The U.S. economy is in decent shape, but we are even more selective given recent outperformance. Even more firms embracing the multichannel retail model. With fewer projects to invest in, some firms continue to route cash toward repurchases and dividends.
Concerns of lackluster economic growth and fears of fiscal austerity have taken a back seat for now, and consumer cyclical stocks are up 11% year to date, outpacing the broader market by 200 basis points. Most management teams are planning for decent top-line growth in 2013, but the tone can be generalized as "cautiously optimistic." Headed toward year four of the U.S. recovery, we're thinking hard about whether the high-end consumer has the will and inclination to support the next leg of economic growth, while questioning the health of the traditional working-class citizen, given, among other things, the payroll tax increase.
For some time we've held the position that the global macroeconomic recovery following the great recession of 2008-10 would be relatively slow and, at times, volatile, and our view hasn't changed. Entering the second quarter of 2013, we've been encouraged by the decline in U.S. unemployment, a rebound in the manufacturing and service sectors, an improved housing market outlook, and normalizing inflation. However, we maintain some caution, as fiscal austerity (domestic and international) and macroeconomic pressure in Europe could remain an overhang on equities over the short run. Even with continued government stimulus, we generally forecast a mild deceleration in both sales and operating margin expansion across much of our coverage universe against more difficult year-over-year comparisons in early 2013 (but with resilient earnings-per-share growth backed by new share-repurchase authorizations).
Despite the elevated uncertainty which has almost become the norm, we peg the average price/fair value ratio for our coverage cyclical universe at approximately 1.05. There are few outright bargains, although we continue to focus on factors such as value, brand ownership, and differentiated products/services, and later-cycle categories such as men's apparel and home, which may strengthen as the economy expands. We would become more interested if the market were to trade down another 10%, but we're quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand potential near-term volatility. Notably, we generally bake in a deceleration in retail sales in 2013 at this point--roughly consistent with U.S. gross domestic product trends--with stable pricing and selective promotional activity (amid lower comparable-store inventory levels) as a partial offset to slowing consumer spending.
Even More Firms Are Embracing the Multichannel Retail Model
Amid an increasingly competitive environment, it has become more difficult for the traditional bricks-and-mortar retailers to differentiate, and many have turned to promotions and exclusives to drive customer traffic into stores. Meanwhile, the shift toward e-commerce has continued (now representing more than 5% of U.S. retail sales and up 15% year over year). Customers are becoming increasingly comfortable with digital media distribution, and we still view Amazon (AMZN) as a long-term winner. With fewer overhead costs and the current avoidance of sales tax in many states, Amazon already enjoys structurally lower costs, so it is nearly impossible for physical retailers to compete at the same price point for comparable goods, especially because the company has shown a willingness to sacrifice margins in order to breed customer loyalty. Simply put, low prices, a rapidly expanding assortment, and timely delivery (facilitated by recent fulfillment-center investments) are a powerful combination in a value-conscious consumer environment which should help Amazon take even more share from traditional retailers.
Traditional retailers face an uphill battle and we believe that a successful firm must be able to more actively control the distribution of its brand and/or differentiate its product or service. For example, Williams-Sonoma (WSM) has created a unique multichannel model that includes enhancing the in-store customer experience and layering in exclusive products, while also embracing the Internet (a channel that represents nearly 40% of consolidated sales), in part by limiting third-party distribution of its products.
Finally, many firms, like Ralph Lauren (RL), VF Corp. (VFC), Gap (GPS), and Vera Bradley (VRA) are developing complex e-commerce strategies, in an attempt to build brand equity and ultimately help the customer purchase "Whatever, wherever, and whenever" she wants. This is an important move, in our view, and while the Internet model may not yet be clearly defined, those companies that aren't headed in this direction risk being left even further behind. Although the up-front cost associated with building out an IT foundation will chip away at near-term free cash flow, higher-margin Web order and fulfillment could translate into a modest sales growth and margin tailwind.
With Fewer Projects to Invest In, Some Firms Continue to Route Cash Toward Repurchases and Dividends
Several consumer cyclical names have accumulated sizable cash stockpiles coming out of the downturn, aided by aggressive cost-cutting efforts and conservative capital budgets. In a near-zero interest-rate environment, we doubt the market is willing to reward companies for sitting on this cash, although having a sizable cushion can convey benefits in this environment. As a result, it's not surprising that an increasing number of consumer cyclical companies announced dividend increases, and/or expanded their share-repurchase programs as part of their quarterly updates.
