Our outlook for consumer cyclical stocks

Generally speaking, we remain encouraged by the current U.S. unemployment picture, a rebound in the manufacturing and service sectors, an improved housing market outlook and manageable inflation levels. However, we find ourselves becoming more cautious as we look to the third quarter, as signals that the Federal Reserve could look to phase out its monetary stimulus program, lingering macroeconomic pressures in Europe and emerging liquidity concerns from China may weigh on equities over the short run. Additionally, we've become increasingly concerned about the personal saving rate in United States, which remains just off five-year lows at 2.5% in April (compared with 7.4% in December 2012) and calls into question how much ammunition consumers have for discretionary purchases.

For some time, we've held the position that the global macroeconomic recovery following the Great Recession of 2008-10 would be relatively slow and at times volatile, and our view hasn't changed. However, with June bringing a 3.5% pullback in the S&P 500, we're taking a closer look about whether the high-end consumer has the will and inclination to support the next leg of economic growth. For better or worse, high-end consumers have become a driving force behind the recovery following the Great Recession, and we now find ourselves in a situation where the economy has become more dependent on a fairly narrow group of consumers. Notably, these are individuals who don't have to spend if they don't want to and often take their spending cues from the movements in global asset markets. If the mood of the big spenders were to become more cautious based on recent equity market volatility, the sentiment of this group of consumers could change in a hurry, with implications for much of the broader global economy.

Even with uncertainty about government stimulus, we generally forecast a mild deceleration in sales and operating margin expansion across much of our coverage universe against more difficult year-over-year comparisons in 2013 (but with resilient earnings per share growth backed by new share-repurchase authorizations). Despite the elevated uncertainty, which has almost become the norm, we peg the average price/fair value ratio for our coverage cyclical universe at approximately 1.02. There are few outright bargains, though we continue to focus on factors such as value, brand ownership and differentiated products/services and later-cycle categories such as men's apparel and home, which may strengthen as the economy expands. We're also quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand potential near-term volatility.

Brick-and-mortar retailers fight back

Already in 2013, we've seen traditional brick-and-mortar retailers adopt more aggressive (and transparent) price-matching efforts as well as other promotional activities designed to stave off consumers' continued shift toward e-commerce (which now represents more than 5% of U.S. retail sales and is up 15% year over year, according to comScore) as well as Wal-Mart's WMT US$6 billion in planned price investments through 2017. This list includes a number of retailers in commodified categories (where consumers will typically make their final purchase decision based on price and not the expertise level of a sales associate), including Best Buy BBY, RadioShack RSH, Target TGT, Staples SPLS, Office Depot ODP and OfficeMax OMX.

We view this is as an important step for these players to remain relevant in light of increasing online competition from Amazon STEC(AMZN/NAS), which enjoys structurally lower overhead costs thanks to the absence of a physical store presence and has shown a willingness to sacrifice margins in order to breed customer loyalty. However, we don't think the margin hit from price-matching efforts or retailers' own e-commerce channel investments has been fully priced into stocks at this point and is one of the primary reasons we find the consumer cyclical sector slightly overvalued at current prices.

Backed by disciplined cost management put in place during the Great Recession and increased labour, supply chain and fulfillment efficiencies, many traditional retailers are running at all-time-high operating margins, so we're not terribly surprised by the year-to-date strength of consumer cyclical stocks. However, we believe the market has, by and large, assumed that margins will continue to improve off peak levels across much of the sector and not fully factored in the implications of aggressive price-matching efforts, increasingly obsolete retail store locations and retailers' own e-commerce expansion initiatives. As such, we believe the aforementioned forces create more downside risk rather than upside potential.

Best Buy provides one of the more interesting case studies for a traditional retailer amid the increasing shift to e-commerce. With a management team squarely focused on returning the brand's relevance and aggressively optimizing the cost structure, we believe Best Buy is in a better place than it was a year ago. We acknowledge the progress made in improving online traffic conversion rates (comparable online sales grew 16.3% during its most recent quarter, which is essentially in line with the mid-teens rate the U.S. e-commerce category has been growing at the past several quarters and an acceleration from past two quarters), the rollout of the Samsung Experience and Microsoft store-within-store concepts, the sale of its stake in the Best Buy Europe joint venture, and other cost-cutting initiatives (management reported that it eliminated $175 million from its cost structure during its most recent quarter, including $145 million in selling, general and administrative expense reductions and $30 million in supply chain, bringing the company to $325 million in annualized cost reductions or a little less than half of the $725 million outlined in the November 2012 Renew Blue analyst day).

