During the past several months, consumer discretionary companies on average produced modest earnings growth against a backdrop of slow but steady U.S. economic growth and improving economic data in Europe.
Second-quarter earnings grew modestly (1.8%) on a year-over-year basis, driven in part by 6.4% year-over-year revenue (sales) growth in the sector (see Earnings Scorecard below, right). Overall, limited growth in inflation-adjusted household income (+1.9% on average in Q2 versus previous year)1 meant strength in spending on certain categories was largely offset by limited spending elsewhere in the sector.
Autos and housing
More specifically, there has been increased consumer spending in credit-sensitive categories, such as automobiles and housing, during the past several months. Automobile sales grew 8.6% year over year, to 16 million units on an annualized basis as of Aug. 31, 2013—the highest sales level since 2007.2 Elsewhere, housing starts continued to recover, increasing 17.8% year over year during the second quarter.3 U.S. home prices rose 12.1% from the prior year, continuing to fuel growth in household net worth.4
During the past six months, however, rising mortgage rates tempered the housing market recovery.5 A key measure of housing affordability declined 6% from the previous year,6 driven primarily by higher home financing costs and secondarily by higher home prices. The number of mortgage applications submitted to lenders declined 4% year over year during the second quarter, as refinancing activity declined.7 Homebuilders also reported a slower pace of recovery in new orders as consumers digested rising home financing costs.8 Overall, while higher borrowing costs dampened the pace of the housing market recovery, the recovery remained on track through September 2013.
Slower consumer spending was evident in some of the retail categories that had been areas of earnings growth strength in 2012. Overall retail sales, excluding autos, increased 3.5% year over year,9 with strength in home-related items (e.g., home improvement and furnishings) offset by limited sales growth in certain general merchandise and apparel retailers.10
In Europe, there were signs of stabilization in the profile of the average consumer. For example, the number of European auto registrations declined 3.8% in the second quarter of 2013 from the previous year—the slowest pace of post-financial-crisis decline since the fourth quarter of 2011—and were briefly in positive territory during April.11
Our company research also showed that auto manufacturers and suppliers are seeing stabilization in European consumer demand, which had been weakening. It is possible that this stabilization in demand is an inflection point that may precede recovery in an industry operating at demand levels last seen during the 1980s.
Another sign of improvement in the European economy was the European manufacturing purchasing managers index, an indicator of manufacturing business conditions, which hit a 26-month high in August and stood above 50 (signaling expansion) for the third straight month in September.12
Elsewhere around the world, economic conditions in China also improved during the past few months. Overall, economic stabilization in China has been led by property market activity and state-led infrastructure investment. Increased fiscal spending and credit utilization have led to broadly improved sentiment, which has contributed to higher real estate prices.13 Retail sales in China increased 12% year over year during the second quarter, and passenger car sales increased 10%.14 Macau gaming revenue increased a healthy 16% on a year-over-year basis during the same period.15
Looking ahead to the third quarter, Wall Street analysts are currently anticipating a 7.5% rate of quarterly earnings growth, which is down from expectations of 12.6% entering the quarter on Jul. 1, 2013.16
Share buybacks continue to be an earnings driver
Based on the volume of shares repurchased in the second quarter ($122.8 billion)—the highest amount since the third quarter of 2011—corporate America continues to deploy capital to reduce share count.17 The consumer discretionary sector remained a major contributor to this volume, buying back roughly $14 billion of outstanding shares.18 During the 12-month period ending in June 2013, consumer discretionary companies were the second-largest repurchaser of shares among all 10 sectors, buying back more than $60 billion.19 [Note: Repurchasing shares is accretive to earnings growth; with fewer outstanding shares, the total amount of earnings a company pays out is distributed to a smaller number of shareholders.]
Media industry evolution: Content versus distribution and the increasing importance of scale
The media industry continued to evolve during the past several months, culminating with a battle between a major television broadcaster and a cable giant over the fees content providers are paid for their programming. The dispute led to a month-long blackout of television programming for many cable-TV customers, beginning in early August. This followed a similar blackout in July 2012 between a major media content conglomerate and a satellite-TV provider.
The high profile disputes highlight increasing conflict between media content owners (such as broadcasters and cable-channel owners) and their distributors (such as cable-TV and satellite-TV companies). With the pay television market largely mature in the U.S., at more than 85% household penetration, media companies are increasingly battling over ownership of this slow-growing profit pool.20 Today, content owners generally hold the upper hand in these negotiations. But the disputes have long-term implications for the sector, as they are likely to drive increased consolidation in order to maximize negotiating leverage on both sides of the table.
Valuations in the consumer discretionary sector are modestly elevated relative to long-term averages. On an absolute basis, consumer discretionary stocks had an average price-to-forward-earnings ratio (P/E) of 17.7 at the end of September 2013, which was above the sector’s long-term median of 15.9 (see the chart, right). The sector’s 17.7 P/E multiple was also above the 14.5 historical average P/E ratio for the broader equity market.
I suspect valuations in the sector increased to some extent in recent months because the European economy showed signs of stabilization and modest improvement, which provided some optimism for economically sensitive stocks, including those in the consumer discretionary sector. At the same time, recent declines in bond prices have made equities more attractive on a relative basis.
Outlook on consumer discretionary stocks
Consider auto stocks
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From a fundamental perspective, I believe the U.S. continues to be in a slow but steady cyclical economic recovery. One of the most important drivers of consumer spending, over time, is employment. While the pace of economic recovery has been frustratingly slow for many consumers, the recovery in the U.S. unemployment rate has been steady and significant in aggregate (standing at 7.3% in August, down from the peak of 10% in 2009).21 The most cyclical measures of consumer activity, including housing starts and automobile sales, continue to improve toward new cyclical highs. This feedback loop of higher construction and manufacturing jobs driving tighter labor conditions and eventually wage growth remains intact despite the slow pace of improvement.
Over the long term, the most important driver of growth in the consumer discretionary sector will likely be the continued emergence of the global middle class. This group is projected to approximately double over the next 15 years, bringing more consumers into the global market than during the previous 100 years combined.22 While emerging-market growth has decelerated in 2013, it remains a top contributor to total growth, and a key strategic focus for our consumer discretionary research team.
For these reasons, I continue to be optimistic about the consumer discretionary sector’s long-term return potential. It is important to note that while the pace of economic recovery has been slow, the environment remains conducive to attractive earnings growth. The sector lends itself to multiple avenues of earnings growth, ranging from domestic market share gains to steady increases in global demand for U.S. products and services, and to intelligent capital allocation (for example, value-creating acquisitions or share repurchases). Combined with reasonable valuations and high free cash flow conversion, these long-term earnings drivers can yield attractive total return opportunities.