They're Still Shopping

S&P's Thomas Graves expects Americans to moderate their spending next year, but he still sees good bets among consumer discretionary stocks

"Consumers will continue to be a major force in bolstering the U.S. economy." That's the view of Thomas Graves, group head of the Standard & Poor's analysts covering consumer cyclical stocks. Indeed, consumers have been absorbing the spike in energy prices, as well as higher interest rates, and continue to spend. However, he does expect them to slow spending next year as higher energy prices take a toll.

Graves likes restaurants, particularly McDonald's (MCD ), Applebee's International (APPB ), and Steak N Shake (SNS ), which are ranked strong buy by S&P. He also favors some specialty retail and apparel retail chains such PETsMART (PETM ), Abercrombie & Fitch (ANF ), and Guitar Center (GTRC). S&P is also bullish on media empire NewsCorp (NWS ).

These were a few highlights of remarks by Graves in an investing chat presented on Oct. 11 by BusinessWeek Online and Standard & Poor's, in response to questions from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from the chat.

(Thomas Graves is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.)

Tom, with energy costs so high and inflation fears rising, how have consumer cyclical stocks been doing?

They've been somewhat weak. However, we believe that consumers will continue to be a major force in bolstering the U.S. economy. Our sector strategist, Sam Stovall, is recommending that investors overweight their position in consumer discretionary stocks, of which consumer cyclicals are a portion.

Sam believes that consumer discretionary stocks will be a possible beneficiary of a prospective easing of gasoline prices, relatively low interest rates, and an expected earnings improvement in 2006.

Which areas of consumer discretionary have done the best so far this year? And do you continue to see strength in these areas?

Through the end of last week, some of the consumer discretionary groups that have done the best this year include department stores, homebuilding, and leisure facilities. However, most of the consumer discretionary sector is in negative territory year-to-date, as measured by the stocks in the S&P 1500 index.

Among the groups in which we currently have favored stocks are restaurants, where we have a strong buy opinion on McDonald's, Applebee's International, and Steak N Shake.

We also have some strong buy recommendations in the specialty retail and apparel retail areas. They include PETsMART, Abercrombie & Fitch, and Guitar Center.

What makes up the "cyclicals" portion of consumer discretionary? And what's the dividing line?

We divide the consumer discretionary sector into two pieces, cyclicals and retail. Consumer cyclical includes groups that are especially sensitive to macroeconomic conditions, such as interest rates. Examples in this area include automobile stocks and homebuilding stocks. The cyclicals also include many media or advertiser-related stocks.

The consumer retail group includes stocks in such areas as department stores, specialty stores, and apparel retail stores.

What do you make of the Delphi (DPHIQ ) bankruptcy filing and its effect on General Motors (GM ) and other auto makers?

In the near term, we do not expect Delphi's filing to disrupt the flow of auto parts being supplied to General Motors. However, given the level of salary and benefit cuts that Delphi is seeking to receive from its unionized employees, we see potential for a disruptive strike in the future.

Under the terms of GM's spin-off of Delphi, GM is responsible for pension and health-care obligations related to some Delphi employees. While GM's obligations are hard to quantify, we believe they could run into the billions of dollars. We have a strong sell opinion on GM.

Another down day for oil stocks -- what does the future hold? Oil isn't really in your sector, but gasoline and fuel oil are certainly big consumer price worries -- thus this question.

We're looking for oil prices to ease. However, we favor some energy-related stocks. For example, we have a strong buy opinion on Baker Hughes (BHI ), Exxon Mobil (XOM ), and Nabors Industries (NBR ).

I agree that energy prices are increasingly on the mind of U.S. consumers. Not only have gasoline prices risen sharply but consumers may face the prospect of home heating fuel prices being much higher this year than they were last winter.

Tom, do you like any media stocks? There has been some consolidation recently, with News Corp. buying some Internet brands like, and rumors about an AOL and Microsoft (MSFT ) linkup.

Among our favorite stocks in the media area are shares of News Corp. (NWS.A and NWS.B ). We have a strong buy opinion on both types of News Corp. shares. And we have a buy opinion on such media stocks as Time Warner (TWX ) and Disney (DIS )

What about Internet-related stocks such as eBay (EBAY ), (AMZN ), etc.? They certainly play to the consumer

Among Internet-related stocks that sell products to the consumer, we have a hold opinion on shares of both eBay and Some Internet stocks are in the discretionary area, but I'll hold off on specific recommendations because of the risk of straying too far into technology.

Why do you like Time Warner? Any idea what it will do with AOL? What about Carl Icahn?

In the latest proxy filing today, Icahn's group again demands a $20 billion Dutch auction self-tender and a 100% spin-off of the company's cable unit. With Icahn's leverage for triggering a major proxy battle still in doubt, we think the filng by his group could at best force Time Warner to hasten previously announced capital return initiatives. Media equity analyst Tuna Amobi at Standard & Poor's has a buy recommendation on Time Warner.

You named department stores as an area that has done well so far this year. Haven't the old-line stores suffered in comparison to discounters on one side and luxury retailers on the other?

The results can vary among the department stores, both on operating results and stock performance. Currently, our opinions vary on different department-store stocks. For example, we have a buy opinion on J.C. Penney (JCP ) but a hold opinion on Federated Department Stores (FD ).

