line has come under pressure, partly from what we view are short-term headwinds (the basics category experienced a low-single-digit decline in 2016) and partly from secular trends toward online sales (only 8% of U.S. revenue was e-commerce). However, Hanesbrands is distribution-channel-agnostic, and we think these trends affect only the near term and create an attractive entry point for investors. The company continues to gain market share, with 2016's flat basics revenue topping industry growth, and the transition to e-commerce is proceeding well, with the online revenue growth rate accelerating throughout 2016. As online sales increase as a mix of business (we model penetration topping 20% in three years), we think total company growth will rebound to our expected 2%-3% rate.

Bed Bath & Beyond

BBBY

Star Rating: 5 Stars

Economic Moat: None

Fair Value Estimate: $64.00

Fair Value Uncertainty: Medium

5-Star Price: $44.80

No-moat Bed Bath & Beyond's shares have fallen in tandem with many soft-line 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. While 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 than in the past (10.6% in 2020 versus a 14% average over the past five years).

Incorporating 2% top-line growth (supported by our 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.

Williams-Sonoma

WSM

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $71.00

Fair Value Uncertainty: Medium

5-Star Price: $49.70

Narrow-moat Williams-Sonoma's shares have declined about 10% over the past year, as high-end home furnishing peers have forced an increasingly promotional environment, pressuring the firm's ability to generate higher merchandise margins. Coming off inventory mismatches due to West Coast port delays in 2015 and increased discounting in 2016, Williams-Sonoma appears better positioned than its peers to meet consumer demand, thanks to its robust trove of consumer analytics that allows the company to forecast unit demand on a more localized level, but margins remain compressed from discounting.

While some pricing pressure from peers could persist, we believe Williams-Sonoma's evolving real estate strategy, supply-chain optimization, and still-growing global reach will help returns on invested capital rise to 16% over the next five years (versus our weighted average cost of capital of 9%). We expect store sales can rise roughly 3%-4% on average over the next decade, while e-commerce will grow at a faster clip of around 8% on average. These growth rates bring us to top-line growth of 5%-6% over our explicit forecast, in line with the mid- to high-single-digit outlook of the company. With operating efficiencies building as scale ticks up, low-double-digit earnings growth persists throughout the majority of our outlook.

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