How covid changed consumer behaviour and company valuations
Morningstar's Dave Sekera on what consumer trends during the pandemic have meant, and will mean, for companies in technology, hospitality, and e-commerce.
Mentioned: Zscaler Inc (ZS), DocuSign Inc (DOCU), Wyndham Hotels & Resorts Inc (WH), Zoom Video Communications Inc (ZM), CrowdStrike Holdings Inc (CRWD), Apple Inc (AAPL), Amazon.com Inc (AMZN), Best Buy Co Inc (BBY), Carnival Corp (CCL), Cisco Systems Inc (CSCO), Domino's Pizza Inc (DPZ), Darden Restaurants Inc (DRI), eBay Inc (EBAY), Meta Platforms Inc (META), Alphabet Inc (GOOGL), Hyatt Hotels Corp (H), The Home Depot Inc (HD), Juniper Networks Inc (JNPR), Lowe's Companies Inc (LOW), Macerich Co (MAC), Microsoft Corp (MSFT), Norwegian Cruise Line Holdings Ltd (NCLH), Netflix Inc (NFLX), Okta Inc (OKTA), RingCentral Inc (RNG), Restaurant Brands International LP (RSTRF), Simon Property Group Inc (SPG), Target Corp (TGT), Walmart Inc (WMT), Yum Brands Inc (YUM)
Within the first 90 days of 2020, collectively our plans changed. Flights were cancelled, events and parties were postponed, and, for the foreseeable future, life as we knew it was put on hold.
The emergence of the coronavirus led to significant disruptions in individual and societal behaviours, leaving investors to wonder: Which of these changes will last? Which will revert back to normal? And how will those changes impact my investments?
With drugmakers around the globe racing to produce a vaccine, we think that the long-term impact on economic growth will be minimal. Still, the pandemic has accelerated the adoption of consumer trends that were already beginning to emerge prepandemic—several of which have the potential to reshape entire industries if they become permanent.
And although broad stock market indexes have recovered from March lows, there has been a significant divergence among company valuations. This divergence is a result of investors believing that certain companies will benefit from pandemic-related trends and that others may be impaired by them.
Making their bets. The returns of Morningstar US Market Index sectors since the onset of the pandemic imply that investors expect widespread societal changes.
Source: Morningstar. Data from 02/20/2020 to 09/30/2020.
Based on our long-term outlook for the economy and the trends within it, some industries and stocks have become overheated, while others have been unfairly overlooked.
We’ve identified three trends that have the greatest ability to reshape the postpandemic economy: shifting workplace patterns, social distancing and its impact upon travel and dining sectors, and acceleration of e-commerce and digital entertainment trends. We dig into how we expect these consumer behaviour trends to play out postpandemic.
Is remote working the future of work?
The impositions of lockdowns and shut-ins forced many employers and employees to quickly revamp from their traditional office structure to remote working arrangements. By our estimates, at the peak of the pandemic lockdowns, 45 per cent of employed US workers were working from home.
Surveys have revealed that the work-from-home experiment has been mostly a positive experience for both employees and employers. However, employees’ success with remote working varied depending on personal factors like technology access, type of work, and whether they had children at home.
- According to Upwork’s April 2020 survey, 56 per cent of hiring managers reported that the shift has “gone better than expected” and 32 per cent of employers reported an increase in productivity. Only 9 per cent of employers indicated that remote working has been worse than expected, with 23 per cent reporting that productivity decreased.
- Many surveys found that over half of respondents would prefer to work from home either full time or more regularly.
Once the pandemic subsides, we expect the vast number of employees to revert to an office environment in the short term. Although there are some indications that employees may need to periodically return to the office—for purposes such as seeing, collaborating with, and building relationships with one another—we think the pandemic will ultimately accelerate the growth of time spent working remotely.
In the long term, we think the maximum percentage of employees that could reasonably work from home is a little under 40 per cent of the workforce—positions that are concentrated in the financial, business services, and technology industries. Service workers, on the other hand, such as those in transportation, hospitality, manufacturing, and construction, would need to continue to be on-site.
By our estimates, 9 per cent of the workforce was working remotely (defined as working outside the office more than 80 per cent of the time) before the pandemic, and we expect that percentage to rise to 13 per cent in 2024—a 44 per cent increase over a five-year period. Further, we expect that many employees and employers will take a more flexible position toward working from home up to several days per week postpandemic. We think this hybrid model could more than double by 2025 to 9 per cent of the workforce from 4 per cent of the workforce in 2019.
Support for a hybrid work model. Most workers will return to the office, but we expect a solid boost in working from home.
