(By Peter Wahlstrom, CFA)
- While pockets of softness still exist, we expect another year of mid-single-digit growth among consumer cyclical firms in 2011 as the U.S. economy continues its slow recovery.
- Commodity headwinds remain a concern, but some manufacturers/retailers have several levers to mitigate the impact.
- With plenty of cash on the sidelines, merger-and-acquisition activity among consumer cyclical names will likely continue
While pockets of softness still exist, our expectation for a modest recovery among consumer cyclical firms in 2011 remains intact, with mid-single-digit top-line growth projected for much of the sector. Retail sales remain particularly strong as the sector recently posted its fifth consecutive month of sequential growth in excess of 6% on an annualized basis. A strong December would bring the string of improvements to six months.
Clarity on the Bush tax cuts and unemployment benefits, sharply improving markets, and new stimulus money (in the form of a 2% cut in payroll tax) should give consumers even more cash to spend in the months ahead. All in, the government appears determined to bring the consumer back to help lead the U.S. economic recovery. To date, we've frankly been a bit surprised by the strength, but the recent trends and data give us increased confidence that sales momentum can continue into the first half of 2011.
Within the consumer cyclical sector are a diverse group of industry categories, including advertising and marketing services, entertainment, publishing, restaurants, specialty and apparel retail, and travel and leisure. While each is unique, we've presented the prevalent themes for each industry during a period of gradual economic recovery:
Advertising and Marketing Services
- Search Advertising: We think the inherent advantages of search (its measurability and effectiveness) and the continued growth of Internet usage will lead advertisers to allocate more of their ad budget to search, resulting in good growth prospects for the industry for years to come. Although the U.S. search market has started to mature, we think there is plenty of growth left in many international markets. These growth opportunities bode well for all industry participants in 2011, especially Google (GOOG), which had 66% of U.S. market share in September 2010 according to comScore, and even higher market share in many European and Latin American countries.
- Outdoor Advertising: We believe the outdoor advertising market bottomed in 2009 and will continue its recovery in 2011. Unlike other old media like newspapers or radio that serve local advertisers, we think advances in technology will eventually expand the number of companies that use outdoor advertising, positioning these firms to take a larger share of local ad dollars from other media. Outdoor advertisers are in the early stages of rolling out digital billboards, which can be changed in a matter of minutes, allowing advertisers to pick specific times to display their messages. Even better, outdoor advertising firms can charge a higher rate for peak traffic times like morning rush hour, making these billboards more profitable for the company. Billboard displays have been a cheap way of generating brand awareness, but now, advertisers can take advantage of call-to-action advertising that can be updated in real time. For example, on a Saturday morning, a local retailer can promote its weekend sale on a billboard.
- Advertising Agencies: While ad growth rates vary by media sector, we think the results of marketing conglomerates like Omnicom (OMC), WPP Group (WPPGY), and Interpublic Group (IPG) are a good barometer of broad-based spending on marketing services, as these firms provide a wide variety of services around the globe. We're optimistic that all three marketing conglomerates will continue to deliver revenue growth over the next few quarters (despite a still-murky economic picture), but we think year-over-year ad growth rates may be near the peak as comparisons become more difficult in the fourth quarter.
Substitutes to the traditional pay television model--such as offerings from Apple (AAPL), Hulu, Netflix (NFLX), Roku, and others--have generated a substantial amount of buzz, but pay television remains a dominant industry. Roughly 90% of television households receive service from a cable, satellite, or phone company, according to Nielsen.
Considering the tough economic times and high unemployment rate in the United States, pay TV subscriptions have been exceptionally resilient. Compared to other cyclical categories, total pay television subscriber growth modestly increased in 2009 (partially a result of the digital broadcast transition that made it more difficult to get over-the-air programming and the aggressive price promotion among distributors) and has remained essentially flat in 2010. We would not be surprised to see some modest subscriber losses over the next few quarters due to cyclical issues such as tepid household formation numbers, but we don't anticipate any precipitous subscriber declines given the lack of comparable substitutes.
We expect demand for television content to continue in 2011 with more viewing occurring on mobile devices and tablet computers like the iPad. In order to satisfy consumer demand, we believe content owners and distributors will come together to allow subscribers to access content on multiple devices with an authentication system. We think both sides of the lucrative pay TV ecosystem recognize the importance of making content available across multiple platforms. Time Warner (TWX) was one of the early proponents of this concept, which it named "TV Everywhere," and its premium HBO Go service allows subscribers to access content through its proprietary website. HBO customers will be able to stream programming on portable devices by early 2011. Included within the recently extended carriage agreement between Disney (DIS) and Time Warner Cable was access to a new authenticated service, which now allows cable subscribers to access ESPN and will soon offer ESPN2, ESPNU, and ESPN Goal Line on multiple devices.
