Consumer Discretionary Sector October 27 th, 2009 Tiffany Arnett, Pinjalim Bora, Sam Brickell

Recommendation Short Term Hold on to the underweight position of the sector in the SIM portfolio. Long Term Depending on the positive organic sales growth in the 3 rd and the 4 th quarter, decide on increasing the weight to the that of S&P 500

Deriving at the recommendation Top-down approach Sector Size and Composition Business Analysis Key Economic Drivers Financial Analysis Valuation Analysis Recommendation Recap

Sector Size and Composition Overview The sector is composed of companies that vie for discretionary household income spent on non-necessities. Industries include: –Retailing, Media, Consumer Services, Consumer Durables & Apparel, and Automobiles & Components

Sector Size and Composition As a percentage of S&P 500

Sector Composition Top 10 Industries ( Market Value Weighted)

Sector Composition Top 10 Companies ( % of market value)

Sector Performance Sector market cap: $26.7 billion, 9.18% of S&P 500 Cyclical sector – moves with the market Sector has underperformed 3% relative to S&P 500 over the past 10 years

Sector Performance Year to date

Sector Performance Quarter to date

Business Analysis Overview Mature Phase of Life Cycle –Competitive Industries –Established companies and products –Focus on productivity Cyclical performance linked with the economy –Poor economic conditions = lower consumer discretionary income Also perception of poor economic conditions –Generally, the sector will recover along with the economy

Business Analysis Five Forces Model Barriers to Entry High Mostly competitive industries Many mature industries Threat of Substitutes High Many brands offering similar products Supplier Power Dependent upon industry Supplier demand derived from industry demand Bargaining Power of Customers Fairly high Customer demand drives the supply of discretionary goods If customers aren’t buying… Degree of Rivalry High Low switching costs Large number of firms

Economic Analysis Overview A few economic indicators - Consumer confidence Real Consumer Spending Inflation Unemployment Personal Savings rate

“..defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending” – Wikipedia Positive correlation - expected Economic Analysis Consumer Confidence (Long Term)

Very high positive correlation “Confidence among U.S. consumers fell more than forecast in October, a reminder that households remain nervous about the strength of the emerging economic recovery.” – Bloomberg.com Economic Analysis Consumer Confidence (Short Term)

Refers to the pure consumer spending number without any effect of inflation High positive correlation - expected Economic Analysis Consumer Spending (Long Term)

Consumer spending boosted by programs like cash for clunkers High positive correlation - expected “US consumer electronics spending is expected to be slightly better this Christmas season than last year, the Consumer Electronics Association (CEA) said Monday in its annual survey” Economic Analysis Consumer Spending (Short Term)

Core CPI (Consumer price index) - excludes goods with high price volatility, such as food and energy High Negative Correlation - expected Economic Analysis Inflation – Core CPI (Long Term)

Positive Correlation – unexpected Possible explanation – Recessions (Inflation low, spending low) Evident opposite movements before recession and by March Economic Analysis Inflation – Core CPI (Short Term)

Negative Correlation – expected Economic Analysis Unemployment rate (Long Term)

Higher Negative Correlation – expected Cyclical unemployment effect Economic Analysis Unemployment rate (Short Term)

Technically, Personal Saving = personal disposable income -personal consumption expenditure Expressed as % of disposable income High Negative Correlation – expected Economic Analysis Personal Savings Rate (Long Term)

High Negative Correlation – expected “U.S. households stocked away most of the extra income they got in January from annual cost-of- living raises, boosting the personal savings rate to a 14-year high, the Commerce Department said Monday.” - Marketwatch Economic Analysis Personal Savings Rate (Short Term)

Economic Analysis Inference/ Expectation Consumer Confidence: Expected to rise, however short term outlook bleak : Negative (short term) Consumer spending: Responsive to incentives. Can retailers provide incentives ? Negative (short term) Unemployment rate: Expected to cross 10% by 2010: Negative (short term) Inflation: Expected to be low in the short term, Target FFR = %: Positive (Short term) Personal Savings rate : Expected to increase : Negative (Short Term/Long term ?)

