Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

The consumer sector is up against some pretty big crosscurrents these days with elevated food and energy prices forcing some households to cut back, while pent-up demand for travel and other services is pushing some industries to a tipping point.

Josh Cummings, a Research Analyst who has covered the consumer sector for more than two decades, says investors in the space will have plenty of data to consider in the coming months.

Josh Cummings: What makes it particularly challenging, I suppose, is that while there’s been a lot of inflation in the system, remember we’ve also had really strong nominal wage growth… And so, there’s a lot of dynamics, they’re not all negative.

Bigda: I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

Josh, welcome to the podcast.

Cummings: Thank you for having me.

Bigda: For much of the year, consumer confidence surveys in the U.S. have been on the decline as households worry about rising prices and a potential slowdown in the economy. At the same time, as the economy reopens from the pandemic, we’ve seen a resurgence of demand for travel and other services that consumers had to give up during lockdowns. Broadly speaking, how have these trends manifested themselves in consumer stocks this year?

Cummings: Yes, so as the year’s progressed and inflation’s gotten higher, we have started to see some elements of discretionary demand crowded out by rents, food, fuel, things like that. For the first part of the recovery, I would say off of sort of the lows during the lockdowns, our Team’s view has sort of been that a rising tide was going to lift all boats; meaning, there would be strong demand for regular old household durables and things like that and there would be very, very strong demand for experiences, travel, things outside the home. That generally played out through much of 2021, and again, as we got into 2022, I think what started to happen is that between inflation and then higher interest rates, it really started to impact demand for certain big-ticket durables that require financing, things like homes and vehicles.

Bigda: There had been quite a bit of demand and purchasing that had gone on with those items before inflation started heating up. Is that correct?

Cummings: Well, so, I think, you know, in the early days of the recovery from the pandemic, there was absolutely a surge in demand for single-family homes in particular. And most of that demand was coming from relatively young consumers, folks just starting a household, and obviously, there was increased demand for space, for privacy, for clean air, whatever it may be. As we got later into the recovery, however, there just wasn’t enough inventory to satisfy demand in single family or multifamily. And so, you saw price increases continuing throughout ‘21 and into ‘22. Then, when you had a shock in interest rates, that’s when we started to see demand start to weaken a little bit for new homes, really around affordability. I don’t think it’s a question of actual demand. I think plenty of people want to buy that first house. It’s really just about affordability, just given the surge in home prices.

And on the vehicle side, you know, I think some clarification is helpful. Vehicle prices, both new and used, have been in what I would call a bubble. Up massively, 30%, 40%, 50% in some cases. But we did not have and have not had a surge in demand or unit sales of automobiles. Now again, that’s partly because of the lack of supply. Would we have sold more vehicles over the last two or three years had there been more supply? For sure. Price inflation would have been lower, and we would have sold more vehicles. So, just taking used cars as an example, it’s something I’m fairly familiar with, on a unit basis, I think in 2021, we were down three or four million units on a base of 41 million or so versus the year ago. So, there has not been a demand bubble in vehicles. It’s just a price shock driven by lack of supply. And a similar dynamic in housing, although I do think that there’s stronger underlying demand there.

Bigda: Right, so more of a supply chain issue.

Cummings: Absolutely.

Bigda: What about other goods that we heard about a lot during the pandemic that people were buying like refrigerators, bicycles, all the accoutrements of, you know, living at home and kind of making life a little bit more enjoyable? Inflation has actually cooled somewhat here in the U.S. during the summer, thanks to a drop in energy prices. But there seems to be some conflicting reports coming out from retailers about whether demand is cooling or staying strong. And so, I’m wondering, what’s the read on that right now for you?

Cummings: Yes, so just stepping back and starting with the first part of your question about durables, you know, related to the home and things that people were attracted to during lockdowns and during the pandemic – for sure, we saw a surge in everything from home office equipment to appliances to consumer electronics to furniture. Absolutely, much of that demand has reverted back toward, you know, what I would consider long-term averages. In some cases, that reversion to the mean has happened a little bit faster than folks expected. Furniture might be an example. In some cases, it hasn’t quite reverted as fast as people would have expected. But in general, you know, we’ve kind of gone through that cycle already. We’re now three, four or five quarters into declining sequential units in a lot of these things. And so, I think the market is adjusting.