We view the "TV Everywhere" model as limiting the threats of cord-cutting and piracy in the long run. While this concept is still in the early stages, we expect cable networks to offer digital access as a negotiating tool to continue to push for higher affiliate fees when negotiating with its cable, satellite, and telecom partners, driving revenue growth rates upward
Following a rough 2008 and 2009, advertising trends at magazine and newspaper publishing industries improved during 2010 and will likely continue in 2011 due to an overall recovery in advertising budgets. However, we don't expect the rebound in advertising to benefit all advertising-dependent companies equally, as the secular shift in media consumption from print to online benefits companies like Google at the expense of newspaper and magazine publishers. Therefore we're expecting gradual advertising declines for the magazines and newspapers beyond 2011.
Several large magazine publishers have formed a consortium called Next Issue Media to jointly work on an electronic delivery business model for e-readers like the Kindle and iPad. The publishers want to make it easy for consumers to browse and buy content on the device of their choice, and plan to work with Amazon (AMZN), Apple, and other device manufacturers. However, we believe a significant challenge for the consortium will be retaining control of the customer relationship, as Amazon and Apple both have closed systems that control distribution. We think electronic reading devices, particularly Apple's iPad, could help increase readership of publications; however, the ad revenue model for digital content is unclear
The domestic restaurant industry has been impacted by a number of headwinds over the past several years, including fewer meals eaten away from home, increased prepackaged meal offerings from grocers and warehouse clubs, elevated unemployment rates, and wage rate hikes. However, we started to see a reversal in several of these trends in 2010, with fast-casual chains--which offer higher-quality ingredients than quick-service chains but at lower average prices than casual-dining restaurants--leading the pack. Collectively, we forecast mid-single-digit top-line growth for the restaurant industry in 2011, driven primarily by improving restaurant traffic (but still well below historic norms). We also anticipate some impact from menu price inflation, as restaurant operators have already started to raise prices in light of rising commodity costs.
Specialty and Apparel Retail
Most retailers saw merchandise margins improve during 2010 as sales rebounded and firms kept expenses in check. There were still signs of aggressive markdowns in some cases, owing to a cautious and value-focused consumer, but with inventory levels near cyclical lows, the full-priced sell-through was much improved. Retailers were also cautious in expanding their selling, general, and administrative expense budgets in 2010, and only added headcount, advertising and marketing spend as they gained visibility on consumer spending trends. A few highlights:
- Apparel/Specialty Retail: lululemon athletica (LULU), Limited Brands (LTD), and Urban Outfitters (URBN) continue to top the charts with impressive same-store sales growth, validating our view that retailers that can provide consumers with something fresh and unique will outperform their peers in the near term, especially since post-recession consumers remain very selective with their purchases.
While the women's apparel segment has held up relatively well, the teen apparel market remains under pressure, driven by high unemployment among 16- to 19-year-olds. Unless the unemployment trends abate, we project additional price cuts at Abercrombie & Fitch (ANF), American Eagle (AEO), and Aeropostale (ARO). To help offset some of the domestic growth concerns, many retailers (including Gap (GPS), Limited Brands, VF Corporation (VFC), and Polo Ralph Lauren (RL)) are focused in on growth opportunities in the international markets and the e-commerce channel. While this has been an ongoing theme over the last several years, we are encouraged that these retailers now have a clearer game plan, including specific strategies and financial targets, which could lead to additional near-term sales momentum.
- Auto Parts Retail: Solid momentum continued into the fourth quarter for auto parts retailers such as Advance Auto Parts (AAP), AutoZone (AZO), and O'Reilly Automotive (ORLY) as consumers searched for ways to extend the lives of their vehicles instead of buying new ones. While new car sales have improved from their historical low of 9 million units in early 2009 to about 11 million units (based on a seasonally adjusted annualized rate) in recent quarters, these figures remain well below the 16 to 17 million units sold on a comparable basis from 1998 to 2008. We think demand for auto replacement parts should moderate as new vehicle sales pick up over the next few years, but momentum is likely to continue well into 2011.
- Department Stores: Even with a stretched consumer, focused on value and price, we believe firms like Macy's (M) and Nordstrom (JWN), for example, will continue to be successful with cleaner inventories and sharper pricing strategies. By focusing on sharper opening points, average unit retail fell during summer months, but these firms saw increased conversion and higher traffic as consumers sought and recognized value. More recently, the trend has reversed, with some consumers willing to even absorb higher prices as they returned to the department store channel. as average unit retail rose consistently in our coverage universe, but some spending constraints are also evident as total ticket dollars or units per ticket declined at various retailers.
