Consumer Cyclical: The Themes Driving Retail's Rebound

• Consumer cyclical sector valuations remain slightly elevated with a weighted average price/fair value ratio of 1.05, edging higher from last quarter's 1.04. We attribute this to healthy consumer sentiment, low unemployment rates, and stable asset market valuations.
• We've long held the belief that those physical retailers that offer a combination of specialization, convenience, and experience were best positioned to compete in an Amazon world. While concerns about potential disruption from Amazon linger, we've seen a rebound among several traditional retailers that have embraced these qualities in 2018.
• We continue to have a favorable view of the specialized auto part retail industry's trajectory. Although growth in miles driven has slowed and fuel prices are rising, we believe that low unemployment and fleet characteristics should propel industry results.
• Retailers that have shown a willingness to invest in convenience and in-store experience--Williams-Sonoma and Nordstrom come to mind--continue to outperform peers across multiple channels.

The market continues to favor consumer cyclical names, with the group continuing to trade at a weighted average price/fair value of 1.05 (roughly in line with the 1.04 ration the group traded at last quarter). We continue to attribute the bullish market sentiment on a number of factors, including healthy consumer sentiment in the U.S. and many other developed nations, low unemployment rates and wage rate increases that are helping to drive middle class consumption globally, and equity and housing market conditions that have been conducive to wealth effect spending.

However, we believe market valuations also reflect the fact that consumer cyclical companies are starting to reap the benefits of recent omnichannel investments. We've long held the belief that those physical retailers that offer a combination of specialization, convenience, and experience were best positioned to compete in an  Amazon (AMZN) world. While it's not easy for a retailer to successfully blend each of these qualities, we still believe those players that can combine a specialized product assortment (including retailers that offer unique, often hard-to-ship products and in-store personnel that would be hard to replicate); an integrated, convenient approach to ordering, fulfillment, and logistics across all channels (in-store, mobile, and online); and experiential retail environments are the best positioned to at least keep Amazon at bay, at least over the immediate future. For this reason, we believe the market had previously overreacted on several names across the retail sector, and not giving credit to those operators who understand how the retail space continues to evolve and will use the potential of competing with Amazon as a way to evolve their businesses. However, we're seeing a rebound in many of the names that have embraced specialization, convenience, and experience.

We believe the auto parts category is a perfect example of how specialized retailers can stay ahead of Amazon. Retailers like  Advance Auto Parts (AAP) have prioritized improving part availability and service levels. On its most recent quarterly update, Advance management noted that its do-it-yourself units sold per transaction has risen for eight straight weeks, which is important as management indicates that a 10-basis-point improvement results in roughly $70 million of incremental segment sales. While the difference between Advance and its peers (1.9-2.0 units versus around 2.4) still reflects a long-standing performance gap, the momentum suggests Advance’s changes are resonating in a way that can boost revenue.

We continue to have a favorable view of the auto part retail industry's trajectory. Although growth in miles driven has slowed (1% over the past 12 months as of February versus 3% in 2016) and fuel prices are rising, we believe that low unemployment and fleet characteristics should propel industry results. We concur with  AutoZone (AZO) management's view that gas prices would have to rise past $4 per gallon for the sector to be significantly affected, particularly as the industry rebounds from the relatively small model year 2008-11 cohort of vehicles' move into sellers' sweet spot. As repair needs grow for 2012 and newer cars and trucks, we expect industry conditions to strengthen, with large retailers showing incremental benefit from a consolidation dynamic driven by their superior standard of service versus subscale peers. Furthermore, as retailer results continue to indicate that sector pricing dynamics have not changed, we remain convinced that digital-only retailers such as Amazon do not pose a material threat to scaled incumbents, at least over the next several years.

Convenience is also becoming as critical as purchase price when consumers are making purchasing decisions. Fifty-eight percent of consumers surveyed by KPMG said that they shopped online because they had the ability to shop 24/7. Another 40% said that it saved time, while 39% said they used the distribution channel to avoid going to shops. With a study by Harris Group showing that 78% of millennials prefer to spend more money on experiences than on material things, it makes sense that they would want to buy the material goods they do need as efficiently as possible because they derive little pleasure from the activity. In fact, 67% of millennials and 56% of Generation X prefer to shop online rather than in-store, according to BigCommerce.  Shopify (SHOP), citing a 2016 Walker Sands Future of Retail Study, highlights that 88% of respondents said free shipping was more persuasive than easy returns or same-day shipping. Retailers have heeded customer sentiment, and free shipping availability has been on the rise. We think that steady growth in the number of retailers offering free shipping will drive further e-commerce purchases, as the most significant price differential is removed. We expect transactions with free shipping to grow 2% on average annually, reaching 70% of transactions by first-quarter 2021 from 48% in first-quarter 2013, with the increase in transactions per person contributing to our 15% average annual growth in e-commerce forecast over the next five years. Although free shipping is one of consumers' largest decision factors, other distribution-related conveniences are important. The Shopify article also highlighted that 69% of consumers would be more likely to shop online with one-day shipping, 68% with free returns/exchanges, 58% with easier online returns, 49% with same-day shipping, and 44% with easier in-store returns.

A good example of a retailer that has embraced evolving consumer views on convenience is  Williams-Sonoma (WSM). The retailer has carved out a solid niche in the fragmented $116 billion domestic home furnishing market, launching most of its brands organically in underserved segments. The firm's brand intangible asset has historically been the supporting factor in its top- and bottom-line growth, as its ability to drive repeat business relies on customer loyalty and smart marketing and merchandising. Relative to its peer group, Williams-Sonoma is in good position to outperform its competitors and hold its share; we think the firm still has access to some of the best analytics in retail.

