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Friday Five: Economy Shakes Off Winter Blues

This week's retail sales report provided more evidence that the economy is bouncing back from a tough first quarter. Plus, Apple conference insights and more.

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Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five, Morningstar's take on five stories in the market this week. Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week, the retail sales report showed more evidence that we're shaking off the winter blues. It was up 1.2% in May. What's your take on that report?

Glaser: This is another piece of data that shows the first-quarter contraction in GDP seems like an outlier. It was caused by weather, it was caused by some other factors that were going on, and it really wasn't a sign that the U.S. economy was careening toward another recession or toward a slowdown.

This was a pretty solid sales report. Like you mentioned, that headline number was up 1.2%. A lot of that was gasoline, which has come up a little bit, and auto sales. But even stripping that out, it was still a broad-based increase across a lot of different categories, which is always good to see.

You look at this report in conjunction with other data, like the jobs report that was very strong last week and some other labor data this week including the small-business optimism data, and you start to get a picture of a U.S. economy that's not necessarily going gangbusters but definitely is bouncing back from those doldrums--and that's good to see.

I think that will definitely be a focus as the Fed meets next week. It's extremely unlikely they will raise rates right now, but it does still seem to be very much on the table in September or later this year given this data.

Stipp: In the industrial sector, Johnson Controls joined somewhat of a trend in slimming down and really focusing on its core business this week.

Glaser: The real trend has been toward bulking up recently in a lot of different industries where we've seen a ton of M&A activity among companies trying to gain scale. In pharmaceuticals, for example, we've seen a lot of M&A.

But there also has been a little bit of a countertrend of companies slimming down in order to be more efficient and to focus on their core business. That's what we're seeing here from Johnson Controls. They are selling off the rest of their auto business, which is mainly seating, so they can focus on their batteries and building-efficiency segments, which they think are going to be higher margin; there is less competition there. That's really where they want to put their investment dollars. They think there is better return there.

This is probably the time to do it. Dave Whiston, who is our analyst on the auto sector, thinks that premiums for auto parts are actually pretty high right now and that they will be able to get a good price for this business and get out of it, focus on what they want to and be paid a pretty dollar to do that.

There is no timeline or detail on exactly how this deal will be structured or who potential suitors are; they just announced that they are exploring this. But certainly it's good to see management making these types of decisions in order to become more profitable instead of just bigger.

Stipp: In talking about M&A, we also heard rumors this week that 3G Capital, a Brazilian firm, was interested in acquiring Diageo, the spirits maker. Just rumors at this point, but what's your take on that?


Glaser: It's interesting to look at the potential strategic rationale of this deal, which of course may or may not ever come to fruition. Phil Gorham, who covers this space for us, sees that, in a lot of ways, this fits into 3G's playbook. Diageo has these big, well-known consumer brands that will probably last for decades to come, which is the kind of business that 3G likes.

But on the other hand, Diageo is a very well-run business. There aren't a lot of opportunities to cut costs, something else that 3G likes to do. So if something like this were to happen, it probably would be for more of a strategic rationale than a financial rationale. Strategically, this would give 3G more access to spirits and wine, areas that are growing quickly and that consumer preferences seem to be shifting to. Maybe that would help 3G over the long run, but we still don't know if this deal would actually get done.

It is interesting to hear 3G's name come up again. Over the last couple of years, they've become an important partner to Berkshire Hathaway. They've become a part of the conversation whenever there is a discussion of consumer names and buyouts, and I think this news is another sign of 3G's growing importance.

Stipp: Lululemon was in the news a couple times this week, the first for a really good quarter that they had, and the stock popped.

Glaser: They had a good quarter. The comps were up 6%, and that's on a constant-currency basis. Bridget Weishaar, our Lululemon analyst, thinks they are starting to be able to meet consumer expectations when it comes to quality, fashion, and actually producing products that people want, which is something that they were struggling with for a while. If you'll remember, they had some manufacturing issues with see-through yoga pants, which created a bit of controversy a while back.

Margins still don't look great. They are dealing with some inventory issues and higher investment into their business in order to keep this momentum going. That's a type of headwind that probably won't go away for them anytime soon. We still see this as very much a no-moat business. There is so much competition coming in to this high-end athletics space that they are going to have to keep investing at these high levels in order to stay on top, and that really is going to sap any profitability or margin expansion that they might be able to see.

The other piece of news we got from Lululemon is that the founder, Chip Wilson, filed to … sell the rest of his stake, which is about 14.2% of the business; he had already sold a substantial chunk of it before.

Generally when you see a founder getting out of a stock or out of a company, you might be a little bit nervous. But in this case, we think it actually might be a plus. He really has been a very controversial figure, has made a lot of controversial statements, created a lot of PR headaches, and having him out of the picture might create some stability for the company and gets rid of some of those headaches for them. It could actually be seen as a long-term positive.

Stipp: Lastly Apple held its Worldwide Developers Conference this week. As an investor, what were some of the interesting takeaways?

Glaser: Nothing huge came out of the conference or the keynote. Sometimes there are big hardware announcements, but we got a lot of incremental changes from the conference this week. Apple added some features to iOS, things like multitasking on the iPad and public transit directions on maps. Those moves really just get iOS up to speed with their competitors like Android. These are features that people are coming to expect, and Apple is just shoring up the defenses more than driving anything new.

There was more discussion of ways that they are trying to widen the moat around iOS, trying to make switching costs higher, so that people really stick with iOS: things like the home automation systems and coming out with next version of software for Apple Watch.

They also launched a music-streaming business, which is coming over from the Beats acquisition that they had. This is competing against the likes of Spotify. Brian Colello, our Apple analyst, doesn't see this as a big game-changer for Apple. If anything, it will just make up some of the lost revenue from the digital downloads. It probably isn't going to become a huge business, but it's definitely another sign that Apple is looking for new ways to engage their customers and try to figure out the digital services side of things, which has been an area that they haven't had a ton of success in.

Stipp: There is always something engaging in the latest version of the Friday Five every week. Jeremy, thanks for joining me.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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