CONSUMER DESCRETIONARY SECTOR Craig Babbert Subu Balasubramanian Dustin Beckel

BUSINESS CYCLE ANALYSIS AGENDA SECTOR OVERVIEW BUSINESS CYCLE ANALYSIS ECONOMIC ANALYSIS FINANCIAL ANALYSIS VALUATION ANALYSIS RECOMMENDATION

SECTOR OVERVIEW OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Sector Overview: Consumer Discretionary What is Consumer Discretionary? Goods and services that are considered non-essential by consumers but desirable if their available income is sufficient to purchase them. Goods include durable goods, entertainment & leisure, apparel and automobiles 87 constituents with 5 industry groups $4.38 trillion market cap Represents 12.5% of S&P 500 Also considered “consumer cyclicals” Rely heavily on business cycle and economic conditions OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Performance vs S&P 500 OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Performance vs S&P 500 OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Top Constituents in Consumer Discretionary Index OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

BUSINESS CYCLE ANALYSIS OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Business Cycle Analysis Demand vs Supply Side Positives: Low gasoline prices Low inflation Low interest rates OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Business Cycle Analysis Threat of New Entrants - High Bargaining Power of Buyers- High Capital intensive for some Economies of scale Incumbent advantages Branding power Price sensitive buyers Discretionary nature of goods & services Multiple choices Degree of Rivalry - High Intense competition to gain customers Innovation key Price competition Bargaining Power of Suppliers - Med Threat of Substitutes - High Porters 5 Forces Threat of New Entrants Much easier for retailers, online retailers, other niche players to enter the market. Very hard for capital intensive firms like automobile manufacturers, fast food chains Advantage for incumbents (online maybe the exception) – solidified customer base Niche areas are main entrance point for new firms High power of branding Economies of scale create price advantages Bargaining Power of Buyers Buyers are price sensitive Several alternatives within each industry group (i.e. restaurants, leisure activities, retailers both online and brick/mortar) Discretionary nature of spend brings buyer power up Bargaining Power of Sellers Union issues (auto) Depends on consumer goods involved – how available are the inputs? Commodities? Degree of Rivalry Price competition Innovation / trends key to success – companies must invest Threat of Substitutes Low switching costs Medium loyalty (brand driven) Discretionary goods – not needed for survival of consumer leads to waiting game/changing mind Industry dependent Union impacts (auto) Input availability by industry Low switching costs Medium loyalty (brand driven) Discretionary nature OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

ECONOMIC ANALYSIS OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Consumer Discretionary Consumer Discretionary : Factors Influencing Sector Performance Consumer Discretionary Inflation Unemployment Oil Price GDP Interest Rate Exports Consumer Confidence OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Impact of Interest Rates on Consumer Discretionary Sector Performance Interest Rates and the performance of the Consumer Discretionary Sector are negatively correlated. The increase in rates by the Fed in December is likely to cause some volatility in the sector, which will impact ROE negatively. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Consumer Confidence vs Consumer Discretionary Sector Performance The Consumer Confidence Index is a lagging indicator and a drop in Consumer Confidence has a direct impact on 5SCOND. The Consumer Confidence Index has witnessed a steady recovery since 2009 and is expected to remain stable in the short term. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Impact of Unemployment Rate on Consumer Discretionary Performance Consumer Discretionary Sector performance has a high negative correlation to the unemployment rate. As jobless claims continue to drop, the sector will continue to experience increased discretionary spending. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

US Total Exports vs Consumer Discretionary Performance Typically Consumer Discretionary tends to expand when exports are strong. However since a majority of the consumer discretionary companies in the S&P 500 are service oriented businesses focused on domestic consumption, the trend is not apparent. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Oil Prices Correlation with Consumer Discretionary Sector Performance Conventional wisdom states that Consumer Spending would expand as Oil Prices decline. However data suggests that there is no direct correlation between the two metrics. Increase in Oil prices may lead to inflation causing a drop in consumer spending but the converse does not necessarily hold true. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

FINANCIAL ANALYSIS OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Cost of Capital : Consumer Discretionary WACC Discount Rate Rates Implication for Investors Risk Free Rate 4% Low ~ Good for Investors Cost of Debt 7% Equity Risk Premium 5% Debt Required Return of Debt Required Return of Equity 9% OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Sales Growth : S & P 500 vs Consumer Discretionary OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Return on Equity : S & P 500 vs Consumer Discretionary OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Profit Margins: S & P 500 vs Consumer Discretionary OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

VALUATION ANALYSIS OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Consumer Discretionary Sector Vs. S&P 500 OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

Multiple Valuation Comparison (As of 10/22/16) OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

SECTOR COMPARED TO S&P 500 YoY One of the reasons for the expansion of the valuation metrics is due to the point in the business cycle. Future expectations for growth for Consumer discretionary companies was high during the expansion cycle and therefore led to higher P/Es (and compared to the S&P 500) Per the forward-looking estimates, the valuation metrics appear to be decreasing relative to its history. This can be an indication that the market doesn’t expect much growth out of the sector and that we may be headed into contraction territory. There As mentioned previously, this could be due to a number of factors including the fed funds rate increasing and heading toward the end of the business cycle. Don’t have a chart for it but some notables about P/E per sector; internet retailers had enormous P/Es, Hotels and travel were above average, and the others were around the average for the sector except for autos, which were lower than average. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

TECHNICAL ANAYSIS Used the iShares Consumer Discretionary ETF (IXY) 5-year chart. Appears that the sector may have hit some resistance around the ~825 mark and the sector is near the top of its range. This could indicate some downward pressure. The 20, 50, and 200 day moving averages appear to say that the trend could continue upward. The other momentum indicators below suggest that the sector has some downward pressure that may continue short-term but then would be oversold indicating a reversal could come shortly after. Technical Analysis conclusion: more toward going long. OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

RECOMMENDATION OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION

OVERWEIGHT Stable jobs market Upcoming Interest Rate Increase Business Cycle RECOMMENDATION OVERWEIGHT In the short term (next couple of years) the sector should still be a strong sector. After that, the business cycle suggests that the sector should then be moved to an underweight rating. Industry overweight: Auto. Good P/E, good earnings growth Industry underweight: Hotel/Travel. High P/E OVERVIEW BUSINESS ECONOMIC FINANCIAL VALUATION RECOMMENDATION

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