Consumer Cyclical: Tepid Mall Traffic Could Constrain the All-Important Holiday Season

• Moving into the fourth quarter, we think attention will shift to holiday traffic in brick-and-mortar locations. Past trends have not been strong, with brick-and-mortar net in-store sales dropping 5% and the number of transactions falling almost 8% over both Thanksgiving and Black Friday in 2016, according to RetailNext.
• We believe the U.S. retail category may be overstored because of disruptive e-commerce forces. According to data from icsc.org, a shopping-center trade group, the United States has 23.5 square feet of retail space per person, compared with 16.4 square feet in Canada and 11.1 square feet in Australia, the next-highest countries.
• That said, we believe there are a handful of traditional retailers offering some combination of product specialization, convenience, and experience that have been excessively punished by the market.

Consumer cyclical sector valuations appear a touch undervalued, with a weighted average price/fair value ratio of 0.98 (a slight downtick from last quarter's 1.01). We attribute this decline to fears regarding Amazon’s ability to disrupt a plethora of retail industries, as well as concerns about falling foot traffic to brick-and-mortar locations.

Entering the fourth quarter, we think all eyes will be on the holidays, with holiday sales representing nearly 20% of total retail industry sales (based on NRF data). Using last year as a guide fails to suggest much improvement is in the cards, as brick-and-mortar net in-store sales dropped 5% and the number of transactions fell almost 8% over both Thanksgiving and Black Friday in 2016, according to RetailNext. For one, we estimate that e-commerce penetration in the apparel space is about 17% and model this reaching roughly 30% over the next five years, which stands to continue pressuring foot traffic at physical outlets.

Further, the U.S. already boasts more than double most countries in retail square feet per person. (According to data from icsc.org, the United States has 23.5 square feet of retail space per person, compared with 16.4 square feet in Canada and 11.1 square feet in Australia, the next-highest countries.) We think this implies multiple future store closures and downsizing.

As of June, the number of store closures this year was 160% higher than in the year-ago period, according to an analysis by Fung Global Retail & Technology. There were over 5,300 store-closure announcements through June, putting this year on track to surpass the 6,100-plus closings in 2008, the worst year in history for closures.

Even with these closures, we believe that we are only in the early innings of right-sizing brick-and-mortar exposure. Since 2005,

In addition to falling sales, declines in brick-and-mortar traffic have also taken a hefty toll on operating margins through deleveraging. We estimate that most retailers need to achieve 2%-3% comparable sales growth to leverage fixed costs. The possibility of lowered rents and recognition of cost savings in operations helps but is insufficient to return operating margins to peak levels, in our opinion. Therefore, we see operating margins stabilizing at single-digit levels in our department-store coverage (Macy’s,

That said, we think some consumer cyclical companies are better positioned to survive the brick-and-mortar troubles than others and have been punished unfairly by the market. First, we think brands, by nature, are channel-agnostic and can successfully shift sales from brick-and-mortar retailers, where sales are declining, to e-commerce players such as Amazon, which boast high growth levels. We also see retailers of performance-based products such as

Top Picks

Mattel

MAT

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $28.50

Fair Value Uncertainty: Medium

5-Star Price: $19.95

In our opinion, brand stabilization had begun to occur at Mattel toward the end of 2016, as indicated by performance of key brands including Wheels and Fisher-Price and Entertainment (about 60% of 2016 gross sales), which delivered solid and sustained constant-currency results. We believe this was due to the focus on improving Mattel's brand equity under the management team, which had restored the company’s creative bent, leading to takeaway at retail as products had begun to resonate with consumers again.

The most recent holiday season proved difficult for Mattel, however, leading to revenue declines and greater-than-anticipated margin pressure from promotions, and this hung over into first-half results, keeping shares at a significant discount and providing a wide margin of safety. We expect current industry softness to be transitory, and it shouldn't negate the company's long-term competitive advantages, but we believe that changes implemented under new CEO Margo Georgiadis' strategy could take a few quarters to bear fruit.

L Brands

LB

Star Rating: 5 Stars

Economic Moat: Wide

Fair Value Estimate: $69.00

Fair Value Uncertainty: Medium

5-Star Price: $48.30

We believe L Brands possesses a wide economic moat and operates in a space where fit, function, and comfort are more valued than price. We view the anniversary of swim and apparel exits, as well as new bra product introductions in the back half of the year, as likely to provide a boost to the top line and margin performance. Furthermore, we see China's long-term potential as capable of catapulting revenue growth back to the 3%-4% range over time. Our five-year outlook calls for low-single-digit average annual revenue growth versus the three-year historical average of 5% and operating margin at midteen levels versus high-teens historical performance, which we see as accounting for risks. Therefore, we think this is an attractive entry point for investors with a long investment time horizon to own a wide-moat company that appears to be at a performance inflection point.

Advance Auto Parts

AAP

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $154.00

Fair Value Uncertainty: Medium

5-Star Price: $107.80

We believe current trading levels for narrow-moat Advance Auto Parts provide a sufficient margin of safety for investors looking to take a position in a company poised to capitalize on favorable long-term industry dynamics. While the acquisition of General Parts has proved far more challenging than anticipated, we think the difficulties have obscured the benefits that Advance should accrue from its substantially stronger position in the faster-growing professional market segment, which accounted for 58% of its sales in fiscal 2016.

As the company refocuses on operational improvements throughout the business and improves part availability, we anticipate it will benefit from a persistent industry trend favoring consolidation, as larger part retailers can deliver superior service levels to professional and do-it-yourself clients alike more economically than their subscale peers. In our opinion, clients' desire for high levels of on-demand part availability, along with DIY customers' needs for advice and services from trained in-store staff, should insulate Advance and its peers from digital-only competitors.

While Advance's turnaround has been complicated by an industrywide slump that we see as cyclical (attributable to mild weather and some economic angst among low-income consumers), we expect the new management team to be able to drive operating margins to over 11% by 2021 (from 9.4% in 2016) and begin to close nonstructural performance gaps with peers. Our forecast incorporates considerably more conservative margin expansion than management's 500-basis-point five-year target, indicating potential upside to our expectations. We foresee returns on invested capital rebounding to 11% by 2021, with steady increases throughout our explicit forecasting period after a transition year in 2017.

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