This year is shaping up to be a good year for U.S.-based consumer cyclical stocks, also known as consumer discretionary stocks. The United States so far has seen positive economic data, rising interest rates, historic low volatility and cheery job numbers. All these indicators point to a humming economy, the central bank's confidence in it, and strength in consumer spending.
The environment couldn't be more favourable for consumer discretionary companies to expand, their sales to grow and their stocks to soar. The U.S. economy is in a relatively healthy place, consumer confidence is rising, and unemployment is sitting at 4.3%, the lowest it's been in 16 years.
The S&P 500 Consumer Discretionary Index has returned an impressive 12.9% (in U.S. dollars), higher than the 11.9% gains for the S&P 500, on a year-to-date basis, as of Aug. 9, 2017, according to the S&P Dow Jones Indices.
Despite the recent surge, and in one case because of a steep pullback, the following consumer discretionary stocks are trading below their fair value estimate, offering attractive investment opportunities, according to Morningstar equity research.
| VF Corp | ||
| Ticker: | VFC | |
| Current yield: | 2.57% | |
| Forward P/E: | 19.1 | |
| Price: | US$63.43 | |
| Fair value: | US$70 | |
| Data as of Aug. 15, 2017 | ||
Apparel manufacturer 
VF Corp. (VFC) owns a large portfolio of leading lifestyle brands including The North Face, Timberland, Vans, Lee, Wrangler and Nautica. The portfolio is organized into four segments: outdoor and action sports, jeanswear, imagewear and sportswear. Consumers are served through multiple distribution channels and geographies, with about 38% of revenue from outside the U.S.
The company's product portfolio is dominated by jeans and outdoor and action sports, expected to account for about 90% of revenue in 2017.
VF's direct-to-consumer channel currently accounts for 28% of revenue and is expected to grow to over one third by 2021, says a Morningstar report. "Within this, we expect store growth to slow and the focus to shift to digital, which management sees growing from 5% of revenue to 12% in 2021," says the report.
The company's limited exposure to the U.S. wholesale market minimizes the impact of ongoing softness in the market, which is expected to remain weak. "More than 70% of the wholesale business is international, specialty and pure-play digital retailers, while 15% of the business is mass merchant," says Morningstar equity analyst Bridget Weishaar, pointing out that "the international channel will be another high-growth channel with the potential to continue growing at a high-single-digit" annually over the next five years.
The growth is particularly driven by China, a key constituent of the Asia-Pacific market that currently accounts for 28% of international revenue and is projected by Morningstar to expand to 32% by 2021.
VF's wide moat, or sustainable competitive advantage, flows from the pricing power it's gained through brand assets, says Weishaar, who recently increased her estimate of the stock's fair value from US$64 to US$70 and considers it to be "an attractive investment."
| Hanesbrands Inc | ||
| Ticker: | HBI | |
| Current yield: | 2.31% | |
| Forward P/E: | 11.0 | |
| Price: | US$24.06 | |
| Fair value: | US$34 | |
| Data as of Aug. 15, 2017 | ||
Hanesbrands (HBI) manufactures innerwear and activewear apparel under brand names Hanes, Champion and Maidenform, at 52 facilities, mostly in Asia, Central America and the Caribbean Basin. Almost 35% of sales come from mass merchants in the United States and the rest from national chains, department stores and international and specialty retailers.
The company's brand assets and manufacturing capabilities are difficult for rivals to replicate, giving Hanes' strong competitive advantage in a highly commodified marketplace. The firm's market supremacy is built on “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,” says a Morningstar report.
Hanes's portfolio of brands, found in 80% American households, hold the number-one or -two market shares in each of the core apparel categories in which it competes, says Weishaar, who appraises the stock's fair value at US$34. The strength of its brand equity and manufacturing capabilities will help the firm achieve 20% returns on invested capital annually over the next five years, well above the 8.4% cost of capital, she adds.
“[The firm's] earnings growth will be driven by innovations in innerwear, which will drive price per unit and margins up, as well as through supply chain leverage, scale, efficiency innovations and capacity additions,” says Weishaar, who projects 7% revenue growth and 5% operating profit in 2017, and operating margin to expand from 15% in 2016 to more than 17% by 2021.
| Under Armour Inc C | ||
| Ticker: | UA | |
| Current yield: | - | |
| Forward P/E: | 35.7 | |
| Price: | US$16.71 | |
| Fair value: | US$24 | |
| Data as of Aug. 15, 2017 | ||
Under Armour (UA) markets athletic apparel, footwear and gear. It also owns technology assets in Connected Fitness. Primarily a wholesaler to sporting goods retailers, the company also operates 205 factory-house stores and 63 brand-house stores worldwide. Roughly 17% of total revenue is generated outside the U.S., including Europe, Japan and China.
Under Armour, whose brand enjoys consumer affinity across categories, has also given an alternative to retailers looking to scale back their dependence on more dominant players like Nike and Adidas. “The firm's entry into additional categories and international expansion have enjoyed early success, along with ongoing gains in the core domestic apparel business,” says a Morningstar report.
The company's increased focus on footwear, women's apparel, direct-to-consumer growth and widening global footprint has turned 2017 into a year of transition and investment, says the report. As part of international expansion, Under Armour has been able to secure sponsorships with marquee names and teams, joining some of the biggest sporting brands competing in that space.
“New licensing deals with Major League Baseball and several high-profile athletes, professional teams and universities should create a halo effect and stimulate demand across its entire portfolio,” says Morningstar sector strategist R.J. Hottovy, adding that these sponsorship deals “give us high confidence the brand will be sought after for at least the next five to 10 years, driving returns on capital higher from the midteens to the high teens over the next decade.”
On the product side, the company's commitment to innovation in multiple categories, along with existing technologies and platforms, will continue to command premium prices, he adds.
“There is a longer-term margin expansion story based on the power of Under Armour's brand, which has successfully migrated into new verticals and geographies over the past few years and opened the door for new licensing deals that should create new avenues of cash flow generation in the years to come,” says Hottovy, who estimates the stock's worth to be US$24.
