Increased visibility behind Federal Reserve policy could support consumer cyclical stocks over the near term, but disconnect still exists between the global macroeconomic picture and valuations. Expect price competition to remain a key theme during the 2013 holiday season and beyond. Apparel retailers are set for a dire finish to the year as traffic and conversion continue to disappoint.
Increased Visibility Behind Federal Reserve Policy Could Support Consumer Cyclical Stocks Over the Near Term, but Disconnect Still Exists Between Global Macroeconomic Picture and Valuations
By and large, consumer cyclical stocks have shaken off concerns about lackluster global economic growth, payroll tax increases, and fiscal austerity measures (both domestic and abroad) thus far during 2013. Morningstar's Consumer Cyclical Index has posted a total return of 28.6% year to date, 760 basis points ahead of the 21.0% total return for Morningstar's U.S. total coverage universe. Generally speaking, we've been encouraged by the current U.S. unemployment picture, a rebound in the manufacturing and service sectors, an improved housing market outlook, and manageable inflation levels. We also believe that increased visibility regarding the Federal Reserve's monetary stimulus program (waiting for more evidence that economic progress is sustainable before adjusting the pace of purchases) should provide support for consumer cyclical stocks (and stocks in general) over the next several months.
Nevertheless, we harbor concerns about a potential disconnect between valuations in the consumer cyclical space and the global macroeconomic picture. In the U.S., we're generally forecasting a mild deceleration in both sales and operating margin expansion across much of our consumer cyclical coverage universe during the fourth quarter owing to an erosion in discretionary spending power among lower- to middle-income consumers due to payroll and income tax increases and stagnant wage growth (although we still generally expect healthy earnings per share growth backed by new share-repurchase authorizations.) We also forecast continued revenue and margin pressures from consumer cyclical companies exposed to Europe (although admittedly, we've seen pockets of stabilization across certain European economies) and China. However, with our consumer cyclical coverage universe trading at an average price/fair value ratio of approximately 1.08, we believe valuations reflect anything but a slowdown in fundamentals. Although there are few outright bargains in the consumer cyclical space, we're quick to gravitate toward firms with established economic moats, usually coming in the form of intangible assets stemming from strong brands or differentiated products/services.
Expect Price Competition to Remain a Key Theme During the 2013 Holiday Season and Beyond
With approximately 20% of annual retail sales taking place during November and December (and as much as 40% for some retailers), the fourth-quarter holiday selling period is a critical time for Morningstar's consumer cyclical research coverage universe. However, consumer spending headwinds suggest retailers might be positioned for disappointment. We anticipate a modest deceleration in comparable-store sales for most retailers during the fourth quarter of 2013, owing to macroeconomic and political uncertainty, payroll and income tax increases, mixed consumer confidence signals, and a calendar shift (there are only 25 shopping days between Black Friday and Christmas this year, seven fewer than in 2012, as well as an earlier start to Hanukkah that may pull promotional activity forward). We anticipate average comparable-store sales growth of roughly 2%-3% across our coverage universe during November and December, which is generally consistent with early industry forecasts (ShopperTrak expects retail sales in the U.S. during November and December to rise by 2.4% compared with the approximately $580 billion generated last year). This compares with average comparable-store sales growth of approximately 3% in 2012 and 4% in both 2011 and 2010. We believe that both in-store transactions and the average transaction size will experience a deceleration, the result of a more cautious consumer and aggressive promotional activity.
