Consumer Cyclicals: E-Commerce Hits an Inflection Point

Morningstar

The shift to e-commerce is accelerating, providing a wake-up call for traditional retailers. Apparel manufacturers have solidified brand identity and cost efficiencies to build moats. A consistent evolution of toy companies Hasbro and Mattel protects their narrow moats.

Shift to E-Commerce Accelerates, Provides a Wake-Up Call for Traditional Retailers
We believe the structural shift to e-commerce from traditional retail reached a critical inflection point over the quarter, with consumers rapidly embracing online and mobile commerce and leaving retailers scrambling to refine their omnichannel strategies. This channel shift was particularly pronounced in Amazon's (AMZN) fourth quarter, where active users (up 19% to 237 million), total units sold (up 25%), and third-party units (up 25% according to our estimates) all outpaced global e-commerce growth trends in the low teens and implying further market share gains.

For much of 2013, the market turned more favorable on a number of traditional specialty retailers as management teams adopted tactical measures to compete with online retailers. This included price-matching efforts as well as other promotional activities, store-within-store partnerships with key suppliers, online order fulfillment from local stores, and the development of more versatile mobile phone apps that enhance in-store shopping trips. While we viewed these efforts constructively, we believe the 2013 holiday season demonstrates that there is still a wide chasm between traditional retailers and Amazon's e-commerce capabilities. Amazon's expedited shipping capabilities were particularly disruptive, with Best Buy's (BBY) management team acknowledging that Amazon "completely shocked" the retail industry by guaranteeing delivery through the Monday ahead of Wednesday Christmas, when the rest of industry cut that off before the weekend.

In our view, Amazon's strong holiday showing validates several of our concerns about many retailers' ability to drive profitable growth over a longer horizon. Competitive pricing has always been central to our investment thesis for Amazon, as the cost to maintain its fulfillment center network is lower than maintaining a large physical retail presence, allowing the company to price below its brick-and-mortar peers while still generating excess economic returns. Although several retailers have predicted a more rational pricing environment in 2014, we don't see any major changes to Amazon's cost advantages over the near term (even factoring in the possibility of nationwide sales tax collection in the near future), suggesting that a promotional pricing environment will extend well beyond this holiday season.

Amazon's fulfillment capabilities effectively extended the company's holiday selling window by several days during an already shortened holiday shopping season, which enhanced its brand intangible asset, in our view. This was evident not only in the sharp increase in Prime memberships (which have effectively doubled in the past year and now stand north of 20 million members globally), but also management's comfort in initiating a $20 increase to the annual Prime membership fee in 2014. In our view, this decision reinforces the network effect that underpins our wide economic moat rating, as well as the meaningful bargaining clout the company has with consumers. Although there aren't any inherent switching costs in the retail industry, we don't expect much attrition due to the fee increase and believe Prime memberships could lock in many Amazon consumers while neutralizing price matching and direct-to-consumer investments by traditional retailers. Amazon has established itself as a vital shopping destination for Prime members, who make the majority of their online purchases on Amazon and spend nearly two to three times as much as non-Prime customers, according to our analysis.

While we continue to believe some business models, like home-improvement and auto-parts retail, exhibit characteristics that insulate them from e-commerce competition (immediacy of need, specialized nature, and diversity of the product assortment, need for salesperson help), others like toys, office supplies, and consumer electronics will continue to see price compression as the channel shift to e-commerce proliferates.

Technological Disruptive Forces Give Apparel Manufacturers the Opportunity to Build Moats
The technological revolution of the past 15 years--including the scaling of e-commerce and the philosophy of quick, cost-efficient manufacturing--has affected almost every aspect of business, and apparel manufacturing has been no exception. Social media, e-commerce, globalization, and manufacturing efficiencies have reshaped the apparel manufacturing landscape, and we think the companies that have adapted to modern times have a real opportunity to develop brand strength (an intangible asset) and cost efficiencies, both sources of an economic moat. Advanced fabrication and construction, seamless integration of the design and production process, more direct-to-consumer opportunities, and efficiencies in manufacturing have given apparel manufacturing companies increased pricing power, a decreased reliance on retail partners, added cost advantages, and ultimately, the opportunity to develop an economic moat versus their peers.

The old method of apparel manufacturing was very simple and linear. Apparel companies designed collections for fall/winter and spring/summer, materials were sourced, products were manufactured, and garments were shipped to a distribution center, where they were delivered to the appropriate retail venues. The entire process required apparel manufacturers to commit approximately six months in advance to the designs for 40%-60% of their seasonal lines. At the start of each season, nearly 80% of that season's inventory was committed, and deliveries to retailers were made about four times a year.

The new manufacturing process is more circular, relying on feedback loops, customization, speed to market, and more frequent inventory turns to increase sell-through of full-priced merchandise. Perhaps one of the best examples of this is apparel retailer Zara, the flagship concept of Inditex. Zara commits six months in advance to only 15%-25% of a season's line and locks in only 50%-60% of the line by the start of the season. Turnaround is quick. The time from design to the garment hitting store shelves can be as short as two weeks. A key theme we have noticed across our coverage universe is the integration of the design, production, and retailing processes to maximize sales and costs. Flexibility and differentiation in design, manufacturing locations, and distribution channels have become paramount to success.

