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Quarter-End Insights

Consumer Cyclical Picks for a Choppy Retail Market

Steady U.S. retail spending and rebounding European and Chinese sales offer decent end-market outlooks for consumer cyclical companies, but the larger retail spending environment remains uncertain around the world.

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  • The consumer cyclical sector still looks overvalued on the whole, but several sectors and individual companies offer compelling opportunities.
  • U.S. retail spending continued on a slow but steady trajectory in the early part of the second quarter, but Europe and China are enjoying reaccelerating trends.
  • Weather was a drag on U.S. retailers' sales in the first quarter, and promotional efforts to liquidate inventory could threaten profitability in the short run.

 

The consumer cyclical sector continues to look a bit overvalued, in our opinion, trading at a median price/fair value estimate of about 1.03. That said, we think several industries offer relative attractiveness, including luxury goods (with a ratio of 0.88), home improvement stores (0.92), and restaurants (0.98). Moreover, several companies outside these areas (as highlighted later in this article) look especially attractive given recent concerns that we don't believe will negatively affect the firms' long-run investment theses. In all, although the broader consumer cyclical end markets have showed improving trends in recent months, we'd still generally point investors toward companies with economic moats, as the larger retail spending environment remains uncertain around the world.

The retail sales picture in the U.S. continued to perform at slow but steady levels in the early parts of the second quarter. As noted by Bob Johnson, Morningstar's director of economic analysis, U.S. sales accelerated slightly (excluding autos and gasoline) in May, but remained in the low single digits. On a stronger note, the European Union enjoyed substantially accelerating year-over-year improvement in retail volumes in April (up 4.9% excluding motor vehicles and effects of inflation, versus less than 2% in previous months), and has now posted nine straight months of gains from the prior year. Recent government monetary actions, intended to continue to revive the economy and spur inflation, could further help the overall selling environment for consumer companies in this region.

Similarly, although the retail sales environment in China had slowed in the first quarter (with year-over-year gains falling to about 12% from more than 13% in the preceding months), the metric ticked up to 12.5% in May. Several luxury manufacturers noted particular strength in China earlier in the year, and we believe global firms with strong brand-driven competitive advantages should enjoy further success as the country's middle class continues to develop.

However, for U.S. retailers, we have some concerns about profitability in upcoming second-quarter results. Many stores' sales were negatively affected in the first quarter by poor weather conditions throughout the country and a need to liquidate remaining inventory could invite price discounting, hampering gross margins. Nonetheless, we generally view this phenomenon as a short-term issue, which could present a long-term buying opportunity, again particularly for those firms with narrow or wide economic moats.

Top Consumer Cyclical Sector Picks

Star Rating Fair Value
Estimate
Economic
Moat
Fair Value
Uncertainty
Consider
Buying
eBay
$63.00 Wide Medium $44.10
Coach $50.00 Narrow High $30.00
Dick's Sporting Goods $61.00 None High $36.60
Data as of 6-23-2014

 eBay (EBAY)
EBay is a commerce platform and provides online marketplaces for sales of goods. It enables commerce through three reportable segments: Marketplaces, Payments, and Enterprise. Shares of the company have come under pressure recently, which we attribute to a number of factors including the May 21 data breach statement, changes to Google's Panda 4.0 search algorithm that negatively affected the search rankings of many of eBay's webpages, the launch of Amazon Payments, and the June 9 announcement that PayPal president David Marcus is stepping down to lead  Facebook's (FB) messaging products. Despite the recent run of negative news, our wide moat rating and positive long-term thesis remain in place, and we believe the current valuation underappreciates eBay's portfolio of technologies.

 Coach (COH)
Coach is a marketer of fine accessories and gifts for women and men. Its product offerings include women’s and men’s bags, accessories, business cases, footwear, wearables, jewelry, sunwear, travel bags, watches, and fragrances. The firm is facing a number of near-term negative trends and cyclical pressures, which have recently fueled investor fears and weighed on the stock. But despite what we believe may be some management mistakes and competitive pressures, we don't think the Coach brand is permanently damaged, and we continue to believe the company has a narrow moat, denoting a sustainable competitive advantage. While the short term looks negative, we believe the current discount assigned to Coach's stock price is too high, and in the long run cash flows will stabilize and improve, giving patient investors a potential profit that outweighs the short-term risks.

 Dick's Sporting Goods (DKS)
Dick's is an authentic full-line sporting goods retailer offering an assortment of brand-name sporting goods equipment, apparel, and footwear in a specialty store environment. Although we don’t believe the company has yet carved an economic moat, Dick's still has ample long-term growth opportunities as it expands westward, and it has slowly edged operating margins higher for more than a decade. With a superior product mix of brands and exclusive labels, the best store environment that attracts the top brands, expanding reach and the effects of scale, the long-run operating profit growth story has not changed, in our opinion.

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Adam Fleck does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.