The Season for Increased Consumer Spending

Six consumer goods segments will benefit from a surge in spending - but how long will it last?

Dave Sekera, CFA 11 December, 2020 | 1:18AM

Gift bags

A significant amount of spending during this year’s retail holiday season will shift away from holiday travel costs and move toward consumer goods. We expect that people will focus their dollars on buying items that support the pandemic-driven stay-at-home lifestyle.

Further supporting consumers’ willingness to spend this year is the expectation that a vaccine will be approved in the next few months. With a pathway on the horizon toward economic normalization in 2021, stock markets have reached new all-time highs.

Historically, strong equity markets have correlated with increased spending on high-end goods and luxury brands as wealthy investors are more willing to splurge on big ticket items. Preston Caldwell, head of U.S. economics at Morningstar Research Services, expects that overall retail sales will increase between 6% and 8% in the fourth quarter this year as compared with last.

However, partially offsetting some of these trends is ongoing high unemployment, especially among the service sectors, and the resurgence of the pandemic. Foot traffic in stores remains low as capacity has been reduced and many are hesitant to venture into public venues. Dining in has been curtailed, and the arrival of winter weather is pressuring restaurants’ ability to serve diners in outdoor seating arrangements.

Still, while the trend toward online sales as a percentage of overall sales has grown significantly over the past decade, the effects of the pandemic will boost this years’ online holiday retail sales even further. However, for investors looking to capitalize on this trend, bargains are few and far between as the stock prices of those companies that stand to benefit the most have already run up to fair value or, in some cases, to overvalued territory.

Here are six areas we expect to see consumer spending support the stay-at-home lifestyle:

Accessories
The shift in spending habits away from travel combined with a desire to reward oneself after living through such a chaotic year should benefit affordable luxury items and high-end accessories.

For example, increased consumer spending can be found in categories like handbags and shoes. Two such beneficiaries may include Capri Holdings (CPRI), owner of brands such as Michael Kors, Versace, and Jimmy Choo; and Tapestry (TPR), which owns Coach and Kate Spade. We view both as undervalued and rate Tapestry with 4-stars and Capri with 3-stars.

Apparel and Beauty
The growth of "athleisure" (comfortable clothes designed for wearing both at home and while exercising) and the decline in business clothing had already been well underway prior to the pandemic. The shift to working at home accelerated demand for this style of clothing.

Lululemon Athletica (LULU) is probably the best-known brand that caters to the athleisure category and will likely have a strong holiday sales season this year. However, similar to many other companies that have been able to benefit from the stay-at-home trend, we think the company’s stock has run too far and outpaced our expectations of future revenue growth. We rate Lululemon with only 1 star and note that it is one of the most overvalued stocks we have under coverage.

While working from home has changed clothing requirements, the growth of video conference calls has helped to support the demand for beauty goods such as makeup, hair/skin care, and grooming products. Estee Lauder’s (EL) focus on premium products has served it well this year, and the firm has been able to capitalize on both growth in China as well as improving its digital capabilities.

Ulta Beauty’s (ULTA) store base has suffered from pandemic-related disruptions, but we expect its online commerce business will grow to 28% of the firm’s sales this year. Looking forward to a post-pandemic world, the company will continue to expand its store base, and we project same-store sales growth will average 5% over our forecast period. Even after incorporating these positive aspects into their valuations, we think the market has gotten ahead of itself for these two beauty stocks and rate both with 2 stars.

Electronics and Gaming
Sales of computers, monitors, and printers surged in the second and third quarter as employees started working in hastily designed new home offices. In the fourth quarter, sales will gravitate toward home theater products and gaming consoles. We expect consumers will reallocate spending the dollars allocated to their entertainment budget toward big ticket items like large-screen TVs and surround-sound systems. In the gaming space, both Microsoft (MSFT) and Sony (SNEJF) have recently released new consoles in the Xbox Series X and Xbox Series S and the PlayStation 5, respectively, and are in high demand.