Peron: And Josh, another crosscurrent, which is under your team’s purview of coverage, is travel. And that’s kind of had a layered-on effect and a preference shift, I guess. Can you talk a little bit about that?

Cummings: Yes, sure. Travel – and I would say just experiences in general, live experiences in particular – has really been an area that the Consumer Team has favored since the depths of the pandemic. We really felt like it was going to recover strongly. And indeed, it has. I think, you know, most recently, what’s been even surprising to us – although we weren’t as skeptical as I think others were – we’ve seen business travel and group travel recover to levels that I don’t think I would have predicted 12 or 18 months ago. So again, more of a normalization process.

You know, I remember when we were kind of in the darkest days of the pandemic, a lot of us internally were debating what’s going to change structurally versus what’s going to stay the same? And the one thing that I and the Consumer Team kept coming back to, based on our experience through past recessions, past, you know, market panics, if you will, or disruptions, was that most things actually stay the same. And oftentimes, you can make more money and it’s easier to make money if you focus on the things that are unlikely to change as opposed to the things that are going to change. We tend to focus, both on the buy side and the sell side, on like what could be different this time because to us, that’s considered insight. However sometimes, again, it’s just, you’re better served by focusing on the things that the market is implying will change but won’t. And we sort of felt like leisure travel and to a lesser degree, business and group travel, certainly fell in that bucket.

Peron: That was a great insight that you’ve had all along and [has] been very helpful to the broader team, to sort of bring us back to the fact that, okay, this is a long dynamic.

So, I guess when you sort it all out, saying, okay, homes are cooling, autos are just stuck in the rut, I guess. Then you have in the retail world, apparel and furniture preference shifting, somewhat crowded out by the inflation dynamic. That and then travel – so, you have a very confusing consumer picture there, isn’t it?

Cummings: You do. And you know, what makes it particularly challenging, I suppose, is that we’re now, we’ve been in a phase of really strong nominal wage growth, really that started before the pandemic, particularly for lower-wage sort of hourly workers. And so, while there’s been a lot of inflation in the system, remember we’ve also had really strong nominal wage growth, particularly at that more sensitive lower end of the economy, as well as the stimulus payments, which we all know about in 2021. And so, the data that we’ve seen recently, Matt, is that while a lot of the consumers and households that received stimulus payments have probably spent the vast majority, if not all of that stimulus, we’re still at checking and savings accounts balances across the income spectrum that are well above where they stood at yearend ‘19. And so, as you said, there’s a lot of dynamics, they’re not all negative.

Peron: And that has been a cushion to some of the concerns about the high energy prices really causing a cratering in demand, alongside with a lower energy intensity by the average consumer. Do you expect that to continue?

Cummings: Yes, well, I think you want to be careful about getting into the business of predicting commodity prices, particularly short term. However, absolutely, it has been helpful that retail gasoline prices have done nothing but go down since July 4^th, and we’re starting to see the soft commodity complex, whether it’s wheat or beef or things like that, also start to move lower. That will absolutely help with the margin.

The other thing that I would, I want to go back and emphasize a point that you touched on, which is the interest rate sensitivity of the consumer economy. It’s vastly different than it was in call it ‘05/’06 when we were heading into the into the Great Recession. We see this a number of ways. We see this through credit card balances, student loan balances, actually, believe it or not, at least relative to income. And we see it in the mortgage market, most distinctly where prior to the pandemic, if you look at sort of yearend ‘19, I think the mix of fixed-rate mortgages in the market was something north of 90%. And it was at least 15, 20, 25 [basis] points lower headed into the Great Recession. And so, while interest rates matter a lot for that first-time home buyer or that home buyer that may not have a lot of embedded equity in their current home, in general, the housing stock and the stock of existing homes and existing homeowners is in a much better place to absorb higher interest rates than it was the last cycle.

