Consumer Cyclical: Consumer Volatility Creates Investment Opportunities
The market now appears to be pricing in more conservative long-term cash flow assumptions than baked into our longer-term consumer cyclical valuations.
After trading at a median price/fair value above 1.00 for the better part of the year, Morningstar's consumer cyclical universe has pulled back in recent weeks and now trades at a median price/fair value estimate of 0.99. We attribute much of the recent weakness to concerns about slowing economies across the globe and foreign-currency headwinds, which we believe have triggered a rotation into less discretionary categories.
Mainstream apparel retailers reported slowing traffic to stores in the third quarter and an excess of inventory in the market heading into the holidays. We think this is due to a few factors.
First, unseasonably warm weather has pressured sales of cold weather merchandise including boots and jackets.
Second, many retailers had expected demand to increase into the back half of the year on the heels of strong employment numbers and improving wages. However, this theory did not pan out. We think that increases in rents and healthcare costs have offset some of the upside. Now retailers have too much inventory, and we think the holidays will be highly promotional.
Third, there is a lack of newness in fashion and, with closets overflowing with skinny bottoms and loose tops, the consumer is bored with the offering and doesn't need any more. We note that big-ticket items, like home goods and autos, have been strong.
Finally, we think that the shift to shopping online is accelerating with poor retail Black Friday performance offset by online gains throughout the weekend.
That being said, there are some standouts in the apparel retail space. We note that off-price retailers (such as TJX (TJX) and Ross Stores (ROST)) have benefited from both a multitude of buying opportunities given excess inventory and demand increases as consumers have remained price sensitive. Athletic apparel is also still outperforming the general apparel industry.
Macroeconomic worries in China have become top of mind for investors. Many of the luxury stocks we cover have experienced volatility and have traded at discounts to our fair value estimates this year. Negative data points ranging from the greater than 40% drop in the Shanghai composite stock index this past summer to the sudden devaluation of the yuan have added to investor worries over companies' prospects for selling goods to China. Luxury goods companies have seen further headwinds from Hong Kong and Macau traffic declines. Investors accustomed to double-digit or higher growth rates are adjusting expectations, and some rightfully harbor concerns that issues will persist or worsen.
However, the stock market fall taken against the relative gains of the prior years means that investors are still better off unless they bought in the spring of 2015, late in the rally. The market is still net higher than in 2013 and 2014, and it is relatively small compared with the bank loan market and consumers' total savings (Chinese consumers hold $9 trillion in savings, according to JPMorgan; Bloomberg cites the People's Bank of China with a similar figure of CNY 50 trillion in 2014). Stock ownership is also less widespread than in developed economies, with various forms of banks loans and bank deposits making up the largest portion of financing in the economy.
Using Morningstar's forecast for Chinese consumption growth of 7% as a basis, we make the assumption that middle- and upper-income consumers can outpace the whole economy for the long run. We believe factors such as increased investment in private businesses, saving rates and increased access to credit, increased government share of social welfare and healthcare costs, better investment returns for the middle class, and further returns for the upper class can all contribute to the high end of consumption outpacing the whole.
With the apparel sector facing near-term headwinds and many luxury stocks trading at a discount given perceived China exposure, we think that there is an attractive entry point for long-term investors.
With investor attention focused on what we perceive to be near-term, fixable product issues within the core Gap brand, we think that Gap's larger and more important margin expansion story is being overlooked. Having invested heavily in a seamless inventory model (expected to be fully integrated by 2016); omnichannel capabilities including ship-from-store, find-in-store, reserve-in-store, and order-in-store; and responsive supply chain initiatives including fabric platforming, vendor-managed inventory, rapid response, and test and respond, we think Gap is poised to close the disparity between its low-double-digit operating margin and the high-teens margins of fast-fashion competitors.
All these initiatives reduce lead times and allow the company to read demand and react to color, size, or silhouette that customers are purchasing. In total, these initiatives should reduce volatility in performance, increase full-price sell-through, and fulfill previously missed sales, putting Gap well on track to matching fast-fashion core competencies. The company expects to increase the percentage of assortment on the responsive model to 50% by the end of 2016. If successful, we see no reason Gap could not reduce the operating margin gap between itself and other fast-fashion retailers and further distance itself from other no-moat companies.
We continue to view near-term product misses at the Gap and Banana Republic brands as fixable and think the brands are on track to post positive comparable sales growth in 2016. Although we do not think new products will hit the shelves until the end of the fourth quarter or early 2016 given current lead times, we think the company is on track with its turnaround efforts. In our opinion, management and brand teams have correctly identified the source of prior product misses--namely fit, quality, and design--and new products will resonate better.
