Consumer Cyclical: Solid Economic Fundamentals Drive Discretionary Spending

• Consumer cyclical sector valuations remain slightly elevated, with a weighted average price/fair value ratio of 1.05, in line with last quarter's valuation. We attribute this to healthy consumer sentiment, low unemployment rates, and stable asset market valuations.
• We've long held the belief that those companies that offer a combination of experience, specialization, and convenience are best positioned to defend their competitive advantages in an increasingly e-commerce world. While concerns about potential disruption from businesses like  Amazon.com (AMZN) linger across many consumer companies, we believe there are certain categories that are better positioned, embracing the aforementioned qualities.
• We continue to have a favorable view of the travel and leisure space, and the increasing share of wallet companies in these categories are capturing. As consumers continue to migrate to experiences over things, subindustries like cruising and lodging should benefit.
• Other consumer product companies that have shown a willingness to invest in convenience, ease of use, and experience--Airbnb and Uber come to mind--continue to grab at market share gains across their user base.

The market continues to favor consumer cyclical names, with the group continuing to trade at a weighted average price/fair value of 1.05, the same ratio the group traded at last quarter. We continue to attribute the bullish market sentiment to a number of factors, including healthy consumer sentiment in the U.S. and many other developed nations, low unemployment rates and wage increases that are helping drive middle-class consumption globally, and equity and housing market conditions that have been conducive to wealth effect spending.

However, we believe market valuations also reflect the fact that consumer cyclical companies are starting to reap the benefits of efforts to cater to the individual demands of consumers. We've long held the belief that those businesses that offer a combination of experience, specialization, and convenience have been best positioned to defend their advantages in an increasingly e-commerce world. While it's not easy for a business to capitalize on each of these qualities, we still believe that companies that can combine experiential environments ( Royal Caribbean’s (RCL) Central Park or hospitality within  RH (RH) locations, for example), specialized products (like cruise operators, which offer a multitude of onboard experiences), and an integrated, convenient approach to usage (Airbnb, Uber) are the best positioned to defend their current competitive advantages, at least in the immediate future. For these reasons, we believe the market had previously overreacted on several names across the consumer discretionary sector, discounting those operators that understand how to connect with the evolution of consumer needs and demands. However, we believe that upside in shares of operators across many of these categories could occur given the spending environment, especially those that have embraced experience, specialization, and convenience.

We believe the cruise industry is a perfect example of how specialized products and experiential environments can grab greater market share. In recent years, cruise companies have differentiated their operations by segmenting offerings to cater to specific consumer cohorts rather than a single total addressable global market. We think increased target market segmentation and geographic diversification should alleviate concerns over the supply of cruise capacity set to arrive in the next five years, ensuring that new ships don’t merely cater to the same customer (a factor that has weighed on share performance in recent periods). Further, we contend that cruise operators still have plenty of untapped opportunities to support demand, both domestically and abroad, to cast a wider net and prevent yield erosion. Domestically, we think the industry can tap into new customers by entering markets with limited prior presence to increase penetration rates (Baltimore, for example, which very few ships have used as a home port). Similar efforts in segmentation and new port markets can also be applied abroad, increasing reach in key areas (including Europe and China) and with key consumers, stimulating demand.

Oversupply concerns have echoed through the marketplace in recent months, weighing on cruise operator shares, with both rising fuel prices and foreign exchange headwinds providing incremental pressure. With factors like value-added bundling and market-to-fill strategies more frequently being used across the industry, we think cruise operators are poised to pivot nimbly to capitalize on evolving consumer trends. Of course as the economic cycle lengthens, the risk increases that new hardware could arrive at the same time as a global recession, ultimately constraining pricing, which we've factored into our 2%-3% normalized yield projections for the cruise lines.

Other travel companies also straddle the experience, specialization, and convenience factors we mention above. For example,  Expedia (EXPE) continues to grow both its international and vacation rental segments at a healthy clip. However, its shares have underperformed since late 2017, given the market's concern over increasing competition and investment, providing a sufficient margin of safety for investors looking to take a position in the narrow-moat company. The company continues to spend to grab share of these segments, which has dampened near-term profits. However, we see this spending as a strong use of capital, supporting longer-term growth. These investments could also buoy Expedia's leading network of 600 million monthly visits and 2 million properties, as brand awareness rises globally thanks to ease of use and improved visibility.