Bigda: So, let’s talk a little bit about how you are modeling in this very confusing environment, when we think about what the earnings outlook is for the rest of the year. I know that it’s a very big category, so you could just take one example, if you want. But what are the things that you are thinking about when it comes to looking at that earnings outlook?

Cummings: Yes, sure. So, as you mentioned, I mean global consumer is a very broad category, so it’s dangerous to generalize. But if we just sort of think about the biggest retailers and restaurants in the U.S. economy, generally speaking, over the last several quarters, companies have successfully been able to pass through higher inflation in the form of higher prices. Now again, you have the backdrop of rising nominal incomes, pretty healthy savings levels, what have you. So thus far, consumers have generally been absorbing those, and we have not seen major changes in unit level demand.

Over the past couple of quarters, what I would say is – and this shouldn’t surprise anybody – there have started to become instances of demand elasticity, particularly again, with things that need to be financed or, you know, certain consumers. Lower-end consumers obviously have to prioritize essentials and, therefore, have a little bit less money every month for discretionary purchases. But really, what I would say is – and I think this is more bullish than the market would have thought several months ago – the resilience here has been notable. Now that doesn’t mean it’s great out there, just that we aren’t seeing demand collapse necessarily for really anything. And thus far, you know in 2022, retail and restaurant earnings have been okay. Estimate revisions aren’t wildly positive, but they’re not cratering either.

Now going forward, the dynamic continues to shift because we probably do have a generally weakening economy as a result of higher rates and things we all know. But in the background, as Matt alluded to, we now have signs that commodities are starting to roll over. We have at least anecdotal signs and commentary from our companies that the supply chain situation is improving, at the margin.

Bigda: That would be a relief.

Cummings: Got a long way to go, but it is improving. And just to touch on labor for a second because that’s the other important sort of cost component in a retailer’s P&L [profit and loss], it’s really now been almost a year since most of my companies have really been vocal about acute labor pressure. So, the labor market does appear to be loosening a little bit, and we see that in [unemployment] claims; claims bottomed several months ago, and it [have] begun to tick up. So, it’s not that wages aren’t still a year-over-year headwind, they are, but not of the magnitude that they were. And now with commodity prices rolling over and the supply chain starting to loosen, I think the hope would be – and my expectation is – that although the top line might not be overly dynamic and might be a little bit sluggish for these companies in the quarters ahead, they’re going to get a little bit more relief in the middle of the income statement than they would have several months ago.

Bigda: So, on the whole, it sounds like the consumer sector is holding up pretty well. But I’m wondering if, in your view, you see the balance of opportunity shifting one way or the other.

Cummings: Yes, well, I mean we still think there’s a way to go in the travel recovery. We do. It’s not going to be as easy as it’s been to date. It gets a little bit harder as the recovery gets more mature and you get closer to sort of what full demand should look like.

You know, but within other categories you know, I’d say yes generally, it’s, it feels like status quo. It feels like not a whole lot of change at the margin. Again, we’ll see what interest rates have to do. If the Fed [Federal Reserve] is “largely done” [with interest rate hikes], then I feel pretty good. I think consumers will get through this period of very high inflation relatively unscathed. However, there’s a case to be made that a lot of the inflation we’ve seen is more structural, driven by wages and so forth. And so, a lot is going to rest on sort of, you know, to the extent CPI [the Consumer Price Index] – let’s say is 7%, 8% right now – how much of that truly was related to the pandemic and to supply chain? Because we do, I’m convinced the vast majority of that is going to prove transitory. The other elements of inflation, you have to be less sure of. I’ve never seen a company lower wages, necessarily. So, we know that that element of it is going to be sticky.

Bigda: What about e-commerce? So, during the pandemic, a lot of people did online shopping. They had to. And you know, the share of retail sales really peaked in early 2021, and that has now since moderated as things open up, people go back to stores again. What is your take, especially given your comment earlier about how a lot of times things stay the same?