We also anticipate expect several retail trends we've observed over the past few holiday seasons to become amplified this year, many of which support our cautious long-term thesis for most traditional retailers. We believe earlier store hours, layaway programs, and deeper Black Friday promotions are not just cyclical pressures, and are in fact more indicative of secular headwinds plaguing traditional bricks-and-mortar retailers. Generally speaking, the retail sector has become much less fragmented (which historically allowed larger retailers to post easy share gains against weaker local or regional players), and we expect price competition from Amazon (AMZN) and other mass merchants to remain a consistent theme in the years to come. Additionally, consumers' increasing comfort with shopping online has fundamentally changed the way traditional retailers conduct business, particularly in commoditized categories like consumer electronics, and suggest that market share gains will be difficult to come by not only during the 2013 holiday season, but also for several years to come. The internet also allows retailers to be more dynamic with respect to pricing, promoting an "everyday low price" business model and less one-time, limited quantity, early morning offers in holiday seasons to come.
Apparel Retailers Set for a Dire Finish to the Year as Traffic and Conversion Continue to Disappoint
Despite lapping high cotton costs and improved consumer sentiment, teen retailers (including Aeropostale (ARO), Abercrombie & Fitch (ANF), and American Eagle Energy (AEO)) indicated that the back half of 2013 is unlikely to offer any promise for a recovery in earnings, reinforcing the no moat ratings we give to each of the names. While we expected that cooler weather would have had an impact on the demand for summer merchandise, we speculated that the earlier fall weather would boost sales heading into the back-to-school season. However, this demand never came to fruition, and most apparel retailers experienced lower traffic, conversion, and comparable store sales versus last year when the weather remained warm well into the back-to-school season and through the end of October. We remain concerned about price competitiveness in the industry, which is aggravated by the commoditized nature of the product being sold and the lack of switching costs. Additionally, the dynamics of apparel retailing continue to change as more fast fashion retailers (including H&M (HMB) and Uniglo (9983)) bring availability of their low-cost products online, threatening the recovery of any pricing power in the future as the global economy stabilizes.
Although we don't think brick and mortar will be going away anytime soon, current trends indicate that companies could still be overstored, particularly in the U.S., as the e-commerce channel comprises a larger proportion of total revenue each quarter. We wouldn't be surprised to hear another round of unit rationalization across the apparel retail sector, as stores ultimately become more of a marketing tool to facilitate incremental spending online. Recent private equity stakes indicate to us that others see the ability to trim businesses with healthy cash flow that could still be operating in a bloated way. With Tiger and Sycamore recently building positions in Aeropostale's shares, we see teen retailing as the low-hanging fruit for these firms.
In our opinion, the companies we expect to outperform in the retail industry over the near term have some combination of scale, pricing power, cost efficiencies, and brand recognition. This would include companies such as Inditex (ITX), H&M, VF Corporation (VFC), and luxury businesses such as LVMH (MC) and Richemont (CFR). These businesses tend to act less cyclically than their competitors. For the retailers with lower price points, operational efficiencies and scale offer better returns on capital consistently, and could benefit tremendously as global consumer confidence improves. For luxury players, we believe a consumer base that is less sensitive to discretionary spending during economic cycles stabilizes the cadence of sales growth, which helps maintain consistent returns on capital.
Our Top Consumer Cyclical Picks
After an impressive ride year to date, we peg the average price/fair value ratio for our consumer cyclical universe at 1.08 (implying that the category is moderately overvalued). There are few outright bargains, though we're quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility. In general, we like companies possessing a combination of brand ownership, scale, pricing power in categories where perceived differentiation matters, exposure to emerging markets (but not overly dependent on these regions), resources to extend brand reach, and strong dividend-growth potential.
Top Consumer Cyclical Sector Picks Data as of 09-20-13.
Morningstar Rating: 4 Stars Fair Value Estimate: HKD 30.00Economic Moat: NarrowFair Value Uncertainty: HighPrice/Fair Value: 0.81 MGM China has a narrow economic moat, with the Chinese casino market an oligopoly. We expect the number of gaming licenses in China to remain at six until at least 2020, and we have a stable outlook for the company's economic moat. The market is effectively pricing in only modest revenue and cash flow growth the next five years, with the stock trading at a next-year P/E ratio of approximately 15 times. We expect, over the long term, positive Macau gaming growth and sustainable long-term growth by MGM China to drive the stock toward our fair value estimate, although the stock faces near-term headwinds of slower economic growth in China, and a slowdown in VIP gambling in Macau.