With its excellent online experience and ability to order and pick up at the store, Best Buy (BBY) is well-positioned to capitalize on these trends. Similar to other companies that have been able to benefit from the acceleration of trends due to the pandemic, Best Buy’s stock price has soared from its March lows and at 3-stars, is back to its fair value. With the upgrade to new gaming consoles, players will look to Activision Blizzard (ATVI), Electronic Arts (EA), and Take-Two Interactive Software (TTWO) for new games next year. We currently rate Activision and Electronic Arts with 3-stars as both are trading near their fair value, but rate Take Two with 2-stars as its price has risen above its fair value.

Home Goods and Redecorating
After staring at the same four walls and furniture, consumers stuck at home have launched into interior design projects with a fervor this year. New housing starts have also rebounded as people flee congested urban areas for the social distancing found in the suburbs. RH’s (RH) (Restoration Hardware) stock price has doubled this year as consumers have furnished new homes as well as redecorated bedrooms, home offices, and family rooms. After normalizing the company’s revenue and taking into account for the cyclical nature of home furnishing sales, we think the company’s stock is more than 60% overvalued and rate the stock with 1 star.

Similarly, without the ability to go out to a restaurant, many have gravitated toward improving their own culinary skills. Williams-Sonoma (WSM) has thrived as home chefs have upgraded their kitchen cookware and the firm’s Pottery Barn brand has flourished from home redecorating. While this trend will likely persist in early 2021, we expect that the firm’s future sales trends will normalize post-pandemic and average roughly 3%. With that in mind, we think the firm is currently fairly valued and rate the stock at 3 stars.

Outdoor Recreation
Outdoor recreation plays on several of the outstanding themes of the pandemic: health and wellness, social distancing, and consumers willing to splurge on big ticket items they may normally not purchase. Based on its strong brands, innovative products, and lean manufacturing, we assign a Morningstar Economic Moat Rating of wide to Polaris (PII), one of the longest-operating brands in power sports.

While we forecast revenue growth that remains strong in the final quarter of 2020, we haven't altered our post-COVID-19 outlook for low-single-digit top-line growth over the next five years. As such, we think the firm is currently fairly valued and rate the stock at 3 stars.

Toys
Over the past decade, toy sales have already shifted toward mass-merchant channels that are designated essential services and have remained open as well as online. As parents juggle working from home with childcare demands and look to keep their kids occupied, toy sales should continue to benefit.

With its portfolio of long-established brands like Barbie, Hot Wheels, and Fisher-Price, we view narrow-moat Mattel (MAT) as undervalued and rate the stock with 4 stars. We view competitor Hasbro (HAS) as fairly valued with 3 stars and think that the company may have a more difficult time this year with generating interest. Hasbro has a higher percentage of products that are linked to movies, which have not had new major theater releases this year.

Investor Takeaway
Spending trends in the fourth quarter will be a continuation of the same patterns that developed since the pandemic. For example, both Amazon.com (AMZN) and eBay (EBAY) will continue to be beneficiaries of increased online spending, yet the market has already priced this into both companies’ stock prices--both are fairly valued, rated at 3 stars. Other beneficiaries include those retailers that have improved their online presence this year such as Target (TGT) and Walmart (WMT). In our view, both of these companies are overvalued as the market has overextrapolated the recent sales growth these firms have experienced from the stay-at-home trend this year too far into the future.

The stocks of many companies that have been the beneficiaries of these short-term trends have become overvalued as the market has extrapolated these trends as a long-term permanent shift of purchasing habits. With economic normalization on the horizon next year, we expect that, as trends normalize, these same stocks will be under significant pressure as they fail to meet those heightened expectations. We caution investors deciding whether to invest in an individual stock to look past the near-term sales growth, which may be temporarily distorted by the pandemic, and focus on the long-term prospects.

About Author

Dave Sekera, CFA  Dave Sekera, CFA, is a senior securities analyst with Morningstar.

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