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Our Outlook for the Consumer Sector

Fears about the consumer have made some stocks very attractive.

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"Be greedy when others are fearful." - Warren Buffett
"The key to making money in stocks is not to get scared out of them." - Peter Lynch

The U.S. consumer continues to face several challenges, including accelerating declines in home prices, a tightening credit environment, and rising food and gas prices. Furthermore, many of these headwinds appear to be getting stronger, threatening to put the ever-resilient American consumer on the canvas. Fears of such an outcome have led to a sell-off of many consumer stocks this year, especially more discretionary ones with ties to housing (e.g.,  D.R. Horton (DHI) and  Office Depot (ODP) are down 45% and 57% respectively,  J.C. Penney (JCP) has shed more than 40%,  Starbucks (SBUX) and  Limited Brands (LTD) have lost more than 30%, and  Home Depot (HD) is down almost 25%)

On the other hand, unemployment remains low, and wage growth has been solid. Encouragingly, holiday sales on black Friday (the day after Thanksgiving) were strong, increasing more than 8% according to Shoppertrack RCT Corp. So, we think it's a little premature to count out the U.S. consumer.

Even if there were a modest slowdown in consumer spending over the next few quarters, we still believe that many industry-leading companies with solid balance sheets would remain compelling buys at their current prices. This is because their intrinsic values are based on future cash flows over many, many years and not some multiple of next year's earnings. In other words, we think the myopic market is providing investors with some excellent buying opportunities.

Valuations by Industry
Within the consumer goods and services sectors, we believe the most undervalued segments are homebuilding and home supply companies (Home Depot and  Lowe's (LOW)). We also see a lot of value in the following groups: furniture retail (including  Bed Bath & Beyond (BBBY) and  Williams-Sonoma (WSM)), restaurants (like  Cheesecake Factory (CAKE),  Ruth's Chris (RUTH), and wide-moat Starbucks), and department stores (including J.C. Penney and  Macy's (M)).

 Consumer Goods/Services Industry Valuations
Segment

Current Median
Price/Fair Value

Three Months
Prior
Change
(%)
Apparel Makers 0.82 0.95 -14
Auto Retail  0.84 0.89 -6
Clothing Stores 0.85 0.85 0
Department Stores 0.77 0.90 -14
Discount Stores 0.82 0.92 -10
Education 1.02 0.93 9
Food Mfg 0.96 0.98 -2
Furniture Retail 0.70 0.84 -17
Gambling/Hotel Casinos 0.92 0.98 -6
Groceries 0.96 0.96 0
Homebuilding 0.62 0.67 -8
Home Supply 0.65 0.80 -19
Household and Personal Products 0.95 0.89 6
Jewelry/Accessories 1.06 1.09 -3
Online Retail 1.00 1.20 -16
Packaging 0.90 0.96 -6
Personal Services 1.04 1.00 4
Photography/Imaging 1.08 1.04 4
Restaurants 0.77 0.79 -4
Specialty Retail 0.81 0.88 -8
Data as of 11-15-07.

With a large number of 5-star stocks, the homebuilding segment looks particularly cheap. Yes, the industry is mired in a severe downturn, which has forced many firms into, or on the brink of, bankruptcy. But not all homebuilders loaded up with debt, built excessive inventories, and purchased land at peak prices. Several companies were actually well-prepared to weather this storm. Still, their stocks have sold off sharply this year, and most now sit far below today's tangible book value. Although we can't say that housing prices or production levels have bottomed, many of these stronger names are simply too cheap to be ignored, including  MDC Holdings (MDC),  KB Home (KBH), and  Ryland (RYL).

Consumer Goods/Services Stocks for Your Radar
The following table presents several consumer stocks to consider:

 Stocks to Watch--Consumer
Company Star Rating Fair Value Estimate Economic
Moat
Risk

P/FV

Carter's  $30 None Average 0.76
Cheesecake Factory $33 None Average 0.72
Kraft $40 Narrow Below Avg 0.87
MDC $60 None Average 0.68
Walgreen $56 Wide Average 0.66
Data as of 12-07-07.

 Carter's (CRI)
Selling, on average, over 10 products for every child born in the U.S., Carter's boasts the leading share of the baby apparel market. Equity analyst Michelle Chang believes the firm will continue to build off the strength of its flagship brand, which is sold through its own retail stores, as well as department stores and mass channels. While the company is struggling with OshKosh (acquired in 2005), Chang believes management should, with time, be able to turn around this well-known brand, which is positioned for an older age range of 2 to 7 years old.

 Cheesecake Factory (CAKE)
With an upscale decor, an extensive menu, and a reputation for decadent desserts, Cheesecake Factory has customers lining up outside the door. Equity analyst John Owens sees potential for the popular chain to more than double in size. Its higher-end Grand Lux Cafe also has excellent prospects. Developers appear very eager to involve these restaurants in their projects, with some offering anchor positions in shopping malls and contributions to help fund construction. The company also boasts a healthy balance sheet and generates solid cash flow to fund expansion.

 Kraft Foods (KFT)
With Kraft no longer operating in the shadow of Altria and attracting the attention of several activist investors, equity analyst Greggory Warren believes that the narrow-moat company is likely to unload many of its ancillary brands and product lines. This would generate significant cash proceeds, which, along with debt issuances, should enable the company to repurchase as much as 25% of its total shares outstanding. Warren also believes that these efforts are likely to make Kraft a much better operator as the company reduces the complexity of its product portfolio and is forced to be more disciplined with its capital allocation decisions.

 MDC (MDC)
MDC is easily one of the best equipped builders to weather, and subsequently prosper from, current conditions. It carries less land and debt than virtually any other builder, a very important criteria in a falling price environment. More than $2 billion in combined cash and available liquidity virtually ensures the company will weather even the worst conditions. And once on the other side, MDC will have myriad opportunities to pick up cheap land, and in the process significantly lower its cost structure.

 Walgreen (WAG)
Walgreen's margins have recently been crimped by lower generic-drug reimbursements and higher labor and advertising expenses, but analyst Mitchell Corwin believes that the increasing number of generic drugs in the prescription mix will continue to be a net benefit to the firm and that management will aggressively seek to rein in operating expenses. In his view, the company's fundamental strengths remain intact. With freestanding stores in plum locations, Walgreen's fills many more prescriptions per store than the average drugstore chain. This leads to better earnings per store, stronger free cash flow, and the highest returns on invested capital in the drugstore industry.

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John Owens has a position in the following securities mentioned above: HD, LOW. Find out about Morningstar’s editorial policies.