You mentioned restaurants and McDonald's (MCD ) -- why do you like this chain?

McDonald's is currently a $32 stock, which is well below the $38 our 12-month target price. We believe the company will have earnings per share of $1.96 in 2005, and we look for an increase to $2.09 in 2006.

How about the travel field -- any interesting stocks among the hotels, or elsewhere?

Within the travel area, one of our favorite stocks is La Quinta (LQI ). We have a strong buy opinion on La Quinta and a 12-month target price of $12.

What's your outlook for homebuilders? Do you think certain areas are at risk of declining?

Our sense is that the environment for homebuilders is looking less favorable, as we expect there'll be increases in interest rates facing consumers. However, rates are relatively low, and there has obviously been strong interest among consumers in buying homes. In general, we've become less bullish on the homebuilding group.

What about sales of existing homes? And of products for fixing them up, via Lowe's (LOW ), Home Depot (HD ), and the like?

In the home improvement area, we have a strong buy opinion on Home Depot. We have a 12-month target price of $48, and we believe the company will be a beneficiary of rebuilding efforts in the aftermath of hurricane Katrina.

In the fiscal year ending in January, 2006, we estimate earnings per shares of $2.63, and for the next fiscal year we expect EPS of $3. Also, we have a buy opinion on Lowe's. Our 12-month target price for these shares is $74.

Looking ahead to the holiday shopping season, which retailers do you think stand to benefit the most?

We're not necessarily pegging our recommendations to how well we think a given company will do in the holiday season. However, there are a number of retail stocks on which we do have a strong buy opinion.

These include Abercrombie & Fitch, and PETsMART, both mentioned earlier. In addition, in the consumer staples area, we have a strong buy opinion on Wal-Mart (WMT ).

Are there stocks in your area you think investors should be selling now? And why?

We have a strong sell on General Motors and Dow Jones (DJ ). As we noted earlier, GM is responsible for obligations covering some Delphi employees, and General Motors is a major customer of Delphi. After news came out this week on the Delphi bankruptcy filing, we reiterated our strong sell opinion on GM.

With Dow Jones, we have a 12-month target price of $33 for a stock that closed today at about $36. We have had some concern about the outlook for technology and financial advertising, which accounts for 30% of Dow Jones's overall ad revenue.

What's your view of electronics retailers Best Buy (BBY ) and Circuit City (CC )?

We have a buy opinion on Best Buy and a hold opinion on Circuit City. With Best Buy, over the longer term we expect its customer-centricity initiative will translate into higher sales and margins. Our 12-month target price is $50. With Circuit City, we have a 12-month target price of $18.

What's your outlook for earnings among the companies you cover?

In the consumer discretionary sector, we generally look for earnings improvement in 2006. However, we do not expect personal consumption expenditures by the U.S. consumer to grow as rapidly next year, on an inflation-adjusted basis, as we expect they will in 2005.

In our view, energy prices will continue to restrain consumer spending and siphon away some dollars that could better be spent on other purchases.

Casino stocks are down so far this year. Do you see any chance for a recovery?

We are not especially bullish on casino stocks. We expect earnings reports for the third quarter will be complicated by damage and interruptions caused by the hurricanes in the Southeast. Also, we think investors have become more wary of casino stocks in light of concerns about growth in consumer spending.

What's the S&P take on inflation? I've been noticing it not just at the gas pump (where it has moderated a bit) but also at the supermarket.

This Friday we are expecting consumer price data for September to be released. We expect headline prices to rise 0.9%, but we look for core rates to rise only a tame 0.2%.

We believe investors are keeping a close eye on both actual inflation data and what the prospects are, since this may influence the attitude of the Fed towards raising interest rates.

Besides your sell ranking on GM, how do you rank the other auto makers? Do all of them face tough times?

That strong sell recommendation on GM reflects our concerns about what we view as increased pressure on profits. Also, we consider earnings visibility to be unusually limited. On Ford (F ), we have a sell opinion.

One of our concerns with Ford is the outlook for large truck and large utility vehicle sales. With DaimlerChrysler (DCX ), we have a hold opinion. Thus, as you can see, we are not especially bullish on the traditional Big Three auto maker stocks but have a different opinion on each one.

Are there any strong buys you haven't told us about yet in your market turf?

Within the consumer discretionary sector, which as I said also includes retail stocks, some of our strong buy opinions include Apollo Group (APOL ), Coach (COH ), Fortune Brands (FO ), Payless ShoeSource (PSS ), and Sanyo Electric (SANYY ).

What do you like about Apollo Group? The stock has been down lately.

We find the stock to be undervalued, using p-e/growth and DCF [discounted cash flow] metrics. Our target price over 12 months is $94, and it closed today around $63. In the fiscal year that ended in August, 2005, we look for the company to report earnings of $2.46 a share. In fiscal 2006, we project $3.05 and in fiscal 2007, $3.75.

And what makes Sanyo stand out from other makers of similar products?

In our view, Sanyo's share price does not reflect our expectation for improvement in future earnings, driven by cost-cutting measures. Our 12-month target price for the stock is $18.

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