Cummings: First, I think, absolutely, e-commerce will continue to gain share of U.S. and global consumer spending over a very long period of time, many years. I don’t think the last several months or a year represents some sort of a comeback for physical retail. And we see that in the data, actually. And this might surprise you, but if you look at e-commerce penetration and you look at sort of the growth in e-commerce versus the growth in, let’s call it, brick-and-mortar retail, there were only about three months during 2021, actually, where that trend reversed, where e-commerce mathematically lost share. And over the last, call it nine, 10 months, we seem to be back on trend, where e-commerce is actually growing a little bit faster. You don’t necessarily see it always in the year-over-year data. You have to strip some things out. One of the things that I like to look at is, the commodity inflation has really been a lot higher than the things that tend to be sold in stores, meaning gas and food. And e-commerce doesn’t really participate in a big way in those categories. But if you sort of normalized for that and sort of look at core retail sales, the picture is pretty clear. Like there really wasn’t that much of a retrenchment in e-commerce as a percent of retail sales. And we think we’re pretty much back on trend. I know that’s a little bit surprising because the narrative right now is stores are doing better than e-commerce, and folks are pretty bearish about e-commerce stocks. But I think largely what has happened is many of those e-commerce stocks just simply got aggressively valued toward the end of 2021. And as often happens in the market, the market has a tendency to want to extrapolate shorter-term data points and draw a straight line off those data points. But nothing that’s happened in the last year or so shakes our conviction in the structural bull case for the digitization of the consumer economy. In fact, what I would say is in a couple of categories that were heretofore very lightly penetrated by e-commerce – think residential real estate or vehicles – we actually think the pandemic is going to prove to be a catalytic event, if you will, to really spur the full transition of those consumer verticals towards e-commerce.

Peron: And as often happens during these challenges, an industry will adapt. So, can you talk about how e-commerce managements are reacting to the recent challenges, which I think you described as a blip in the long term. But they’re resetting their business models to some extent, right?

Cummings: Yes, to some extent they are, Matt. And I think, not to be too cynical, but I think it’s a reaction to what the market is demanding. If the market is taking your stock lower day after day after day, and sending a very clear signal that they want these businesses to stop burning cash, you ignore that at your peril. And so, what we have seen in a lot of digital business models – not just in consumer, but really across tech – is that, you know, in late ‘21 or throughout ’21, again, this extrapolation of near-term data points, I think a lot of these companies probably hired too aggressively, built out capacity too aggressively, kind of believed their own narrative, if you will. And so, what we’ve seen in recent quarters is those companies say, ‘Ah ha, I got the message,’ and they’re cutting costs, they’re looking for efficiencies where they, they always knew those efficiencies were there, but you weren’t really incentivized to harvest them when the market only really cared about growth. Now that the market kind of cares about growth and profitability and perhaps some free cash flow, those priorities are kind of shifting toward more of a balanced approach.

And to your point, Matt, the fact that all these companies are now taking a harder look at their expenses and optimizing their networks and trying to become more efficient, to the extent e-commerce sales do begin to accelerate, there’s quite a bit of inherent operating leverage in these business models. And so, the earnings revisions could look quite attractive as we move into ‘23 and beyond, given that these companies have had this period where they’ve been forced to look internally and make sure they’re operating as efficiently as they need to be.

Bigda: And what has it done to valuations? Has this sort of period of reckoning improved valuations for investors?

Cummings: Yes, valuation has come down quite a bit. Just going back to 2021, when everybody was really just focused on the growth and the long-term potential of a lot of these digital business models, if you’re not generating positive EBITDA [earnings before interest, taxes, depreciation, and amortization] or earnings, generally, what the market is going to fall back on is enterprise value to revenue, some sort of a revenue multiple. Now, the further you get away from free cash flow, the more dangerous using multiples gets. And revenue is kind of like the most dangerous, in a sense. I guess eyeballs might be the metric that’s even more dangerous. But in many cases, we’ve seen revenue multiples for consumer and for tech companies come down from, you know, 10x-plus which is very high by historical standards, to something more low single-digits, which is still fairly high and implies a rosy future. But it’s very clear that what is implied in current share prices for these companies is quite a bit less aggressive than what was implied just six to 12 months ago.