Financial Analysis Revenue Growth Retail – Computers and Electronics Sector

Financial Analysis Revenue Growth Cable and Satellite Apparel and Accessory

Financial Analysis Return On Equity Sector Retail – Computers & Electronics

Financial Analysis Return On Equity Cable & Satellite Apparel and Accessory

Financial Analysis Net Profit Margin Sector Retail – Computers & Electronics

Financial Analysis Net Profit Margin Cable & Satellite Apparel and Accessory

Are Margins expanding? Margins are likely to expand on an absolute basis as economy improves Margins are likely to expand for Consumer Discretionary versus the market Price raising, etc. Positive Cash Flow? Of course Mature Companies Financial Analysis Inference / Expectations

Financial Analysis Recap - Inference / Expectations MeasureOutlookView RevenueDownward trend mainly due to macro economic circumstances Negative Return on EquityMuch less than medianNegative Net Profit MarginAt historical low levelsNegative

Valuation Analysis Trailing P/E Sector Retail – Computers & Electronics

Valuation Analysis Trailing P/E Cable & Satellite Apparel and Accessory

Valuation Analysis Forward P/E Sector Retail – Computers & Electronics

Valuation Analysis Forward P/E Cable & Satellite Apparel and Accessory

Valuation Analysis Price to sales Sector Retail – Computers & Electronics

Valuation Analysis Price to sales Cable & Satellite Apparel and Accessory

Valuation Analysis Price to book Sector Retail – Computers & Electronics

Valuation Analysis Price to book Cable & Satellite Apparel and Accessory

Valuation Analysis Price to cash flow Sector Retail – Computers & Electronics

Valuation Analysis Price to cash flow Cable & Satellite Apparel and Accessory

“We don’t need no stinking technical analysis.” People who are a fan of technical analysis probably say that “support is forming” or some such crap like that In reality the trend might be upwards in the long term as signs of the economy improving show themselves and consumers gain confidence Valuation Analysis Technical Analysis

The Future Valuations likely to expand on an absolute basis as economy improves Valuations likely to expand for Consumer Discretionary versus the market Due to nature of the sector Valuation Analysis Expectations

Valuation Analysis Recap - Inference/ Expectations Trailing P/EForward P/EP/SP/BP/CF Sector Retail Electronics Cable & Satellite Apparel & Accessory The sector seems to be trading at a premium. Few industries inside the sector seems undervalue or cheap at present

Sector Conditions review AnalysisConclusionsView BusinessMature industry, cyclical in nature.Neutral EconomicConsumer confidence and consumer spending bleak in short term and weighed heavily by unemployment outlook which seems degrading although in a slow pace, personal savings rate increasing, low inflation Negative slowly moving towards positive FinancialOverall Revenue growth, profit margin and ROE declining In the short term for the sector as a whole. Negative; depends upon the economy. ValuationSector seems to be trading at a premium with pockets of opportunities within it. Slightly negative

Recommendation Short Term Hold on to the underweight position of the sector in the SIM portfolio. However, reshuffle the underlying composition. Long Term Depending on the positive organic sales growth in the 3 rd and the 4 th quarter, decide on increasing the weight to that of S&P 500

Current SIM holdings Currently, Consumer discretionary is underweight by 1.39%

Current SIM Sector Composition Dividend Yield Cost Current Price Unrealized gain/loss Target Price Upside Best Buy1.4%$48.18$39.30(18.4)%$ % Coach0.9%$28.27$ %$ % Comcast1.8%$16.44$14.84(10.28)%$ % Game StopN/A$25.32$24.11(4.8)%$ % Mc Donald’s3.7%$54.64$ %$ %

Consumer Discretionary Sector Presentation Questions & Discussion