We note five key themes, which seem to give companies a competitive edge:

Differentiation of product through advanced fabrication, functionality, or fit instead of simply fashion Use of direct-to-consumer and retail formats in addition to wholesale channels, allowing more control over brand development and less reliance on traditional apparel retail outlets A well balanced and geographically diverse distribution system A flexible manufacturing process that balances speed, frequency of shipments, and just-in-time inventory with cost efficiencies; Ability to defend against rising labor, material, and energy costs Narrow-moat names Hanesbrands (HBI), PVH (PVH), and VF (VFC) rate very highly in these attributes, while no-moat names Gildan (GIL) and Guess (GES) trail in a couple of categories.

Smart Marketing, Innovation, and Acquisition Position Toy Companies for Success
We have become increasingly concerned that evolving children's play patterns continue to shift demand away from traditional toy manufacturer offerings. Most notably, digital products have proliferated to become more pervasive and easier to obtain than in the past. Narrow-moat firms Mattel (MAT) and Hasbro (HAS) are taking steps to adapt to children's (and parents') changing demands, but will need to do so at an increasing pace to stave off smaller competitors or new entrants. In addition, categories historically outside of the core purveyance of Mattel and Hasbro (like construction) have continued to perform well, leaving those focused on weaker performing categories (infant, dolls) behind. Despite the increasing presence of digital products, we think there are key countermeasures toy manufacturers can take, including updates to strategic marketing plans and consumer engagement tactics, and faster responses to shifts in consumer tastes. In our view, these strategies could help preserve the companies' intangible assets and scale advantages, something necessary to maintain market share and keep their narrow moats intact.

While digital properties continue to encroach on traditional toy offerings, we still think that the storied brands Hasbro and Mattel distribute have allowed the companies to become sales and marketing powerhouses, supporting strong intangible assets and our narrow economic moat rating. We think there are a few key initiatives that could strengthen both the awareness and the brand intangible assets of these companies' products. First, toy companies should reevaluate their strategic marketing initiatives, focusing on key product launches (like Mattel's Boom Co) and pockets of weak product demand, to build brand equity. Second, internal marketing should be used to drive additional direct to consumer sales. In our opinion, Hasbro and Mattel could improve brand awareness (and presence) by growing the direct to consumer segment through expansion of the catalog selection, better targeted email focus and increased loyalty programs.

Additionally, we see innovation as key in driving demand consistently for products, either by participating in new categories or through acquisitions. Over the last decade, categories like building sets, youth electronics, and outdoor have grown rapidly, while those like dolls, vehicles, and arts and crafts have experienced declines. In order to grow market share, we think Hasbro and Mattel will have to adapt to these changing trends, which both have started to do. Last year, Hasbro acquired a majority stake in Backflip Studios, the creator of digital games like Paper Toss and Dragon Vale, to help improve the mobile gaming strategy at the firm. Backflip addresses changing play patterns and provides a revenue stopgap from those shifting away from traditional board games and play into the digital arena. Additionally, Mattel has recently launched its foray into outdoor with Boom Co, a differentiated blaster that is expected to deliver better distance accuracy and technology than the current outdoor offerings. Mattel also recently made a key acquisition in the construction space, buying Mega Brands, which we think plays nicely into an important growth category where the firm lacked presence.

We still see Mattel, Hasbro, and Lego as the best positioned toy companies in the industry, which should be no surprise, as they all have meaningful brand awareness, massive scale, and good negotiating power with retailers since their products make up the majority of the toy aisle. However, we still think structural headwinds (depressed domestic birth metrics, increased reliance on international markets for growth, and lower per capita spending on toys in emerging markets) could weigh on the businesses' medium-term growth potential, leading us to maintain our stable moat trend ratings. Below the top players, we think the industry is fairly fragmented, with some companies performing well in certain areas and some in others. To us, this indicates the top players in the market are protected and that it would be difficult for new entrants or current competitors to threaten the leaders in a meaningful way. Competitors would have to spend more marketing dollars and launch more products; doing so could change the economic profile of the business, which for some is already spotty (Build-A-Bear operating margins are negative versus Mattel's 18%).

Our Top Consumer Cyclical Picks
On the whole, our consumer cyclical coverage universe continues to look overvalued, with an average price/fair value estimate ratio of 1.10. Given the economic uncertainty that persists in most major markets, such as slowing retail sales figures in the U.S. and lingering macro questions in Europe and Asia, we still gravitate toward companies with sustainable competitive advantages, particularly in brand name and economies of scale. We also tend to prefer firms with decent exposure to emerging markets, where a growing base of middle-class consumers could help to offset broader economic concerns over the long run. We highlight five names that we believe are currently undervalued, below.

Top Consumer Cyclical Sector Picks
Data as of 3-18-14.