Despite these positives, we believe the market continues to overestimate Best Buy's ability to consistently drive in-store and online traffic when rivals like Amazon, Wal-Mart and Costco COST still have numerous competitive countermeasures at their disposal (price investments of their own, membership program benefits, and in Amazon's case, a vastly expanded content library). We believe Best Buy's price investments -- which were cited as a key reason for the 190-basis-point decline in domestic gross margins to 23.4% during its most recent quarter -- will extend well beyond the near term.

In our view, aggressive price matching is the primary factor that will prevent the company from reaching management's longer-term operating margin goals of 5% to 6%, and our US$21 fair value estimate remains predicated on normalized operating margins of 3% to 4%. Although Best Buy's relative valuation metrics appear punitive to industry and historical averages, we believe investors should approach this name cautiously because of the competitive and channel shift pressures (key vendors taking products directly to consumers) that are likely to intensify in the years to come.

Given state budget deficits and lobbying efforts by brick-and-mortar retailers, we haven't been surprised that online sales tax collection legislation has garnered more attention in recent months, with lawmakers introducing legislation encouraging states to compel online retailers to collect sales tax. Obviously, implementation of sales tax collection would narrow Amazon's advantages and make traditional retailers more competitive. Still, even if more-stringent tax collection laws were put in place, we believe Amazon could maintain its value proposition and attract customers through other means, including changes to shipping policies or new Amazon Prime membership features. We believe it will be difficult for traditional retailers to maintain peak margins while embarking on price wars with companies with lower cost structures like Amazon, Wal-Mart and Costco.

To fully combat price competition from e-commerce and mass merchant rivals, brick-and-mortar retailers must be able to more actively control the distribution of their brand and/or differentiate their product or service, in our view. For example, Williams-Sonoma WSM has created a unique multichannel model that includes enhancing the in-store customer experience and layering in exclusive products, while also embracing the Web (a channel that represents nearly 40% of consolidated sales), in part by limiting third-party distribution of its products.

Strong results for home-improvement retailers

In our view, recent results from home-improvement retailers Home Depot HD and Lowe's LOW reinforced our wide moat ratings for both names as well as their favourable position relative to the ongoing U.S. housing market recovery, where private fixed residential investment, household formation, housing turnover and home prices continue to trend in the right direction.

Adding further credence to the ongoing housing recovery was the fact that for the first time since early 2008, Home Depot's pro customer segment outpaced growth in its consumer segment in the most recent quarter (though management admitted that this was helped by softer gardening category sales, which skews more toward the consumer segment). Transactions for tickets over $900 (representing 20% of Home Depot sales) increased 9.7% during the quarter, compared with a 1.6% decline in transactions in tickets under $50 (which also represent approximately 20% of the revenue mix). In total, the average ticket increased 5% for the quarter, owing to pro customer transactions, increased appliance sales, and to a lesser extent, commodity price inflation (lumber and copper).

Lowe's also noted relative strength in big-ticket purchases (greater than $500) during its most recent quarter. We expect the average ticket trends to remain directionally positive over the next few quarters because of the retailers' ability to drive customers through everyday low pricing, which is at the heart of our wide moat ratings.

Although Lowe's same-store sales have lagged Home Depot's in 16 out of the past 18 quarters (with the same-store sales spread between the two retailers around 5% in the most recent quarter), Lowe's April and May numbers were similar to Home Depot's (which reported a 9.9% gain in total same-store sales for April) and may suggest that in-store productivity efforts (coordinated inventory planning and better in-stock positions, line resets centered on reducing redundancies and prioritizing higher-velocity items, negotiating lower unit cost terms with vendors, and increased staffing to improve weekend close rates) are bearing fruit.

Despite our near-term optimism about both names, we believe that the market has fully priced in improving fundamentals and current housing market conditions, and we would look for a wider margin of safety before establishing a new position in the name. However, we still view Home Depot as a core portfolio holding, and with a dividend ($1.56 per share per year) that equates to a 2% yield at the current price, the shares may be worth a look for more income-oriented investors.