Bigda: So, a little more rational at this point.

Cummings: Absolutely.

Bigda: I do want to just hit on one more point that you made earlier, talking about the changes in consumer behavior. And I know you’re not a behavioral scientist, but why would there be a structural shift toward buying cars online, but business travelers have decided that they want to hit the road again? How do you determine, you know, those trends as an investor?

Cummings: That’s a great question. So, just to step back for a second, although business and group travel has recovered more sharply than I think anyone would have expected a year ago, we’re still not back to pre-pandemic levels and so it does remain to be seen, maybe there is an element of this that is structural. Maybe we don’t get back all the way to pre-pandemic levels. So, a little bit TBD on that point, Carolyn.

And then in terms of like changing behavior, you know, why people are buying cars online? You know, it’s really interesting. So, we did a lot of work on this space, on real estate and on vehicles prior to the pandemic. And our conclusion at that point was just, look, this is an easier way to transact. And you think about all the friction and all the money that gets doled out when you transact on a single-family home. I mean, think about our own business. We trade stocks and bonds. Can you imagine trading the biggest asset you’re going to own in your life for a 6% spread, like a 6% commission? It just seems kind of ludicrous, frankly. And a big part of what we do, obviously, is we think about disruption and we think about profit pools getting collapsed and who’s earning economic rent that isn’t really deserved structurally or long term, and I think, you know, real estate’s a great example of that where you think about what the intermediaries do in this business in terms of delivering consumer value; I think it’s questionable. And it’s certainly questionable why anybody would want to pay 5% or 6% to transact in a house. So, we just think over time that profit pool is going to shrink and it’s going to most likely accrue to consumers as it has in e-commerce. You know, in the early days of Amazon, it used to cost $10 to $15 to ship a reasonably sized package, and it would take a week or a week-and-a-half. Now, it’s free or, in essence free if you’re a Prime member, and it takes a day. So, similar types of patterns, we think, are going to play out regardless of the product or service.

In vehicles, you know, I think it should be fairly obvious. Going to a car dealer is not most people’s idea of a great way to spend a Saturday. There’s a lot of friction, there’s a lot of opacity in the process. Consumers aren’t sure if they’re getting a great deal or not. I feel like I’ve really leaned on my experience with CarMax. CarMax is kind of the original disrupter, I would say, in the industry and companies are taking the original CarMax principles – no haggle pricing, your trade-in is unrelated to the car you want to buy, financing is completely disaggregated from the car you want to buy or trade in – and digitizing them. Completely digitizing them. What if you could do all of that, but you don’t even have to go anywhere? What if the cars came to you and you could test drive them and return them at will? So, we think that’s where it’s going. And we think, ultimately, this is going to be beneficial as it has been an e-commerce-for-scale players who can drive that kind of a change in the industry. And we think it’s going to disadvantage the independent operators. And the last thing I would say about auto is how fragmented it is. And I’ll just give a point about the used car space. The top 10 used car retailers in North America have 9% market share combined. That’s really interesting. So, this is going to be tectonic. It’s going to take time, but we think this is a 20- or 30-year march upward.

Peron: And I would say one correction, perhaps, that I think Josh is a behavioral psychologist.

Bigda: Oh, yes.

Cummings: Inadvertently, I think, after 26 years of doing this…

Bigda: We’ll have to add that to his credentials, then.

Peron: For sure, but kidding aside, his Team, what they really do well, in my view, is look at these long-term trends. He mentioned this earlier, identifying what’s durable and what’s not, but marrying them to the, you know, patterns that we’ve seen before and looking at the opportunities and saying okay, here’s an opportunity to capture economics that benefits all parties. Here’s something, people aren’t going to go for that, that’s temporary, that’s a distortion by the pandemic, whatever. That’s really fascinating to watch, whether it’s in spirits, discount retailers, the whole consumer complex is quite fascinating to watch.

Bigda: Well, I think that’s a perfect segue to my next question, Matt, which is, Josh, right now, at this moment, everyone’s eyes are trained on inflation and consumer confidence. But do you think investors might be overlooking some positive long-term trends in the consumer space? And if so, what are they?