PVH Corp (PVH)
Star Rating: 4 Stars
Fair Value Estimate: $140.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Price/Fair Value: 0.85
Narrow-moat PVH is one of the highest-ranked stocks across all categories covered in our apparel manufacturing company analysis, with the highest rating in direct-to-consumer penetration, geographic expansion opportunities, and defense to rising costs. It also ranked relatively high in manufacturing efficiencies, given its scale. We also believe PVH has a significant revenue and margin expansion trajectory on the strength of its Tommy Hilfiger and Calvin Klein brands, which account for about 85% of operating profit. Following the Warnaco acquisition, we think the company should achieve about $100 million in cost synergies over the next four years. After structural issues with the acquisition normalize, we think the Tommy Hilfiger and Calvin Klein brands should be able to achieve mid-single-digit annual revenue growth on average over the next five years and about 200 basis points of operating margin expansion to 16.7% through high-margin international market penetration, upmarket distribution channel shifts, and supply chain upgrades. We see PVH as firmly committed to investing in brand strength, and we think this will yield ongoing pricing power, the basis for our narrow moat rating. We estimate PVH can achieve an average annual ROIC of 18%.

Swatch Group (UHR)
Star Rating: 4 Stars
Fair Value Estimate: CHF 700.00
Economic Moat: Wide
Fair Value Uncertainty: High
Price/Fair Value: 0.80
We view Swatch as one of best ways to play the global luxury space, European recovery, and emerging markets middle class simultaneously. We believe new technologies for mechanical watches could be a game-changer for the watch industry, driving consumer awareness and shifting preferences further to mechanical watches, enabling retail build-out for Swatch brands, and that increased automation in production will drive long term margins. In addition, Swatch's watch components business has high entry barriers and should increase margins over the long term with new Swiss Competition Authority rulings. The wide-moat name currently trades at a substantial discount to our CHF 700 fair value estimate.>

Kingfisher (KGF)
Star Rating: 3 Stars
Fair Value Estimate: GBX 430.00
Economic Moat: Narrow
Fair Value Uncertainty: Medium
Price/Fair Value: 0.96
Large format DIY home improvement retailers like Kingfisher have inherent competitive advantages that should limit penetration by online and discount players to well below the retail average. Sometimes consumers require a level of service that online and everyday-low-price players do not have the capability to match. Other times, the time to delivery is a barrier to entry for online competitors because demand for consumption is immediate. These factors allow Kingfisher to prices above mass merchants and discounters, which is a key factor in our narrow moat rating. Although the stock rallied in 2013, we believe there is still an opportunity to invest. With British house prices rising and the government propping up the housing market with its Help to Buy scheme, business momentum is gathering in Kingfisher's largest market.

Priceline.com (PCLN)
Star Rating: 4 Stars
Fair Value Estimate: $1,570.00
Economic Moat: Narrow
Fair Value Uncertainty: High
Price/Fair Value: 0.83
We think Priceline's growth is sustainable through the end of the decade, and that investors bearish on the stock are ignoring two important factors that we think will act as tailwinds that will enable over 20% average annual EPS growth over the next 10 years. First, Priceline benefits from a powerful network effect that is becoming stronger over time. As the supply on the company's websites increases, it increases the attractiveness of booking through Priceline's websites to customers looking for one-stop shopping for booking travel, which further enhances the attractiveness of Priceline to hotels. Booking.com has more than 430,000 properties in its network and more than 200,000 in Europe alone, compared with only 75,000 for Expedia in Europe. Second, Booking.com uses an agency model, in which hotels are the merchant of record and pay Booking.com a fee, which helps it to capture market share from online travel agents with a merchant model. The agency model is attractive to hotels in that the commission is typically in the low- to midteens, compared with 20% or more for the merchant model. Priceline's agency revenue has no associated cost of revenue, and the firm's margins are likely to increase significantly in the next several years. We currently view Priceline as undervalued, with the stock trading at 17% discount to our fair value estimate and a relatively attractive next year P/E ratio of 19 times.

Urban Outfitters(URBN)
Star Rating: 4 Stars
Fair Value Estimate: $43.00
Economic Moat: None
Fair Value Uncertainty: High
Price/Fair Value: 0.84
With fewer stores than most brick-and-mortar retailers and a more eclectic set of offerings, Urban remains one of our favorite apparel companies. In our opinion, the company remains understored (Urban Outfitters brand has only 230 locations globally) and we see ample room for location growth internationally. Direct-to-consumer captured nearly one fourth of sales last year, something we see as important as e-commerce continues to steal share from traditional channels. In the most recent quarter, the namesake Urban brand weighed on quarterly results, delivering comps that contracted 9%, but those at Free People and Anthropologie more than carried their weight, with comps rising 20% and 10%, respectively. That said, we expect pricing power inherent in these latter concepts to drive future growth, and we're encouraged that the firm was able to lower the weeks of supply (by one full week), shorten product lead times (by 10%), and reduce product delivery times in the direct-to-consumer channel (fulfillment time was down 30%, and shipping time reduced 15%).

Neither Bridget Weishaar nor R.J. Hottovy, CFA, does not own shares in any of the securities mentioned above.

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