Our top consumer cyclical picks

After an impressive ride over the first five months of 2013 but a modest sell-off in June, we peg the average price/fair value ratio for our consumer cyclical universe at 1.02, implying that the category is slightly overvalued. There are few outright bargains, though we're quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility. In general, we like companies possessing a combination of brand ownership, scale, pricing power in categories where perceived differentiation matters, exposure to emerging markets (but not overly dependent on these regions), resources to extend brand reach and strong dividend growth potential.

	Top Consumer Cyclical Sector Picks
		Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Value
	Baidu		$125.00	Narrow	High	0.75
	eBay		$63.00	Wide	Medium	0.81
	Kohl's		$61.00	Narrow	Medium	0.83
	John Wiley & Sons		$45.00	Wide	Medium	0.88
	McDonald's		$105.00	Wide	Low	0.93
	Data as of 6-24-13

Baidu  BIDU
Chinese search engine Baidu is a narrow-moat Internet firm well positioned to benefit from the favourable mix shift to online advertising in China and meet growing demand for targeted advertising with measurable results. We believe PC-based search will continue to account for the bulk of paid search revenue over the next several years in China, and Baidu should remain the dominant player, given its strong record of good user experience and extensive searchable content inventory. While the firm's competitive position does not look as strong in mobile Internet at the moment, Baidu has moved aggressively in recent quarters to speed up mobile service launch and to align itself with Apple's iPhones and leading Android phones in China--moves that in our view can help bolster and solidify the firm's position in mobile search.

eBay  EBAY
EBay's shares have traded down recently, which has created an intriguing entry point for a name that is well positioned to capitalize on favourable, sustainable long-term trends in commerce online (via site enhancements, adjacent formats, increased PayPal acceptance) and offline (through mobile shopping and payments, in-store PayPal tests, same-day delivery services for retailers). With an extremely capital-efficient business model and a wide economic moat grounded in a solid network effect, eBay's role as a global commerce facilitator should translate into excess economic profits over the next several years. We also believe management's goal of $300 billion in enabled commerce volume by 2015 (which compares with $175 billion in 2012 and includes approximately $75 billion in mobile enabled commerce) offers several potential sources of upside to our current estimates. The shares trade at 18 times our 2013 EPS estimate (or 15 times, excluding the $8.70 per share in cash and equivalents on the balance sheet), understating the company's long-term growth opportunities, in our view.

Kohl's  KSS
Despite short-term worries, we still believe Kohl's will outperform in the long term thanks to higher margins and efficient capital deployment. Kohl's lowered prices in 2012 after raising prices to combat input costs. Now it must win customers back, and it has made significant changes to its merchandising team. We believe lower commodity inputs and easy comparisons should work in Kohl's favour as the macro economy improves for Main Street. Kohl's benefits from a more cost-efficient box, more convenient locations and consumer-traffic patterns, compared with older real estate and declining traffic and demographic patterns of many older department stores.

John Wiley & Sons JW.A
Wiley is an intriguing value play. There is negative market sentiment on Wiley because the company faces a decline in its college publishing business (about 30% of its operating profit). The entire college publishing industry is down as book rentals are taking share and the transition to digital books is going slower than hoped. Wiley is proactively taking costs out of the business over the next two years. Its scientific journal business (60% of operating profit) gives Wiley a wide moat and remains healthy. The journals are must-have content and are already distributed online. Growth has been slow as library budgets in the U.S. and Europe have been pressured, but the business remains fundamentally sound.

McDonald's  MCD
McDonald's recent results suggest that the broader restaurant category has become increasingly challenging to operate in, but we remain optimistic about management's plans to protect market share while maintaining a foundation for long-term revenue growth and margin expansion. McDonald's is taking steps to protect its share of restaurant industry traffic through expanded value menu marketing efforts across all regions, modernization efforts (including restaurant interior and exterior upgrades), and throughput capacity/point-of-sale system enhancements. Although these efforts have had a dilutive impact on recent comparable sales results and margins, we expect top- and bottom-line trends to reverse course in mid-2013 as new premium products come to market and the company laps several cost headwinds.

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