As the stock is currently trading at a discount to our fair value estimate, given product challenges and an underappreciation of the margin expansion opportunity, we think that this is an attractive entry point for investment.
Wynn Resorts (WYNN)
We view Wynn Resorts as a well-established high-end iconic brand that is well positioned to participate in the attractive long-term growth opportunity of Macau (70% of EBITDA), as the company expands its room share to 9% from 6% through the Cotai Palace opening in 2016. The offset to this expanded room presence is the continued shift away from VIP and gaming revenue (where Wynn has an outsized exposure) toward nongaming and mass play, as well as its existing Macau property being located on the peninsula, where traffic has lagged Cotai.
It is not unreasonable to expect Macau visitation and revenue to reaccelerate to above a mid-single-digit pace in a few years, as new casinos open in 2015-17 (increasing Macau room supply toward 43,000 from 28,000 currently), infrastructure is built out in 2017 and beyond (easing overcrowding and accessibility issues), and nearby Hengqin Island is developed over the next decade (three times the development area of Macau). This increased supply should easily be matched with demand, as the population within a few hours of Macau is seven times that of Las Vegas, yet the number of Macau rooms and visitors were only one-fifth and three-fourths that of Las Vegas in 2014. With Wynn holding one of only six gaming licenses, it stands to benefit from this growth. That said, the Macau market is highly regulated, and as a result the pace and timing of growth is at the discretion of the government.
In Las Vegas, Wynn's casino properties generate industry-leading EBITDA (around 30% higher than the next-largest property, Bellagio). Las Vegas doesn't offer the long-term growth potential or regulatory barriers of Macau, so we do not believe the region contributes to Wynn's moat. But there have been very minimal industry supply additions this decade, which is expected to continue over the next few years, supporting solid industry Strip occupancy (93% in 2014).
Arctic Cat (ACAT)
Arctic Cat is one of the longest-operating powersports manufacturers. Unlike its closest peers, the firm is at a critical juncture in its life cycle, making an aggressive attempt to rebuild its revenue and earnings results after clearing bloated inventory levels in the retail channel. The firm has sacrificed price, running promotions to move older units rapidly out of dealer inventory but has been able to gain share thanks to faster unit sales. Although discounts continue to prevail, which we believe will persist through the end of fiscal 2016, Arctic Cat should restore operating profit growth beginning in 2017. Despite no switching costs, we think the company's long-standing brand intangible asset and leading market share position garner competitive returns on invested capital and a narrow economic moat.
We expect unit demand to stem from the delivery of new, innovative products after retail inventory levels are restored to normal, which should help improve the firm's gross margin profile. Management has also articulated its willingness to expand in new channels, both through bolt-on acquisitions and partnerships. We liken this updated strategy to the one Polaris (PII) has implemented in recent years and see acquisitions like Motorfist (in parts, garments, and accessories) and partnerships with Toro and Yamaha as integral to scaling faster and becoming more operationally efficient and better diversified. With no debt on the balance sheet and the likelihood for rising free cash flow, Arctic Cat should be able to capitalize on appropriate acquisition opportunities at will.
However, the firm has robust 2020 goals that include an 11% sales CAGR ($1 billion), operating margins that grow more than twentyfold, and gross profit margins that rise more than 1,000 basis points--these would represent never-before highs in both the gross and operating margin ratios, above prerecession levels. Though our model incorporates significant traction in these metrics, our forecast includes lower 2020 results ($804 million in sales, gross profit margins of 25%, and EBIT margins of 10%), since much of this expansion depends on precise operational execution and a stable economic environment.
More Quarter-End Insights
Market Outlook: Late-Cycle Behavior?
Economic Outlook: Escape Velocity Not in the Cards for U.S. Growth
Credit Markets: Volatility and Spreads to Remain Elevated
Basic Materials: Fates Tied to Faltering China
Consumer Defensive: Bargains Harder to Come By
Energy: Pain Persists as OPEC Refuses to Play White Knight
Financial Services and Real Estate: Fiduciary Standard Rule Could Have Drastic Impact
Healthcare: Even After Uptick, Some Great Values Remain
Industrials: Unsettled Global Economy Serves Up Individual Stock Bargains
Tech & Telecom: Cord-Cutting and Programmatic Advertising Trends Continue
Utilities: Don't Fear the Fed--Yield and Growth Still Look Good After 2015 Slump
Bridget Weishaar does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.