Williams-Sonoma relies on its e-commerce business (53% of total 2017 sales) to build the brand cost-effectively and leverage costs, driving operating margin improvement (e-commerce EBIT margins are 22% versus 9% in retail). The firm should enjoy opportunities to build the brand globally while improving the cost structure, thanks to an improving supply chain and distribution network as a result of direct sourcing and furniture delivery operations. Additionally, the firm's expanding global footprint could help improve sourcing and distribution costs longer term, improving operating margins. Global expansion allows access to a wider profile of consumer preferences, lending to better local merchandising and marketing, which could facilitate higher unit sales as supply increasingly matches demand.

Last, customer experience is often thrown out by retail management teams, but we've found that very few retailers have been willing to make the investment or operational changes necessary to build a retail model that stands out from peers. In our opinion,  Nordstrom (JWN) is one of those companies, building a brand worthy of significant pricing power through a best-in-class service model, a localized curated product selection, and unique in-store offerings capabilities. Evidence of brand power is featured in Nordstrom's 2% average annual comp sales growth over the past five years versus  Macy's (M) moderately negative comp sales growth and  Kohl's (KSS) flat growth. This is despite continued overall U.S. department store retail market share declines (from 5.2% of retail sales in 2010 to 3.0% in 2017). We think much of this results from a curated and differentiated product selection, featuring partnerships such as TopShop at Nordstrom and Madewell, as well as the dual full-price and off-price offering.

Notably, Nordstrom has been able to maintain its price points and reputation for superior service and in-store experience despite its aggressive rollout of off-price Nordstrom Rack. Successful balance and differentiation of the two brands has enabled Nordstrom to take advantage of the high-growth off-price retail space without cannibalizing its core business. Nordstrom Rack is an important source of new customers, adding 6 million shoppers in 2017. We believe this channel has been a rich source of younger purchasers. It has also allowed Nordstrom to maintain industry-leading inventory turns (with about 75 days inventory in 2017, versus over 100 at Macy's and Kohl's), which enables higher full-price selling at Nordstrom and higher conversion rates with the increased stream of new products. This inventory capability enhances the brand’s reputation as a cutting-edge source of new trends, in our opinion.

Top Picks

 L Brands (LB)
Star Rating: 5 Stars
Economic Moat: Wide
Fair Value Uncertainty: Medium
5-Star Price: $42

Although wide-moat L Brands still has work ahead, we believe that improving comparable sales growth throughout fiscal 2017 (from a 9% decline in the first quarter to 2% growth in the fourth quarter) and easing gross margin pressure (from a 280-basis-point decline to 37.1% in the first quarter to a 100-basis-point decline to 42.3% in the fourth quarter) point to a recovery in progress. We continue to believe that L Brands can return to comparable sales growth in fiscal 2018 and that gross margin pressure will ease with the comping of swim and apparel exits and mix challenges.

In our opinion, L Brands has a wide economic moat, with brand strength in a category characterized by high levels of consumer brand loyalty and prioritization of quality and fit over price. In the near term, we see multiple catalysts for an inflection point in sales and margin performance with discontinued categories being comped, bralette penetration stabilizing, Victoria's Secret Beauty improving, and new structured bra introductions. Further, we believe the company has a healthy long-run growth opportunity in China. With recovering comparable sales pointing to intact brand strength, we think the current discount to our $69 fair value estimate is unjustified and view this as an attractive entry point for investment.

 Hanesbrands (HBI
)Star Rating: 4 Stars
Economic Moat: Narrow
Fair Value Uncertainty: Medium
5-Star Price: $20.30

We have a high degree of confidence in the defensibility of Hanesbrands' competitive position, given advantages that are difficult for competitors to replicate: the efficiency of the firm's large owned and controlled supply chain, core product positioning in a space where brand is more important than price, and economies of scale achieved through a growing portfolio of synergistic brands. We think the company is poised to post significant operating margin growth through recognition of synergies ($85 million in 2018 and 2019), $100 million in net cost savings from Project Booster, and $30 million-$40 million in manufacturing efficiencies.

The company operates 50 manufacturing facilities, mostly in Asia, Central America, and the Caribbean Basin. In 2017, more than 70% of units sold were from own plants or those of dedicated contractors. When Hanesbrands can internalize high-volume styles, we estimate that it saves as much as 15%-20%. Utilizing this manufacturing platform, Hanesbrands has been successful in making acquisitions to drive earnings growth.

Hanesbrands' top line has come under pressure from secular trends to online sales (only 11% of revenue globally was online in 2017, and retailers were hit with bankruptcies and downsizing). However, Hanesbrands is distribution-channel-agnostic, and we think these trends affect only the near term and create an attractive entry point for investors. The transition to e-commerce is proceeding well, with the online revenue growth rate hitting 22% in the fourth quarter of 2017. As online sales increase as a mix of business (we model penetration reaching the midteens percentage of total sales in 2018), we think total company growth will rebound and see 1% organic revenue growth in 2018 (versus a slight decline in 2017) as well as contributions from acquisitions.

 Myer Holdings (MYR)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Uncertainty: High
5-Star Price: AUD 0.40

For investors seeking exposure to the Australian department store sector, no-moat-rated Myer provides the greatest leverage: All of Myer's operating earnings are generated by department stores. However, times are tough for Australian department stores, and this pressure is unlikely to let up soon. We expect Amazon to prove similarly disruptive to incumbent retailers in Australia as in the U.S., compounded by a continued decline in the sector's relevance to consumers as they shift their spending to entertainment, leisure, and specialty shops.

Myer is undeniably in a hard spot, but management is following a clear strategy to cope with the challenges facing the sector. Key strategic targets include a more concentrated physical footprint, greater cost efficiencies, productivity gains, and investment in online capabilities to drive sales and profitability.

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