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Quarter-End Insights

Consumer Cyclical: Poised to Perform in the Second Half

With macroeconomic stabilization, cost-efficiency efforts, improved inventory levels, and a relatively healthy consumer, we are optimistic about the sector.

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  • On a valuation basis, the consumer cyclical sector appears to be roughly fairly valued, with a market-cap-weighted price/fair value estimate ratio of 0.97 as of Aug. 31.
  • After a brief disruption at the time of the announcement, the impact of Brexit on the consumer appears minimal, and many companies have indicated a rebound in consumer cyclical sales in Great Britain.
  • Overall, the consumer appears to remain healthy, with retail and food services sales up 2.6% year over year in the second quarter, following 3.8% growth in the first quarter. We expect this strength to continue with employment rates and wage increases providing a tailwind.
  • Previously bloated retail inventory levels, which had led to high levels of discounting in the first half of 2016, now appear under control and should yield improved average unit retail in the back half of the year.

In our opinion, the consumer cyclical sector appears poised for strong performance in the back half of 2016, fueled by consumer strength, global macroeconomic stabilization, and improved expense and inventory management. That said, much of this upside appears to be priced into the stocks with a market-cap-weighted price/fair value estimate ratio of 0.97 as of Aug. 31. We would be strategic in locating stocks with an attractive margin of safety.

On average, discretionary company performance did not appear to be heavily affected by Great Britain's vote to exit the European Union. We attribute this to two factors. First, many of the companies we cover are global in scale and therefore did not have outsize exposure to Great Britain. Second, once the shock of the vote settled, consumers appeared to accept that this would be a multiyear controlled process, and many companies noted that sales in Great Britain rebounded over time.

In the United States, the consumer appears to remain strong. Retail and food services sales were up 2.6% year over year in the second quarter according to the U.S. Census Bureau, following 3.8% growth in the first quarter. We expect this strength to continue with employment rates and wage increases providing a tailwind. Unemployment sits at 4.9% as of August, the third month in a row at this level. Wages increased about 4% in July versus the prior year.

Retailers appear to be well positioned to compete in the all-important holiday season. After heavy discounting to clear bloated inventory levels in the first half of the year, the majority of retailers appear set to capture sales at higher average unit retail in the holiday season. We also think that retailers will resume orders in the back half (albeit at a more cautious level than in the prior year) and that this should benefit manufacturers.

Top Picks

Williams-Sonoma (WSM)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $73.00
Fair Value Uncertainty: Medium
Consider Buying: $51.10

Narrow-moat Williams-Sonoma's shares have declined about 14% year to date, as high-end home furnishing peers have led to an increasingly promotional environment, pressuring the firm's ability to generate higher merchandise margins. Coming off inventory mismatches due to West Coast port delays in 2015, Williams-Sonoma should now be better positioned than its peers to meet consumer demand, thanks to its robust trove of consumer analytics that allows the company to forecast unit demand on a more localized level. Although some pricing pressure from peers could persist, we believe Williams-Sonoma's evolving real estate strategy, supply chain optimization, and still-growing global reach will help returns on invested capital rise to more than 16% over the next five years (versus our weighted average cost of capital of 9%). We expect store sales will rise roughly 3%-4% on average over the next decade while e-commerce grows at a faster clip, around 8% on average. These growth rates bring us to top-line growth of 6%-7% over our explicit forecast, in line with the mid- to high-single-digit outlook of the company. With operating efficiencies building as scale ticks up, low-double-digit earnings growth persists throughout the majority of our outlook.

Hanesbrands (HBI)
Star Rating: 5 Stars
Economic Moat: Narrow
Fair Value Estimate: $39.00
Fair Value Uncertainty: Medium
Consider Buying: $27.30

We see Hanesbrands as one of the best opportunities for investment in the apparel space. We think the shares' current discount is unjustified, given an underappreciated margin expansion opportunity, contributions from two recently announced acquisitions, and the fact that replenishment category sales correct more quickly than general apparel. We believe the majority of Hanes' top-line growth deceleration is due to cyclicality and not competitive moat degradation. If we look at the three largest retailers of Hanesbrands ( Wal-Mart (WMT) with 23% of sales,  Target (TGT) with 15%, and  Kohl's (KSS) with 5%), we see the weakness is channelwide, not company-specific. Additionally, we think apparel manufacturers in the replenishment space can correct faster in cyclical apparel downturns. Of consumers purchasing underwear in the past year, 56% did so because they needed new pairs, 47% because old pairs were worn out, and only 37% because they wanted new and different underwear. However, it is the margin expansion story that we think is most underappreciated by investors. Hanes has a history of achieving margin expansion through the pricing power attached to innovations as well as through cost efficiencies. Over the past three years, adjusted operating margin has increased from 9.7% to 15.0%. Hanesbrands has added $120 million in operating profit through acquisitions but then added an additional $170 million in operating profit through revenue, selling, general, and administrative, and manufacturing synergies it achieved. We believe margin expansion is in the early stages with a long runway for further improvement.

Bed Bath & Beyond (BBBY)
Star Rating: 5 Stars
Economic Moat: None
Fair Value Estimate: $64.00
Fair Value Uncertainty: Medium
Consider Buying: $44.80

No-moat Bed Bath & Beyond's shares have fallen in tandem with many softline retailers as consumers have shifted their spending in recent periods to more durable categories. However, we think the firm still has a defensible business model as a best-in-class merchandiser in the home, baby, and beauty goods spaces. Although we think the cadence of couponing is unlikely to slow over the near term, we believe Bed Bath & Beyond's improving omnichannel presence, disciplined real estate expansion process, and still-robust international opportunities will help offset the company's inability to price at a premium, ultimately leading to slightly lower operating margins over the next decade (11.6%) from 2015 levels. Incorporating 2% top-line growth (supported by Morningstar's mid-single-digit outlook for spending in the repair and remodel market through the end of the decade) with moderate selling, general, and administrative expense leverage over time underlies our fair value estimate. We believe the shares have become attractive and are out of favor as a result of consumers' temporary shift away from lower-price discretionary items.

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