- Home Improvement: Home Depot (HD) and Lowe's (LOW) have performed this year, as the companies focused on expense management to deliver solid cash flow amid a challenging macro environment. The bad news is that there aren't many signs of near-term improvement on the horizon, which points to yet another "transition" year for these firms. The good news is, both companies have retooled their expenses so that, even if there isn't a meaningful lift in comparable store sales in 2011, they are poised to drive margin gains and achieve double-digit earnings growth (after share repurchases). With shares of both companies trading below their respective fair value estimates, we continue to like both Home Depot and Lowe's as the U.S. economy and housing markets recover and normalize over the next few years.
- General Merchandise Stores: General merchants have fared well as traffic gains were further affirmation that these firms are retaining some incremental shoppers even as the economy continues its measured recovery. Value remains a consistent theme, though accessories, holiday, sporting goods, and other small discretionary item sales remain a bright spot for the likes of Costco (COST) and Target (TGT). While TV volume was flat/up, pricing remains under pressure, and some other electronics categories have yet to stabilize. We continue to expect low- to midsingle-digit comps for most general merchandise stores heading into 2011, driven by low- to midsingle-digit store traffic gains and inflationary average transaction growth.
Travel and Leisure
The travel and leisure industry remains in recovery mode after a multiyear slump. We are optimistic that trends will slowly continue to improve for the travel industry in 2011. Although many indicators have improved markedly since their lows, we still think there is room for further improvement before reaching more normalized levels. Vehicle miles driven and global air passenger enplanements have both improved, foretelling positive trends in other travel spending such as cruise vacations, rental car bookings, hotel bookings, or leisure activities. However, we do not expect sentiment or travel volumes to return to 2007 levels anytime soon. Most of the gains to be had from increased consumer willingness to spend were achieved in the recent past; gains from consumers' ability to spend are much more slow to arrive and will only be reached as the employment situation improves.
Dealing with Commodity Headwinds
As consumer cyclical firms take a moment to reflect upon 2010, many will agree that it has been a trying yet ultimately successful year. Despite an uneven consumer appetite, most companies will have reported a solid rebound in sales, low inventories, and record margins. As we detailed above, there are a number of reasons for continued near-term optimism as it relates to the first half of 2011, and we recognize further signs of an improving economy. At the same time, while we have become less concerned about sustainability of the top line, our attention has turned to commodity costs, which may have more of a mixed impact on firms' margins next year.
Many retailers already warned against rising input costs in the first half of 2011, specifically citing transportation, labor, and cotton as the primary culprits. Companies like Polo Ralph Lauren , VF Corporation, Carter's (CRI), and Phillips-Van Heusen (PVH) have gone out of their way on conference calls, in filings, and at investor events to highlight these pressures and set expectations. Management's statements are a clear indication that firms across the retail supply chain are being impacted by the higher input costs, and even the largest and most financially sound manufacturers will be forced to raise prices over the course of calendar 2011.
Kohl's (KSS) and J.C. Penney (JCP) are managing vendors, assortments, and product makers for cost increases. First-half 2011 orders are already booked with only modest cost increases, but there is increased uncertainty surrounding the back half of the year. Retailers are delaying orders, and vendors are weighing whether to lock in materials; there is work to be done to avoid dramatic price increases, particularly for cotton-based merchandise.
For example, cotton prices increased by 30%-50% from the $0.80-$0.90 per pound range earlier this year as demand from apparel manufacturers picked up, outpacing supply. The supply/demand imbalance was further exacerbated by bad weather in the world's largest cotton producers, including China, India, and Pakistan (which account for 30%, 20% and 8% of global production, respectively) in recent months, pushing cotton prices up to $1.55 per pound in November 2010. Since the lead time for apparel manufacturing is typically about six to nine months, apparel retailers will start to see the impact of higher cotton prices hit home in spring 2011, with further sourcing cost pressures projected for the fall season. However, consistent with prior cycles, we project that cotton prices will eventually moderate as more supplies come online, and prices have started to retreat from the peak. Cotton prices have averaged $0.70 per pound over the longer term; we think the downward trend will continue over the back half of 2011.
Restaurants are another industry category that will face inflationary cost pressures in 2011. Despite our outlook for solid top-line growth, we believe restaurant operating income growth may be more muted in 2011 than it was 2010, as restaurant operators contend with higher food prices across several beef, wheat, dairy, and coffee inputs. Additionally, we believe restaurant chains will need to invest more on labor and other in-store improvements in 2011 to satisfy heightened consumer demand.
