Earnings growth in the consumer discretionary sector was robust during the fourth quarter (Q4) of 2012, up 16.6% on a year-over-year basis and above Wall Street analysts’ expectations (see chart below, right). Healthy earnings growth continued into the first quarter of this year as well. This favorable trend is impressive considering the numerous challenges U.S. consumers faced heading into 2013, including higher payroll taxes, delayed tax refunds, and concerns over sequestration.
Though each of these headwinds has weighed on consumer confidence at times so far in 2013, overall spending trends remain healthy, due in part to a strong recovery in U.S. household finances (see "Housing helps consumers recover").1
U.S. retail sales increased 3.6% year-over-year in the first quarter (Q1) of 2013, slowing slightly from Q4's 4.1% year-over-year pace, but remaining in growth territory.2 In particular, retailers and restaurants were faced with consumers who were focused on promotions and value, and cold spring weather was an incremental challenge in Q1 2013 following an unusually warm spring in the Northeast and Midwest a year earlier. Department stores generally were a disappointing category in Q1, driven largely by strategic changes at one major chain. At the same time, auto sales helped support overall U.S. consumption, with lightweight vehicle sales up nearly 8% from the prior year.3
Elsewhere, U.S. housing remained the bright spot for the sector during the first quarter of 2013, with housing starts climbing 27% on a year-over-year basis and at an annualized pace of 917 million units4—relatively low compared to history and normalized demand. In January, the S&P/Case-Shiller Home Price Composite Index, a proxy on U.S. home prices, grew 8% year-over-year, the fastest pace of growth since the economic recovery began, and a rate not seen since the second quarter of 2006.5
New home sales helped drive construction payrolls up 91,000 from the prior quarter, the largest quarterly improvement since 2006.6 A recovery in both residential and non-residential construction has the potential to help broaden the U.S. economic recovery.
Today, college graduates have a substantially lower unemployment rate (3.8%) than Americans without a high-school diploma (11.1%). But encouragingly, the latter rate of unemployment has been among the fastest-recovering segments in the U.S. work force, down from 15.7% in mid-2010.7
Outside the U.S., Europe continues to be negatively influenced by austerity and the ongoing financial crisis along the periphery of the European Union, including Cyprus. European Union retail sales are trending flat to down slightly year-to-date, and new vehicle registrations have declined 9.5% thus far in 2013— consistent with their contraction in Q4 of 2012.8 The Eurozone Manufacturing Purchasing Managers Index, a survey of manufacturing activity, ticked further into contraction in March, to 46.6.9
In China, while the pace of growth has slowed, the level of growth remains above that in most developed-country markets.10 Chinese GDP growth decelerated to 7.1% in Q1 2013, from 7.9% in Q4 2012, while retail sales growth decelerated to 12.4% year-over-year in Q1 versus 14.5% in Q4.11 Although the pace of growth slowed in the first quarter, China remains among the fastest-growing end markets for global consumer companies, and a key strategic focus for management teams.
Increasing shareholder value via share buybacks
With low prevailing interest rates, consumer discretionary companies with strong balance sheets and high rates of free cash flow have continued to take advantage of their access to low-cost capital in the debt markets to increase shareholder value. Some have been refinancing their outstanding debt at lower rates and extending maturities. Others have taken additional leverage onto their balance sheets, and have been using this borrowed capital to buy back outstanding shares of company stock and drive earnings growth.
During the one-year period ended Dec. 31, 2012, consumer discretionary companies spent 117% of free cash flow on share buybacks—the highest level of any sector and 4.5% of the average of all outstanding shares—compared with a 79% share of free cash flow for the broader market.12 Despite a fairly tepid global growth environment, shareholder-friendly corporate capital allocations have been a positive contributor to earnings growth in the sector.
As of the end of March, consumer discretionary stocks had an average price-to-forward-earnings ratio (P/E) of 16.9, which was slightly above the sector’s long-term median of 15.8 (see chart right). Relative to the broader equity market (Russell 3000 Index), the sector was also modestly above its long-term average on a price-to-forward earnings basis.
One of the industries driving higher valuations for the sector has been media, where the average P/E has risen 32% since the end of 2011, versus 22% for the sector as a whole. The revaluation of media stocks has been driven in part by announced divestitures, designed to highlight the value of faster-growing segments such as cable networks, and to spinoff more challenged assets, such as publishing units. After more than a decade of large acquisitions with mixed results, investors more recently have rewarded the stocks of media conglomerates for simplifying their businesses, focusing on their best assets, and returning excess cash to shareholders.
Outlook on consumer discretionary stocks
Although consumers on a global basis face challenges such as rising tax burdens and tepid employment growth, we believe the current economic environment remains conducive to strong earnings growth and attractive total return opportunities for many companies within the consumer discretionary sector.
Many have adapted their businesses models throughout the Great Recession to generate earnings growth even at low levels of global economic growth. For example, the retail and restaurant industries are fragmented sectors of the global economy, where public companies have continued to gain share at the expense of struggling independents.
Another example is the media industry, where many companies have become less reliant on advertising—historically tied directly to economic growth—and more dependent on subscription revenue streams that generate stable growth. In the global apparel industry, many U.S. brands are early enough in their lifecycle that they are generating revenue and earnings growth even in troubled economies such as Europe.
Finally, there are pockets of economic strength in the U.S., such as housing and auto sales, that continue to drive earnings growth for the sector. With valuations at reasonable levels relative to history, there continue to be significant opportunities to invest in consumer discretionary stocks, even in the context of a slower global growth environment.
2. Source, retail sales: Haver Analytics.
3. Source, auto sales: U.S. auto sales (autos and light trucks) rose from 12.9 million units sold to 14.5 million units sold on a year-over-year basis at a seasonally adjusted annualized rate during Q1 2012. Source: Haver Analytics.
4. Source, housing starts: Haver Analytics.
5. Source, S&P/Case-Shiller home price composite: Haver Analytics.
6. Source, construction payrolls: Haver Analytics.
7. Source, unemployment rate: Haver Analytics.
8. Source, European retail sales: Haver Analytics.
9. Source: European auto registrations: Haver Analytics.
10. Source: GDP in China: Haver Analytics.
11. Source: China retail sales: Haver Analytics.
12. Source: FactSet “Buyback Quarterly” report, April 2, 2013.