The implications of the work-from-home phenomenon are widespread across many sectors, most prominently the technology sector. Investors have long realized this, sending valuations skyrocketing. Through the end of September, the sector rose 29.20 per cent as compared with the Morningstar US Market Index, which only rose 5.84 per cent. In early September, the price/fair value ratio for the technology sector reached 1.24, the highest this ratio has traded in more than 15 years.
Tech takes off. Investors quickly realised that working from home will benefit technology companies.
Source: Morningstar. Data as of 09/30/2020.
Types of companies that have played a key role in this new world of remote working include:
- Communications services. These companies have supported an enormous surge in the usage of video conferencing and collaboration tools. Traditional communications and corporate interactions have been transitioning to a new platform in which the bundle of unified communications is provided as a bundled cloud service. Relatively new entrants such as Zoom Video Communications (ZM), Slack Technologies (WORK), and RingCentral (RNG) have been the beneficiaries of this trend, but established players such as Alphabet (GOOGL) and Microsoft (MSFT) have also staked their claims in the market, with the advent of tools such as Google Meet and Microsoft Teams.
- Work-from-home-enabling technology. Employees have required new functionality to remotely perform tasks that would normally require physically accessing their offices or managing paperwork. For example, Citrix Systems (CTXS) provides employees with the ability to safely connect with their corporate computers through desktop virtualisation and allows remote access to their network drives. And DocuSign (DOCU), a leader in electronic signatures and contract life cycle management software, helps manage contracts that previously required paper. Its product modernises the contracting process by transforming it to an automated virtual process.
- internet architecture and security. The surge in the use of online communications and networking, which requires high bandwidth and data throughput, has strained the capacity of many internet providers. In order to address these capacity constraints, internet providers and enterprises will look to update their hardware and associated software, providing a tailwind to Cisco Systems (CSCO), Juniper Networks (JNPR), and VMware (VMW) over the next few years. In addition, with employees working remotely, companies have needed to heighten their security to thwart hacking and other internet breaches. Working from home has accelerated the adoption of cloud-based security software from enterprise-based security, primarily benefiting companies like CrowdStrike (CRWD), Okta (OKTA), and Zscaler (ZS).
However, as we noted above, investors looking for opportunities to capture these trends will need to tread carefully. The markets have not only driven up prices of many of those companies that will benefit but in many cases have also driven up those prices to valuations that imply unrealistic future scenarios.
What does keeping our distance mean for consumer spending on travel & dining?
The shutdowns and requirements for social distancing that took effect earlier this year led to a drastic reduction for many services, including dine-in restaurants, hotels, air travel, and large events. Commuter traffic dwindled, airline traffic plunged as both business and leisure trips were cancelled across the board, and hotel occupancy dried up to the lowest levels ever recorded. Scheduled vacations and destination trips were revamped to staycations or shorter car trips to rental properties that afforded families the ability to maintain social distancing. Cruise lines cancelled entire voyages as the spread of covid-19 on ships garnered headlines around the world.
Consequently, stocks for the cruise industry fell hard and fast and, to date, have only barely recovered off their March lows. With the pandemic expected to recede in 2021, we anticipate that cruise operators will have to reassure passengers of the safety of cruising and offer pricing discounts to entice cruisers back onto ships. In addition, the cruise operators will incur higher costs to implement tighter cleanliness and health protocols.
Yet, even after reducing our own fair value estimates to account for the near-term pandemic-instigated headwinds, we see value for long-term investors as we expect yields and capacity for the cruise industry will recover by 2023. At the end of the third quarter, we rated both Carnival (CCL) and Norwegian Cruise Line (NCLH) as 4-star stocks.
Another sector impacted by mass travel cancellations—as well as by the rise of working from home—was energy. Not only did oil prices hit multi-decade lows, but in April, oil also briefly traded at a previously unthinkable negative price (oil producers had to pay buyers a price to take the oil off their hands as storage facilities filled up).
After bottoming out earlier this year, the travel industry is continuing to slowly recover (as did oil prices—but at US$40 per barrel as of 30 September, they are still trading near the lower end of their trading range over the past 15 years and futures prices are not much higher). We expect that recovery in the travel sector will ramp up meaningfully by mid-2021 if a vaccine is widely distributed by then.
In the short term, we expect that leisure travel will rebound more quickly than business, car-driven trips will overshadow flights, and local travel will outperform international. In this environment, cheaper hotels, such as economy and midscale units, will fare better than more expensive ones. Because economy and midscale hotels are often found off the interstate and in nonurban areas, they align better with consumer behaviour in a world where road trips and socially distant travel are the norm. In the hotel sector, companies like Wyndham Hotel & Resorts (WH) will benefit first. Then, as business travel returns, hotel chains such as Hyatt Hotels (H) will benefit.
