Coronavirus' Impact on Consumer Spending
Can e-commerce offset lower foot traffic?
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Consumer cyclical stocks have collectively seen the steepest recent sell-off after the energy sector. Social distancing, event and facility closures, canceled travel, and shaken consumer confidence will be felt by many companies. Even though consumer defensive sector share prices have held up relatively well, brewers have dropped 29% this year to March 19. In contrast, e-commerce retailers are benefiting. We see some investment opportunities to capture an eventual recovery in consumer confidence.
Stock Price Declines Offer Chance to Shop for Luxury Names
Aligned with our overall assessment of the economic impact of COVID-19, we believe the pandemic’s impact on the luxury goods sector is likely to be severe but short-lived, with no material long-term implications. We saw most luxury shares as overvalued at the beginning of the year, trading well above our fair value estimates and at multiples well above their historical averages. Now, with price declines of 10%-35% following the outbreak, those valuations appear closer to reasonable levels and create investment opportunities.
We believe luxury industry revenue could decline by some 6% in 2020, with a more pronounced drop in the first two quarters. This compares with an 11% decline in luxury industry revenue during the financial crisis.
We expect demand to bounce back after the pandemic peaks, with some pent-up demand from delayed spending, especially for seasonless items like accessories, watches, and jewelry. We had been anticipating some cyclical weakness for luxury goods, and the virus outbreak moves that downturn forward. We don’t expect long-term negative implications for luxury goods demand, so our fair value estimates remain intact.
First-Quarter Sales Hit, but China Ahead in Recovery
We expect the impact to be felt most in the first quarter of 2020 because of less demand from Chinese clientele domestically and abroad. Mainland China accounts for 10%-11% of luxury industry revenue, and according to company commentary, between one third and one half of the stores in China were closed for around a month in the first quarter. The remainder of stores operated at reduced hours and experienced traffic declines of 70% to over 80%. Toward the end of February and early March, stores began reopening, but with no improvement in traffic. Travel restrictions on Chinese customers globally, imposed in late January, remain in place at the time of writing and should continue damping Chinese luxury demand into the second quarter. We expect Chinese luxury demand abroad and domestically to be reduced by 35%-50% in the first two quarters as a result. We expect some stabilization in the third quarter, with domestic Chinese buying bouncing back sooner than demand abroad, given the seemingly effective containment measures in China and uncertainty about the global spread of the virus. Italy, now in lockdown, contributes around a mid-single-digit percentage to luxury industry sales, by our estimates.
Rest of World to Bounce Back in Fourth Quarter
We expect steep declines in other Asian luxury buying, with double-digit declines in Japanese consumption (10% of total luxury) and other Asian countries (10%) and the Korean market hit strongly in the first two quarters. A decline in tourist buying (around 46% of European luxury goods sales) is likely to have a material impact on demand for luxury goods in Europe; however, we expect local demand to also remain muted and decline 2% annually. So far, we expect similar declines in American luxury buying, albeit the situation on both continents remains very fluid.
On a global basis, we expect demand to bounce back in the fourth quarter (20%-25% growth for Chinese buying with some pent-up demand) and a strong recovery into 2021 on a very low comparable basis. By luxury subsector, we expect apparel with its higher share of seasonal items to be more adversely affected because of less pent-up demand. A consumer who didn’t buy a winter coat in January is unlikely to purchase a winter coat in summer. On the other hand, accessories, jewelry, and watches are more likely delayed rather than omitted purchases, should personal incomes and wealth not experience lasting declines. Over 70% of luxury purchases are researched online before purchase, so with spare time at hand, consumers could choose and buy their next purchase while being quarantined.
By channel, we expect online luxury to outperform, while airport retail is set to lag. We expect online luxury purchases to grow 12% this year versus a 6% decline in total luxury buying, bringing the share of online industry penetration to 14%. This compares with around 20% growth in luxury e-commerce in 2019, with the online growth rate weakened by general soft consumer sentiment and potential logistics disruptions at e-commerce operations of some brands. Pure plays like Farfetch (FTCH) so far haven’t seen an adverse impact from the pandemic, with no disruptions to either supplies or logistics.
With Italy in a lockdown, supplies of leather goods, apparel, and jewelry may be disrupted. However, given that there is also a demand shock, scarcity of supply should not be a major problem; orders have been reduced as it is. For smaller Italian companies like Moncler (MONC), Prada (01913), and Salvatore Ferragamo (SFER), Italy is a meaningful revenue contributor (Moncler 11%, Prada 14%, Ferragamo 18%) and could be hurt not only by the decline in Chinese tourism, but also by a decline of tourism from other European countries and the United States, as well as subdued local consumption.
Outside of luxury retailing, we expect e-commerce overall to be the preferred channel, with Amazon (AMZN) and China’s JD.com (JD) and Alibaba (BABA) benefiting and taking share during the crisis, assuming that e-commerce remains safe. Our current thinking is that it’s unlikely the virus would survive transfer to a surface or box in a warehouse and then transit to a home.
