By Alessio Corcelli and Maurizio Parrella
Consumer discretionary sector
The recovery from the global financial crisis shed light on an evergreen, yet recently white hot, equity group: consumer discretionary. The consumer discretionary industry comprises all companies participating in the value chain to produce a good or provide a service which is deemed as non-essential by the target customer segment. Unless you live in a remote tribe, (reading this article online – congrats on that) you’re probably exposed to consumer discretionary goods every day. Products within this sector tend to be durable goods: automobiles, apparel and leisure goods but also services such as restaurants and entertainment are covered as well. The defining characteristic of such goods is their cyclicality. Demand increases when the general state of the economy improves and target consumers have the discretionary income and confidence to allocate toward non-essentials. Compared to meagre periods, consumer staples (food and beverage and other essentials) captures a larger share of spending. Thus, consumer discretionary equity performance can be read as the pulse of the general economy and consumer confidence.
Over the past decade, in the wake of the global financial crisis, consumer discretionary shares have been relatively overlooked by analysts. Private equity then brought the sector into the limelight as a considerable amount of funds decided to invest into companies within consumer discretionary. In particular, two types of private equity investors emerged: consumer discretionary-focused, which specialize in this area, and mixed PE funds, which build heterogeneous portfolios that include consumer discretionary companies. Nowadays, it’s difficult to find a generalist PE fund that does not indulge in the sector.
Consumer discretionary equities have provided a bonanza in terms of growth. The chief indicator to assess the sector’s performance is the S&P 500 Consumer Discretionary, which can be benchmarked against the S&P 500. The former reported a 15.22% YTD five-year return, compared to a 11.72% YTD five-year return of the latter. In particular, as the US economy reported a slow but constant growth since 2008, consumer discretionary companies remained unperturbed boasting well above-average returns. For instance, the discretionary sector reported a 224.8% return while the S&P 500 gained 94.5% over the ten-year timespan from Q2, 2008 to Q2, 2018.
The predominant causes of the recent outperformance primarily rely on labor market conditions. The labor market showed signs of recovery across the significant developed economies, both in terms of limiting unemployment and rising wages. Due to the consumer discretionary sector cyclicality, the improvement of worker conditions explains the willingness of consumers to spend an increasing share of their income on discretionary goods and services. On the flip side, these goods are the first to be stricken from a household’s budget in a worsening economy. So while dipping into the trove of consumer discretionary stocks seems to be a surefire way to secure alpha, there is significant risk attached.
Private equity appeal and playbook
In an environment of economic recovery and growth, the upsurge of the sector could represent a potential investment opportunity for stock investors and private equity players. The industry is ripe for the latter as it is decidedly fragmented, with high barriers to entry and flaunts a wide customer base. Moreover, most products are easily patentable and scalable, add-on opportunities are abundant and the business and its supply chain are not particularly complex to manage. At the same time, these qualities make it all the more competitive – portfolio companies must differentiate themselves. The best way to do so is through branding. Contrary to the consumer staples sector, where essential products are more easily interchangeable by the buyer and thus have lower substitution costs, in the consumer discretionary sector brand loyalty is fundamental and companies deploy a large portion of funds into consolidating their brand image.
A pertinent example of branding when catering to customers with the license to exercise discretion involves The Carlyle Group and Supreme. In Q4 of 2018, the PE giant purchased a 50% stake for $500m of the streetwear brand which lately has been gripping the attention of fashionistas and trendsetters globally. The company serves a niche, rolling out very limited quantities to the public. It relies on influential users and absurd aftermarkets to generate appeal – not to mention waiting lists to enter its retail locations. This concept seems to be fundamentally at odds with the private equity approach – maximizing cashflows oftentimes involves expanding customer bases and capturing market share. The new strategy for the brand has not yet been revealed and it certainly is a head-scratcher. Will Carlyle be content with Supreme’s current style of undersupplying the market, which in part is responsible for its hype and brand image? Or will they divorce the concept and recreate the brand by pursuing greater volumes instead? If so, this would be a very delicate procedure and an interesting one to follow.
While strategies at the portfolio constituent level are relevant, macro strategies should be in place as well. The trend of the private equity investments in the sector has taken two different directions. Some investment firms, at domestic, regional and global levels, have entered consumer discretionary to diversify and bedeck portfolios, whereas others have decided to specialize exclusively in this sector. KSL Capital Partners for instance, is one of the largest investment firms with a sole focus on the discretionary sector investing in travel and leisure in particular. The fund’s portfolio includes Whistler Blackcomb and Orion Cruises and has raised approximately $9B in equity commitments since 2005. In the now competitive marketplace of consumer discretionary, specializing and knowing the ins-and-outs of a business can certainly give GPs an edge over more generalist PE firms.
Select recent transactions
Golden Goose Deluxe Brand – The Carlyle Group. Carlyle followed a series of previous investments in the European fashion and apparel industry (Moncler, TwinSet and Hunkemoller) with a €400m bid for a 100% stake of Golden Goose Deluxe Brand in 2017. The Italian designer has a strong foothold in the global luxury sneakers market; Carlyle seeks to strategically leverage the brand’s industry knowledge and pursue additional investments in order to build growth potential for the brand, particularly in Asia and the United States.
La Piadineria – DeA Capital. Another Italian deal, or rather Italian job seeing as it was an extremely lucrative one for DeA Capital. In 2015, the fund invested €15m for 70% of La Piadineria, a nationwide piadina restaurant chain. After supporting the company’s growth on the Italian peninsula for two years, DeA Capital was able to sell a majority stake for more than €200m to Permira, a diversified PE player, which will direct La Piadineria’s international expansion.
Aston Martin – Investindustrial. The fund made ritzy moves purchasing a 37.5% stake in the premium automotive company. The play was indeed sumptuous to the point of recklessness as the unprofitable luxury car brand required a major ticket to launch its new generation of cars in order to upend losses. Yet thanks to the fund’s backing, Aston Martin’s sales growth doubled while EBITDA growth increased by 197% – stabilizing the troubled car manufacturer. At the time of the IPO, six years after the initial investment of €150m in 2012, Investindustrial realized a return of almost ten times entry.
The recent market recovery and the consequent upswing of consumer discretionary stocks has captured the attention of several private equity firms. It’s remarkable how these equities and indices put up above average returns during the bull run however it’s difficult to imagine incredible yields in the more saturated and competitive environment that exists today; unless, of course, investments are small such as La Piadineria or struggling like Aston Martin was. Safe companies that are easily managed and expanded are textbook private equity qualities, and therefore, the best portfolio targets will be plucked and entry multiples will increase. At the same time, the consumer discretionary market remains massive and, all else equal, saturation will take time. Based on this, it is credible that the recent streak of this sector is a product of economic timing and as long as consumers continue spending then discretionary will thrive. In light of these considerations, private equity firms will be wise to exploit economic cyclicality.
Editor: Eric Peghini
Authors: Maurizio Parrella, Alessio Corcelli