Collectively, we're forecasting low-double-digit earnings-per-share growth across our consumer cyclical coverage universe in 2013, which might seem somewhat aggressive in the context of our industry expectations for mid-single-digit comparable-store sales growth, negligible overall unit expansion, and modest operating margin expansion. However, we're comfortable with the notion that consumer cyclical firms will be able to support aforementioned channel diversification, infrastructure investments, and other asset renovations while simultaneously buying back shares, indicating another year of earnings growth. If realized, more retailers may opt to return cash to shareholders, even after fully funding domestic, international, and e-commerce growth initiatives. In our view, we wouldn't be surprised to see additional first-time dividends coming out of the consumer cyclical sector during the next few quarters.
Our Top Consumer Cyclical Picks
Data as of 03-20-13
After a choppy yet impressive ride (the S&P 500 is up double digits year to date), we peg the average price/fair value ratio for our consumer cyclical universe at 1.05 (implying that the category is modestly overvalued). There are few outright bargains, though we continue to focus on later-cycle categories such as home improvement and furnishings, which may strengthen as the recession cycles.
We would become more interested if the market were to trade down another 10% or so, but 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 (particularly China), resources to extend brand reach, and strong dividend-growth potential.
MGM China Holdings (02282)
Star Rating: 4 Stars Fair Value Estimate: HKD 28.00 Economic Moat: Narrow Fair Value Uncertainty: High Consider Buying: HKD 14.00 The market is effectively pricing in flat revenue and cash flow for the next five years, with the stock trading at a next-year P/E ratio of approximately 12 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, though the stock faces near-term headwinds of slower economic growth in China, and a slowdown in VIP gambling in Macau.
Star Rating: 4 Stars Fair Value Estimate: $61.00 Economic Moat: Narrow Fair Value Uncertainty: Medium Consider Buying: $42.70 A return to positive comp-store sales and the demonstration that the company can continue to grow the top line through openings and e-commerce will drive the stock higher. Input-cost pressures continue to ease in 2013, and middle-class employment improvement also is an ongoing positive, even if the process continues to be painfully slow. Other pressures on middle-class consumers, such as gas prices, food-price inflation, and domestic fiscal worries, should also ease at some point, taking pressure off Kohl's presently tepid comps. The woes of other retailers such as Sears or J.C. Penney (JCP) could also benefit Kohl's in the long run if an economic disruption were to cause either major retailer to undergo an even more radical restructuring. We also believe the market is underappreciating the impact of share buybacks, which could even accelerate if solid cash flow generation continues as the company has access to additional cheap debt, and also, we point out, if stock price remains low.
Weight Watchers International(WTW)
Star Rating: 4 Stars Fair Value Estimate: $60.00 Economic Moat: Wide Fair Value Uncertainty: High Consider Buying: $36.00 Shares of Weight Watchers could remain in the penalty box for some time as investors absorb the operational missteps and the uninspiring new product launch, which has hurt meeting attendance. 2013 is looking like another tough year for the firm, as growth has stagnated somewhat. However, there is plenty to like in the firm's long-term story, including current obesity trends around the world, the upgrade of its current North American locations, and penetration of the more profitable online business. The company still benefits from a strong brand name and nutrition-based program that drives repeat business and generates solid free cash flow.
Star Rating: 3 Stars Fair Value Estimate: $300.00 Economic Moat: Wide Fair Value Uncertainty: High Consider Buying: $180.00 New product categories, ancillary businesses, and the evolution of the Kindle should drive high-teens average annual revenue growth from 2013-17. However, following an extended fulfillment, technology, and content investment cycle, we believe margins are now poised for an upward trajectory. Prime memberships and other subscription-based services, AWS, and third-party sales should add margin expansion to an already compelling growth story. Shares seem modestly undervalued versus our $300 fair value estimate; we believe Amazon has ample opportunities to diversify its business and add potential upside to our long-term assumptions.
Star Rating: 4 Stars Fair Value Estimate: $67.00 Economic Moat: None Fair Value Uncertainty: High Consider Buying: $40.20 NetEase relies mostly on organic growth, and we think catalysts in the near term include the new release of several in-house games with new graphics and features as well as the launch of more "World of Warcraft" games following the extension of licensing agreements with Blizzard. Although the overall gaming market remains volatile and increased scrutiny over the structure of Chinese ADRs is a concern, we expect investors to build more confidence in steady top players such as NetEase, given its strong and balanced portfolio of in-house and licensed games, unrivaled research capabilities to keep the gaming experience fresh and exciting, and operational expertise in managing the gaming platforms.
Peter Wahlstrom, CFA does not own shares in any of the securities mentioned above.