Cummings: Yes, look. I think number one, the consumer sector has always been a space where innovation thrives. Competitive destruction is just the constant in this space. And so, you know, partly enhanced by digitization, companies’ abilities to consistently innovate is as strong as ever. And we find that companies that are continually reinvesting in their business and reinvesting in innovation and reinvesting in offering compelling, fresh, unique products and services to consumers, they’re continuing to thrive. You know, the U.S. consumer is probably more stable than the nightly news would have you believe and incredibly resilient. And I think we learned a lot of lessons through 2007/2008. That was a near collapse of our financial system. And at that time, I remember we were really questioning, is there going to be a Wall Street in its current form? Are we still going to go to stores in 10 years? I mean it was that crazy. And I think what that taught us again is that, yes, some things change at the margin, for sure. Financial or other types of shocks, they absolutely do bend demand curves for a period of time in certain things. But many, many, many more things stay the same than change.

Bigda: What are you most worried about right now? Or maybe put another way, what do you think could drive volatility for the sector? Is it ongoing labor shortages, rising wages, a spike in energy [prices]? What’s sort of the big variable out there that you’re concerned about?

Cummings: Yes, I mean, I’m actually sort of worried about the opposite of that. I’m worried that the labor market has peaked. I’m worried that the outlook, the consumer’s outlook for future wage growth has probably peaked. And, you know, to the extent interest rates keep rising, I am increasingly worried that lower prices in all risk assets are going to start to create more of a wealth effect on spending than we’ve seen so far. If you go back to March/April, when interest rates really started to move and the market started to finally believe [Fed Chairman] Jerome Powell that he was serious about inflation, the narrative at that point was, ‘Oh gosh, like high gas prices, high interest rates, high inflation, that’s a real problem for low-income consumers.’ Well, I don’t think we’re in that place anymore. I think where we are now is high inflation, lower asset prices, less of a risk-on growth mentality is kind of a problem for everyone. And so, I guess the concern would just be that the Fed can’t get in front of inflation, economic growth continues to, let’s say, stagnate, decline, disappoint. And we go through a prolonged period of fairly weak GDP [gross domestic product] growth, which probably still means fairly weak performance for risk assets, including stocks.

Bigda: Okay and so to take the other side of that question, what are you most excited about?

Cummings: What I’m really excited about is kind of what I’m always excited about, which is specific business models. At any given point in time, the Consumer Team is talking about really interesting long-term business model stories. And so, what I would say is, you know, although the current environment has been somewhat challenging for a number of consumer companies, we’re no less excited about not just the innovative business models we’re seeing, but also how a lot of these large legacy companies are continuing to innovate. And to us, when you do that effectively, what it effectively does is it increases the duration of your future cash flows, which is supportive of valuation, supportive of multiples.

One example would be in quick-service restaurants, where once the pandemic hit, a lot of companies were very quick to pivot their strategy toward a first-party app and getting hooked up with delivery aggregators. And many of these companies have built substantial digital businesses without necessarily sacrificing their traditional dine-in traffic, which is now largely recovered in the United States. So, it looks like several of these companies have actually used the pandemic to layer on another revenue and profit stream that they just simply didn’t have before. So, just a great example of how flexible a lot of these big companies can really be, you know, when they need to be.

Peron: I thought you were going to say the new biodiesel fuel in the Formula One cars.

Cummings: I’m really excited about that.

Peron: But I think Josh is right that our whole Research Team is really focused on just the unbelievable pace of innovation. Whether it’s in health care, as we talked about in our last podcast, or in consumer, the pace of innovation is just fast and furious, and hopefully, that’s going to benefit the economy, as well as shareholders going forward.

Bigda: Well, I think both of you have answered that question as only research analysts with decades of experience investing could. So, Josh, thanks very much for joining us today. It’s been a real pleasure having you on.

I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.

 

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

EBITDA, or earnings before interest, taxes, depreciation, and amortization, is an alternate measure of profitability to net income.

The Fed, or Federal Reserve is the central banking system on the United States.