Consumer Cyclical: E-Commerce a Key Threat for Some, But Not All

• Consumer cyclical sector valuations rose slightly this quarter, with a weighted average price/fair value ratio of 1.03, slightly ahead of last quarter's 0.98. We attribute this increase to rising consumer confidence, a factor that should support spending across numerous discretionary industries.
• That said, we still 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 overheated, with a weighted average price/fair value ratio of 1.03 (a slight uptick from last quarter's 0.98). We attribute this increase to relatively stable consumer confidence figures, implying consumers' willingness to spend remains robust. We surmise some of this tick up was a function of the expectation for successful tax reform.

With the key holiday period largely behind us, we think investors will be reassessing companies’ competitive positioning and their individual abilities to capture incremental operating margin. With much operating leverage already squeezed from consumer businesses, improved operating efficiency will largely stem from capitalizing on a better customer experience, which could come from faster delivery times, speedier product innovation cycles, and a more individualized, experiential environment (think, restaurants in

As noted above, our main concern comes from the fact that many of these customer experience updates cannot be undertaken without increased capital expenditures in the near term. For example, Home Depot noted it would be spending 2.5% of sales in capital expenditures over the next three years while building out its direct fulfillment distribution network (about $2.7 billion annually versus $2 billion or less in recent years) in order to get closer to its consumers.

And although this can potentially crimp near-term operating margin potential, we contend that this type of spending extends current brand relevance, ultimately paying dividends for companies willing to spend on positive perception investments.

This, in turn, will theoretically lead to better gross margin performance longer-term as those that have invested in their brand experience can reap the rewards of higher demand and improved pricing, leading to ROICs that should generally exceed our weighted average cost of capital estimates. However, we still think some firms will continue to invest but have gains competed away by secular headwinds, leading to operating margins that languish to lower than historical levels, like those at

Additionally, some consumer cyclical companies are better positioned to survive these brick-and-mortar troubles than others and have been punished unfairly by the market. We believe the market has overreacted on names such as

In addition to being decent operators in their respective categories, we believe each of these companies understands how the retail space continues to evolve and will use the prospect of competing with Amazon as a way to advance their businesses. For some discretionary retailers, the ability to compete in the future is reliant on customer experience and infrastructure investments, leaving industries like home furnishings and beauty facing some pressure over the next several years that could result in margin containment.

Top Picks

Mattel

MAT

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $25.50

Fair Value Uncertainty: High

5-Star Price: $15.30

In our opinion, brand stabilization had begun at Mattel toward the end of 2016, as indicated by the 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 new 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 2016 holiday season and Toys 'R' Us' bankruptcy have proved difficult for Mattel to navigate, though, leading to revenue declines and margin pressure from promotions that were greater than anticipated, hindering performance in 2017, keeping shares at a significant discount, and providing a wide margin of safety. We expect current company headwinds to be transitory and shouldn't negate the company's long-term competitive advantages, but we think changes implemented under new CEO Margo Georgiadis' strategy could take a few quarters to bear fruit.

Hanesbrands

HBI

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $32.00

Fair Value Uncertainty: Medium

5-Star Price: $22.40

We have a high degree of confidence in the defensibility of Hanesbrands' competitive position because of advantages that are difficult for others 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 the company is poised to post significant operating margin growth through recognition of synergies ($85 million in 2018 and 2019), $100 million in cost savings from Project Booster, and $30 million-$40 million in manufacturing efficiencies.

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 view this as a sustainable cost advantage.

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

Hanesbrands' top line has come under pressure, partly from what we view as short-term headwinds (the basics category experienced a low-single-digit decline in 2016) and partly from secular trends to online sales (only 8% of U.S. revenue was e-commerce in 2016, and retailers were hit with bankruptcies and downsizing).

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 low-single-digit growth.

Advance Auto Parts

AAP

Star Rating: 5 Stars

Economic Moat: Narrow

Fair Value Estimate: $155.00

Fair Value Uncertainty: Medium

5-Star Price: $108.50

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. Although the acquisition of General Parts proved far more challenging than anticipated and exacerbated pre-existing performance shortcomings, we think the difficulties have obscured the benefits that Advance should gain 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 parts availability, we anticipate it will benefit from a persistent industry trend favoring consolidation, as larger parts retailers are able to deliver superior service 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 parts 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, some economic angst among low-income consumers, and the relatively small number of new vehicles that were sold in 2009-11 aging into parts retailers' sweet spot), 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 there could be upside to our expectations. We foresee returns on invested capital rebounding to 11% by 2021, with steady increases throughout our explicit forecast period after a transition year in 2017.

Quarter-End Insights

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