Morningstar Rating: 4 Stars Fair Value Estimate: $63.00Economic Moat: NarrowFair Value Uncertainty: HighPrice/Fair Value: 0.83 As one of the largest online travel agents with a global reach, Expedia remains well-positioned to benefit from the favorable shift of bookings online and booming travel demand in emerging markets. The firm's slowing volume growth in the past quarter was mainly driven by changes at channel partner TripAdvisor, and we believe the effect could be temporary as both parties are working on restoring efficiencies in Expedia's marketing spend. We believe Expedia is gaining traction in the $600 billion international travel market, by expanding the supplier network in Europe and Asia, and building local expertise through direct investment, acquisition, and strategic alliances. While the entry of Priceline's booking.com in the U.S. increases competition in the domestic market, we think Expedia has worked hard to maintain its relationship and value proposition with large hotel chains and travelers, which could help the firm defend its market share and preserve the network effects on its platform.
Advance Auto Parts(AAP)
Morningstar Rating: 4 Stars Fair Value Estimate: $95.00Economic Moat: NoneFair Value Uncertainty: MediumPrice/Fair Value: 0.84 Advance is putting last year's weather headwinds behind it, and should return to more normalized sales growth during the back half of 2013. We continue to be watchful of lagging do-it-yourself sales, as Advance has transitioned many of its stores to a more commercial-centric focus. However, commercial represents a significant growth opportunity for Advance, and we think the company is making good progress fine-tuning its store and distribution infrastructure toward these needs. The industry remains fundamentally attractive for the largest players, in our view, and Advance should be one of the main beneficiaries of industry consolidation trends. The recent acceleration of new vehicle sales could be a temporary headwind for Advance and its peers, but long-term industry tailwinds have been positive, as improving vehicle quality continues to structurally increase the average age of vehicles, and raise demand for aftermarket parts.
Morningstar Rating: 4 Stars Fair Value Estimate: $63.00Economic Moat: WideFair Value Uncertainty: MediumPrice/Fair Value: 0.87 EBay remains a name that is well-positioned to capitalize on favorable, sustainable long-term trends in commerce online (via site enhancements, adjacent formats, increased PayPal acceptance) and offline (through mobile shopping and payments, in-store PayPal tests, same-day delivery services for retailers). With an extremely capital-efficient business model and a wide economic moat grounded in a solid network effect, eBay's role as a global commerce facilitator should translate into excess economic profits over the next several years. We also believe management's goal of $300 billion in enabled commerce volume by 2015 (which compares with $175 billion in 2012, and includes approximately $75 billion in mobile enabled commerce) offers several potential sources of upside to our current estimates. Shares trade at 18 times our 2013 earnings per share estimate (or 15 times excluding the $8.70 per share in cash and equivalents on the balance sheet), understating the company's long-term growth opportunities, in our view.
Morningstar Rating: 4 Stars Fair Value Estimate: $105.00Economic Moat: WideFair Value Uncertainty: LowPrice/Fair Value: 0.92 McDonald's Corp.'s recent results suggest that the broader restaurant category has become an increasingly challenging space in which to operate, but we remain optimistic about management's plans to protect market share while maintaining a foundation for long-term revenue growth and margin expansion. Specifically, McDonald's is taking steps to protect its share of restaurant industry traffic through expanded value menu marketing efforts across all regions, modernization efforts (including restaurant interior and exterior upgrades), and throughput capacity/point-of-sale system enhancements. Although these efforts have had a dilutive impact on recent comparable sales results and margins, we expect both top- and bottom-line trends improve during the back half of 2013 as new premium products come to market and the company laps several cost headwinds.
Neither R.J. Hottovy, CFA, nor Jaime M. Katz, CFA, own shares in any of the securities mentioned above.