But in the long term, we expect that travel and travel-related sectors will rebound to prepandemic levels and return to normalised trends. Based on our analysis of recovery from both prior recessionary environments and health concerns stemming from SARS, H1N1, and MERS, we think overall travel demand will recover to prepandemic levels in 2023.
Few areas in the hospitality industry were hit as hard as the restaurant industry. By the end of March, the combination of shutdowns and social distancing had taken its toll, with total industry revenue dropping to 50 per cent of its prepandemic levels. Demand for pizza delivery surged as much as 20 per cent, with firms such as Domino’s Pizza (DPZ) garnering a significant share of the increase; however, revenue for casual and fine-dining eat-in establishments fell by 80 per cent—tracking with a world in which ordering food was limited to takeout and delivery services. By the end of June, eat-in establishments had recouped some of their sales as restaurants gradually began reopening, but revenues remained 40 per cent below prepandemic levels.
Inhospitable environment. Few areas of the hospitality industry have been hit as hard as restaurants.
Note: Represents the number of businesses marked closed on Yelp that were open March 1. Closures updated through July 10. Source: Q2 2020 Yelp Economic Average Report.
Fiscal stimulus provided by the US$2 trillion Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, such as the economic impact payments and Paycheck Protection Programs, helped many restaurants survive the first few months of closure. Many restaurants took that time to work out how to revise their operations to support the drastic increase in takeaway and home delivery orders—a consumer trend that had already been capturing a larger share of the restaurant business over the past two years and resulted in many chains investing in digital ordering platforms, such as OpenTable and DoorDash. We expect that demand for these options will continue even after the pandemic.
However, for the time being, restaurants are subject to depressed guest counts and elevated safety and operational expenses. In order to survive, restaurants will need to adapt their business models to address this lower income and higher costs. Just as important, they will need to enhance their online platforms and boost their digital engagement to reflect the new ways that customers are interacting with restaurants.
Overall, we expect that casual-dining and fine-dining operators without to-go platforms, strong balance sheets, or access to temporary funding will struggle to survive, resulting in as many as 15 per cent of overall US restaurant locations at risk of permanent closure—most of which will be concentrated among smaller independents. These smaller businesses are harder-pressed for the cash needed to develop digital offerings and will struggle more to make it through the colder months when outdoor dining isn’t possible.
It is the large publicly traded companies that generally appear to have the financial wherewithal to survive the downturn and capacity to make investments in digital ordering platforms. As smaller players exit the specialty-coffee and casual-dining categories, we see meaningful market share gains for many of the larger incumbent players. Some net unit closures will be offset by an acceleration in new types of restaurant formats such as delivery hubs, ghost kitchens (food preparation facilities designed only to offer delivery meals), and to-go/pick-up stores.
This trend has not been lost on investors. Consider Darden Restaurants (DRI), whose core brands are Olive Garden, LongHorn Steakhouse, and Cheddar’s Scratch Kitchen. The firm briefly traded at a 5-star rating during the market downdraft in March but has since returned to trading near our fair value estimate, which places it firmly within the 3-star range. However, we still see additional opportunity for restaurants that:
- Possess the scale to be aggressive on pricing over the near term.
- Are able to provide customers greater access through robust digital ordering, delivery, and drive-thru capabilities.
- Have healthy balance sheets.
Two 4-star-rated companies that fit this bill include Restaurant Brands International (RSTRF), whose brands include Tim Hortons, Burger King, and Popeyes Louisiana Kitchen, and Yum Brands (YUM), which operates KFC, Pizza Hut, and Taco Bell.
Will accelerated online consumer spending be the final nail in physical stores?
Online sales had already been a rapidly growing proportion of retail sales for over a decade, but the trend accelerated this year as many consumers quarantined at home or found themselves staring at closed signs at their go-to stores.
From February through the end of September, nonstore retailers had realized a 22 per cent increase in sales, while overall retail sales increased 7 per cent. Top areas of online consumer spending included:
- Food and other household staples, which skyrocketed in the early days of the pandemic as households loaded up their pantries and as cautious consumers avoided physical stores.
- Electronic and technological infrastructure, reflecting the needs of employees who were suddenly forced to work from home.
- Supplies for home improvement projects, lawn and garden, and home entertainment, which increased as consumers found themselves stuck at home with the time to pursue tasks around the house.