Aside from Amazon, big U.S. retailers Walmart (WMT) and Target (TGT) should be able to benefit from their strengthening ship-to-home capabilities. While both companies still depend on in-store traffic for over 90% of sales, their ability to move some sales to their digital platforms should help offset the negative impact of traffic headwinds after stock-up trips subside as the outbreak takes hold.
However, we do not expect a one-for-one transfer, with Amazon’s far more robust infrastructure, assortment, third-party marketplace, and logistics options likely to lead some sales that otherwise would have gone to omnichannel players toward their main digital rival. Walmart’s ability to fulfill digital orders outside of stores gives it more flexibility than Target, with its significant grocery delivery capabilities allowing it and rivals like Kroger (KR) to benefit from an acceleration in online sales that may persist, building on an existing durable digitization trend. (Digital sales for grocers and general merchandisers remain margin-dilutive, though.)
Still, the impediments to e-commerce adoption among lower-income consumers (including shipping costs, limited access to credit cards, and delivery difficulties in high-crime areas) remain in place, cushioning in-store sales at companies like Walmart and Dollar General (DG) to the extent that the employment picture and local health conditions permit. Companies like the off-price apparel retailers are considerably more vulnerable as they do not have meaningful e-commerce operations, though discretionary apparel is likely to be far from the top of homebound shoppers’ minds in a severe outbreak, regardless of channel.
In China, we think the impacts of the coronavirus outbreak on the e-commerce sector are more positive than negative in the long term, mainly because of faster penetration of online shopping into lower-tier cities and rural areas, and into groceries and fresh food, with Alibaba and JD.com the main beneficiaries. Because of the fear and discouragement of going out, this epidemic has led to more people in the lower-tier cities and rural areas trying online shopping, and people in all regions trying to shop for fast-moving consumer goods, groceries, and fresh food. In fact, in 2003, SARS helped give rise to e-commerce in China.
Restaurants Under Pressure, but Several Opportunities
The restaurant sector is under pressure as several markets have restricted dine-in service in an effort to curb the spread of COVID-19. Restrictions vary by state and city, but even in markets where carryout and drive-thru orders are still permitted, we expect severe guest count declines for at least the next two months and an uneven traffic recovery into the back half of 2020. The situation is fluid, but our best guess is that most U.S. quick-service chains will experience at least high-single-digit to low-double-digit comparable-sales declines for the year, while casual-dining chains are looking at comp declines of 30% or more. While restaurants find themselves with a difficult 2020 ahead, we believe the sector’s pullback offers several investment opportunities.
What criteria should investors use to evaluate opportunities during heightened uncertainty? First, value-oriented players tend to outperform during economic shocks, positioning those players that can be more aggressive on pricing for relative transaction outperformance as the year progresses. Second, we believe those players that are further along with their mobile platforms--particularly, personalized marketing efforts--should be better positioned to communicate with consumers during the social distancing and the coronavirus recovery period. Third, we’d look at companies and franchisee systems with healthy balance sheets.
As a result of recent refranchising activity, many operators and their franchisees are now overleveraged (many are now leveraged at 6-7 times forward EBITDA), making it more difficult to navigate extended periods of restaurant restrictions.
Brewers Decimated in Short Term by On-Premises Closures
Our new base case for brewers assumes a fairly short-lived global recession, with all regions affected in similar ways. During the quarantine period, which we assume to last three months and to occur globally, we estimate that around two thirds of the on-premises channel will be decimated, mitigated to a limited degree by a shift to the off-premises channel. The net impact is a mid- to high 20s percentage reduction in revenue in the affected quarter, although the timing of the impact varies based on the geographical exposure of the business, and a high-single-digit decline for the full year. Beyond the lockdown period, we expect a global recession, with elevated unemployment rates and beverage volume recovering only gradually throughout the rest of the year. With several major sporting events being postponed rather than canceled, however, it seems likely that revenue will recover to the 2019 level in 2021, with the secular growth rate of 4%-5% resuming thereafter. Our moat ratings for the brewers are unchanged, and we see little long-term impact to business models or cash flow generation.
These assumptions appear roughly consistent with the limited commentary from the companies. In its 2019 results release, Anheuser-Busch InBev (BUD) management guided to a negative impact to revenue of $285 million in the first two months of 2020. Extrapolating that to the three-month estimate for the peak impact of the virus and assuming a similar quantum across the globe, AB InBev’s revenue could fall around 8% in fiscal 2020 on a constant-currency basis. Likewise, Pernod Ricard (RI), making similar assumptions to us in terms of the length of the lockdown period, estimated that the drop in Asia sales would slow profit from recurring operations growth by around 3 percentage points. Extrapolated across all geographies, we estimate the impact to be around 7%. The length of the lockdown period is a key assumption and as yet unknown; a prolonged period of enforced social distancing forms the basis of our bear-case scenarios.
Overall, the decline in volume and revenue will have a negative impact on profitability. We estimate that around two thirds of the brewers’ total operating costs are fixed, which would imply further operating deleverage at the EBIT line. At an organic decline rate in revenue of 8%, we forecast a roughly 12%-13% drop in operating profit, which is roughly in line with the historical degree of operating leverage of roughly 1.5 times.
Dan Wasiolek, Chelsey Tam, and Philip Gorham contributed to this article.
Jelena Sokolova does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.