Is the Hurting U.S. Consumer Reason To Avoid Discretionary Stocks?

Is the Hurting U.S. Consumer Reason To Avoid Discretionary Stocks?

As the global economy slowly recovers from the worst financial crisis in decades, consumers are ever-so-modestly increasing their spending habits. This has been a boon for consumer discretionary companies, whose financial fortunes have measurably improved in the years since the Great Recession.

Not surprisingly, companies in the consumer discretionary sector rely heavily on consumer attitudes. When consumers lose confidence in their financial futures and tighten their purse strings, it means there's less money to go around for non-essential purchases. As a result, recent consumer data may prove dangerous for these consumer discretionary stocks, particularly those with lofty valuations.

Discretionary stocks flashing warning signals?
The U.S. Commerce Department reported that personal consumption expenditures inched up by 0.1% in October from the previous month, falling short of economist expectations. Furthermore, consumer confidence fell in October to a six-month low.

In the meantime, there's little in the recent earnings reports from some major consumer-oriented companies that echoes the sentiment that consumer confidence (and by extension, spending) lost momentum in the past few months. However, what matters is what happens in the future. And, should data points continue to disappoint, results in subsequent quarters may fall short.

Starbucks recently provided its full fiscal-year report, which signaled that it's a company that, for now, can simply do no wrong. Growth was strong both in the Americas and globally. The company saw revenue increase 13%, and diluted earnings-per-share hit a record in the quarter. Moreover, Starbucks bumped up its dividend by 24%.

PaneraBread showed strength in many of the metrics important to a specialty eatery, including generating growth in total revenue and comparable restaurant sales, which include sales at locations open at least one year. Despite total revenue and system-wide comparable restaurant sales increasing 8% and 1.3%, respectively, both measures failed to meet analyst estimates.

And, for its part, Chipotle Mexican Grill increased total revenue and earnings per share by 18% and EPS by 17%. Comparable store sales were particularly impressive, rising 6.2% versus the same period last year, driven by higher traffic. Chipotle has ambitious growth plans, expecting to open up to 180 new restaurants this year followed by as many as 195 new openings in 2014. Going forward, whether or not consumers can keep up with the company's strategic initiatives remains to be seen.

The market has duly rewarded Starbucks, Panera, and Chipotle with soaring stock prices, and as a result each of them holds valuations that blow away the valuation of the broader market.

Starbucks reported fiscal 2013 earnings per share of $2.26, meaning the stock now trades for 36 times its full-year results. Panera expects full-year diluted earnings of $6.80 at the midpoint of its guidance, which pegs the company's 2013 P/E ratio at a more reasonable 24 times. Chipotle, meanwhile, trades for more than 50 times trailing twelve-month earnings. Compare this to the market multiple, which stands in the high teens.

The bottom line
Starbucks, Chipotle, and Panera are all well-run, highly profitable businesses that have great brand strength within the extremely competitive food and beverage industries. Moreover, they've shown remarkable growth rates over the past several quarters, defying expectations of slower consumer spending. To be clear, there isn't anything wrong with any of their underlying businesses.

However, investors would be prudent to not turn a blind eye to valuation. The lofty multiples enjoyed by each of these three stocks can be easily reduced should growth decelerate, which can't be ruled out as consumer confidence and spending continue to disappoint.

As a result, investors who have long waited to buy Starbucks, Chipotle, or Panera may want to wait on the sidelines for more favorable prices. Pullbacks of 10% or more would likely be welcome buying opportunities, and could happen should consumers clutch their purse strings more tightly in the months ahead.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, Panera Bread, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, Panera Bread, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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