Online retailers get a boost. Consumers’ rush to buy online during the early days of the pandemic benefited Amazon.com and eBay, which captured most sales.
Source: US Census Bureau. Data as of 09/30/2020.
Like remote working, increased digital consumer spending also contributed to the surging valuations in the technology sector as a whole. The largest, most well-known household names in the sector—Alphabet, Amazon.com (AMZN), Apple (AAPL), Facebook (FB), Microsoft, and Netflix (NFLX)—rose on average 42 per cent this year through Sept. 30. The market capitalization of these six stocks accounts for almost 20 per cent of the overall Morningstar US Market Index; whereas, a year ago, they only accounted for 14 per cent of the index. At the end of the third quarter, we rated 39 per cent of stocks in the technology sector as 1 or 2 stars, indicating that we thought they were overvalued.
During the initial rush to buy online, Amazon and eBay (EBAY) particularly captured the preponderance of sales. We have raised our fair value estimates on Amazon and eBay by 52 per cent and 37 per cent, respectively, this year.
However, even their systems and distribution chains became overwhelmed by the sheer volume of purchases. This led consumers to trial other services they had not tried in the past—benefiting retailers such as Walmart (WMT), Target (TGT), and Best Buy (BBY), who have been both investing in their online platforms and refining their digital engagement over the past few years.
After this initial wave for household staples and business supplies, companies such as The Home Depot (HD) and Lowe’s (LOW) were the beneficiaries of the focus on household projects and realized 20 per cent or more same-store sales growth earlier this year. However, although both companies’ stocks surged this year, we caution investors that we think that sales will normalize back to pre-covid-19 trends once the pandemic subsides. As such, we think that, at current levels, both stocks are trading at levels significantly above fair value.
The intensification of online retail sales has emphasized what retailers with physical stores will need to stay successful throughout the pandemic: In addition to developing their own competitive online presence, they also must be able to provide such a combination of service, convenience, and experience that consumers will be willing to pay a premium. Those retailers that sell nondifferentiated products, have poor online execution, and are unable to provide a valuable in-store experience will struggle to survive in this new environment.
There has already been an increasing number of bankruptcies in the retail space, similar to the restaurant industry. Already this year, several brands that serve as anchor tenants for malls—such as JC Penney (JCPNQ), Lord & Taylor, and Neiman Marcus—have filed for bankruptcy, as have other familiar brands such as Ann Taylor, Brooks Brothers, GNC, and J.Crew. While a number of these retailers will use the bankruptcy process to rethink their capital structure, close underperforming stores, and re-emerge, many others will end up liquidating their merchandise and closing their doors for good.
Malls are another area inevitably struggling with decreased in-person traffic. In recent years, malls have been moving away from relying on the power of their location and looking to make their sites more “experiential”—for example, by revamping closed stores for use as restaurants, physicians’ offices, exercise facilities, and other experiences that cannot be replicated online. By accelerating this trend, many mall owners are aiming to recapture foot traffic as consumers become more willing to venture back out into the public.
To determine the impact to mall operators, we adjusted total retail sales to compare sales that we view as relevant to both retail REIT tenants and e-commerce (that is, we stripped out categories such as gasoline, grocery, and building materials). By our estimates, e-commerce sales growth will average in the mid-single digits over sales growth for brick-and-mortar retailers for the foreseeable future. Using these calculations, we forecast that e-commerce sales as a percentage of modified retail sales will grow to 42 per cent by 2028 as compared with 22 per cent in 2019.
While this shift will have a significant impact on the overall brick-and-mortar and mall-based retailers, we expect that the worst impact will be to lower-quality malls that are already experiencing declining foot traffic. We expect that over the long term, higher-end mall REITs such as Simon Property Group (SPG) and Macerich (MAC) will maintain their ability to drive foot traffic and, therefore, be able to both preserve their strong tenant base as well as attract e-tailers looking to establish a physical presence. Both of these companies' stocks have been hit hard this year, but we see value as both companies are trading well below our fair value estimates.
Consumer trends advance
The short-term impact covid-19 has had on our lives and the economy has been unparalleled in modern history. Yet, after analysing the history of multiple global recessions, we expect the long-run impact on total US gross domestic product will be minimal.
However, the pandemic has led to an acceleration of multiple consumer behavioural trends that will have significant impact on particular sectors. As such, in many cases, the markets have already priced those changes into those company’s stock prices and, in other cases, have overestimated the long-term impact. While some stock prices have soared above our estimates of intrinsic value, we do continue to see value among others in which the markets remain overly pessimistic.