As we consider such headwinds, we think that the larger and more established consumer cyclical firms have more of an opportunity to offset these higher commodity costs: 1) Selective price increases are "inevitable," according to several management teams. 2) Although promotions may continue, most retailers appear to be holding clean inventory positions, suggesting that markdown activity in 2011 should be less than this year. Discounting will also remain a key theme in restaurants, but we believe competition will be more rational than it was in 2010. 3) Companies will place additional advertising and marketing behind their faster-growing (and most profitable) products/brands in an attempt to take incremental share. 4) Product mix will undoubtedly change. In apparel, shifts toward wool, polyester, sportswear other non-denim (high cotton content) products will be made in an attempt to preserve overall margins. We also expect restaurant menus to continue their shift toward beverages and portable snack items to drive operating income higher. 5) Consolidated top-line growth may become even more dependent on international markets. Some domestic brands are becoming well-known in the local Chinese marketplace, which should drive incremental gross profit dollars to firms in 2011.
With Plenty of Cash on the Sidelines, M&A Could Continue
On Nov. 23, J. Crew (JCG) became the latest to join the M&A fray after the company announced that it would be acquired by private equity firms TPG Capital and Leonard Green & Partners. This marks the second LBO deal in the specialty retail space in the fourth quarter alone (following Bain Capital's acquisition of Gymboree). Under the agreement, J. Crew shareholders will receive $2.8 billion, or $43.50 per share, a 16% premium to the stock's closing price from Nov. 20, before takeover reports surfaced. On the flipside, some firms are taking steps of their own: Radio Shack (RSH), Barnes & Noble (BKS), and BJ's Wholesale (BJ) had at one point or another this year reviewed strategic alternatives, while Aeropostale was reported to have hired Barclays Capital as its strategic advisor to help fend off potential offers by private equity firms.
There is still a large amount of uncommitted capital available for takeovers (more than $400 billion, according to market research firm Preqin), with U.S.-focused buyout firms sitting on more than half of the available funds. Therefore, we expect a continued appetite for similar leveraged buyouts in the consumer industry over the next several months. While private-equity deals in the retail sector have been a mixed bag historically, given the cyclical nature of the industry, these companies exhibit strong free cash flow generation with minimal debt on the balance sheet, which fits the typical LBO profile.
Morningstar has developed a proprietary scoring system, which assesses each firm's feasibility of takeover based on company size, current capital structure, free cash flow generation, and management's ability and/or barriers in pursuing a possible transaction. Based on the rankings, we think lululemon athletica, Carter's , Wendy's/Arby's Group (WEN), and Sonic (SONC) could potentially be the next takeout targets. Additionally, several names that have been the subject of recent takeover rumors, such as Aeropostale, Chico's (CHS), American Eagle, and Brinker International (EAT), also scored high on our list.
Consumer Cyclical Stocks for Your Radar
| Consumer Cyclical Stocks for Your Radar|
Price/ Fair Value
|International Speedway || 5 || $38.00 || Wide ||Medium||0.67|
|Lowe's (LOW)|| 4 || $36.00 || Wide ||Medium||0.71|
|Sonic Corporation (SONC)|| 4 || $13.00 || None ||Medium||0.82|
|Staples (SPLS)|| 4 || $27.00 || None ||Medium||0.83|
|Opentable (OPEN)|| 1 || $25.00 || Narrow ||Very High||2.77|
|Data as of 12-20-10. |
International Speedway (ISCA)
Demand for motorsports entertainment has been largely impacted by high unemployment, but we expect International Speedway will see a steady influx of fans returning to the sport as more job-seekers find work in the coming years. Much of this growth will fall directly to free cash flow because a large portion of the firm's costs are fixed, regardless of revenue. The firm is currently trading at 23 times trailing earnings, but only 10 times our estimate for 2012 earnings. Our fair enterprise value is 8 times 2010 EBITDA.
Despite a shaky macro environment, Lowe's has remained profitable and continues to generate significant cash from operations. The market's pessimism reflects persistent fears surrounding housing and consumer spending uncertainty. The removal of homebuying stimulus and higher interest rates could remain downside risks in the short term; however, we expect shares to recover as U.S. economic growth normalizes and macro concerns subside.
Near-term restaurant traffic and margins will likely be plagued by high unemployment and aggressive industry discounting, but we're optimistic about Sonic's long-term prospects. We find the firm's domestic growth opportunities, profitable menu mix, ascending royalty rate structure, and lower capital requirements particularly compelling. Same-store sales trends should start to improve against easier comparisons.
High unemployment and small-business budget constraints have weighed on results, but we believe the market is underestimating this company's ability to deliver a strong performance as the economy improves. Staples is the dominant retailer of office products, and continues to see an uptick in customer traffic while rivals have seen declines. Corporate Express continues to have a positive impact on international and North American delivery segment profits, and we remain optimistic about the long-term synergies.
An exceptional business model and strong growth potential are not enough to justify an excessively lofty valuation for this firm. Even under our most optimistic forecasts, the stock appears expensive and is currently trading at more than 60 times our forward fiscal-year earnings estimate.