Furthermore, we continue to contend that other companies outside of traditional travel and leisure businesses that are focused on ease of use and convenience, along with experience, will remain in good favor with its consumer base. A good example of a company that has embraced evolving consumer views on convenience is Airbnb. The company has carved out a leading position in the travel industry and offers several attractive features when it comes public (anticipated in 2019-20), including a powerful and rare network advantage that should drive continued share gains in a rapidly growing alternative accommodations market; an opportunity to expand its network and addressable market with vertical extension into hotel, experiences, corporate, and transportation; and strong profitability prospects driven by the company's high consumer awareness that allow it to leverage top-line growth. We believe Airbnb's IPO should be on the radar screens for investors seeking exposure to a company positioned to gain share in the nearly $700 billion global online travel market that we estimate will grow 9.4% annually on average over the next five years, a rate that implies that it is set to outperform its hotelier peer set.

Overall, we believe that companies that make it easy for customers to work with them will continue to succeed and that a rising percentage of discretionary spending will be allocated to experiences over things, benefiting businesses that focus on individualization of ongoing trends, factors set to bolster the firms we discussed earlier.

Top Picks

 Greencross
Star Rating: 5 Stars
Economic Moat: None
Fair Value Estimate: AUD 6
Fair Value Uncertainty: Medium
5-Star Price: AUD 4.20

Despite not having an economic moat, we believe Greencross is attractively valued at the current share price. The company is a leading player in the Australian pet care retailing and veterinary service industry. The industry fundamentals are strong, with increasing humanization of pets and premiumization of pet foods likely to drive continued growth in expenditure per pet.

Greencross is well placed to benefit from these tailwinds, supported by its transition to a one-stop-shop model. Currently, around 22% of its retail stores have a veterinary clinic, although this is rapidly increasing and by fiscal 2023 we estimate almost 50% of the retail network will feature an in-store clinic, along with other services, including grooming, washing, boarding, and adoption.

We expect the integration of services within the retail store network to drive foot traffic, cross-selling opportunities and scale benefits, while also adding some insulation from online competition. This strategy is still in its early stages, and in the initial years the new clinics are margin-dilutive, but we expect margins to improve as the clinics mature, which in our opinion is a likely catalyst for rerating. Early success of this strategy is highlighted by the 8.5% like-for-like sales growth generated by the integrated sites during fiscal 2018, considerably higher than stores without vet clinics.

 Hanesbrands (HBI)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $27
Fair Value Uncertainty: Medium
5-Star Price: $18.90

We have a high degree of confidence in the defensibility of Hanesbrands' competitive position, given advantages that are difficult for competitors to replicate: the efficiency of the firm's large owned and controlled supply chain, core product positioning in an industry 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 net cost savings from Project Booster, and $30 million-$40 million in manufacturing efficiencies.

The company operates 50 manufacturing facilities, mostly in Asia, Central America, and the Caribbean Basin. In 2017, more than 70% of units sold were from owned plants or those of dedicated contractors. When Hanesbrands can internalize high-volume styles, we estimate that it saves as much as 15%-20%. Using this manufacturing platform, Hanesbrands has been successful in making acquisitions to drive earnings growth.

Hanesbrands' top line has come under pressure from secular trends to online sales (only 11% of revenue globally was online in 2017, 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 transition to e-commerce is proceeding well, with the online revenue growth rate hitting 22% in the fourth quarter of 2017. As online sales increase as a mix of business (we model penetration reaching the midteens percentage of total sales in 2018), we think total company growth will rebound and see 1% organic revenue growth in 2018 (versus a slight decline in 2017) as well as contributions from acquisitions.

 Anta Sports Products (02020:HK)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: HKD 55
Fair Value Uncertainty: Medium
5-Star Price: HKD 38.50

We think Anta’s share price is still recovering from a short-sellers attack two months ago. We continue to stand by our rebuttal to the short-selling report and do not believe the recent material drop in the stock price was warranted. At the same time, Anta's book of business is looking stronger than ever. Sales of Fila products are on track to deliver a 44% CAGR over the next three years, and the core brand should continue to grow steadily in second- and third-tier Chinese cities.

Additionally, we think the company’s intention to acquire Amer Sports is strategically sound. With potential sales and supply-chain cost synergies between the two businesses, we believe the buyout offer is valuation-neutral. We reiterate our fair value estimate of HKD 55 on Anta Sports and encourage investors to focus on the long-term positives coming out of the acquisition.

Furthermore, we believe the Chinese sportswear market is set to boom over the next 10 years as disposable income rises and sports participation grows. This is coupled with growing acceptance of wearing activewear outside of the sports setting. As the leading domestic sportswear company with a stellar operational track record, Anta is set to benefit. We see Anta shares as significantly undervalued and urge investors to buy shares of the company and capture the potential upside.