Morningstar Advisor - February/March 2012 - (Page 34)

Sector Rap MacKay: At current spreads, we find OfficeMax and Office Depot interesting. They’re yielding close to 10%, and as a debt holder, I think that you will get your money paid back. I think that would be very attractive for an investor, if you’re willing to deal with a little bit of risk. Guziec: There are some interesting dynamics in consumer electronics. are fairly solid cash generators, but that’s something that could quickly dry up. So, while they may look good on the surface, I think it’s important that we keep a market-weighted recommendation on the bonds for these retailers, given that the industry dynamics could change in a hurry and really zap these firms’ free cash flow potential. Guziec: Spreads are not wide enough to justify merchants. You won’t see them at Wal-Mart; you won’t be able to purchase one on Amazon. Feng: The three major players—O’Reilly ORLY, R.J. Hottovy: I think some of the dynamics the risk? MacKay: And not wide enough to recommend them at this point. GameStop is the third company in our credit coverage for now, but it is actually going to pay off all of its debt by the end of 2011 (final numbers weren’t available in time for this issue’s deadline), so we probably won’t be talking about it from a credit perspective soon. Guziec: What about auto parts? parallel what Joscelyn described with the office-products industry, but consumer electronics takes it one step further without having the contract side of the business to fall back on. Consumer electronics companies are facing competitive pressure from a lot of large mass merchants—Wal-Mart, Amazon, and Costco—who have taken considerable market share from Best Buy BBY, Radio Shack RSH, and GameStop GME the past few years. We’re seeing other competitive pressures, too. Namely, a number of key consumer electronics vendors, whether it be Apple AAPL for consumer electronics, or AT&T T or Verizon VZ on the wireless side, are building out their own retail networks and becoming a lot less reliant on traditional specialty retailers to distribute their products. This gives the vendors a lot more negotiating power in and a lot more pricing power over these retailers. Also, a number of high-margin products, such as entertainment media, are moving to digital distribution platforms. Wireless contracts are being moved to the vendors themselves or even distributed online through players like Amazon. It’s making the store space for consumer electronics retailers a lot less productive, and I don’t think that’s something that’s going to be easy to reverse. It plays into our longer-term thesis of margin compression in the consumer electronics retail industry. Guziec: That sounds interesting and ugly. Hottovy: It’s not a great space. At first glance Advance Auto Parts AAP, and AutoZone AZO—essentially form a mini oligopoly, enjoying very high returns. Overall, we really like their position in the industry, because they continue to consolidate market share from smaller industry participants and generate quite a bit of free cash flow, which means they should be able to continue servicing their debt with relatively few problems. They are countercyclical, so if new car sales rise higher than the 14 million replacement rate, then we could see a reduction in the number of older vehicles on the road, and that could be a headwind. But since they’re consolidating the industry, taking market share from smaller players, and selling items that are nondiscretionary, we think their debt is relatively safe. MacKay: The industry’s countercyclicality and other attractive dynamics have attracted bond investors in the past couple of years. Investors have felt safer owning these bonds in a recession, but the bonds trade at a level that’s too tight, in our opinion, and we do have some concerns over the next couple of years as the economy rebounds that the countercyclicality will work against auto-parts retailers. Mid-to-weak BBB credits—around where we have the auto-parts retailers rated—are trading around the mid-to-high 200 basis points area. Yet, the auto-parts retailers’ 10-year credits trade around the low 200 basis points area, which we think is way too tight for a BBB/BBB– credit. Guziec: The businesses are in good situations, but they aren’t good bond investments. MacKay: Investors have already gobbled up those bonds, making them not so attractive anymore. K Philip Guziec, CFA, is a derivatives strategist for Morningstar and co-editor of Morningstar OptionInvestor online newsletter and research service. Liang Feng: In general, we like the auto-parts retail industry. Unlike many other specialty retail segments, auto-parts retail is countercyclical—during recessions, people are less likely to replace their existing vehicles, so the size of the old vehicle fleet has been increasing. Since people don’t want to buy new cars, they choose to go to the auto-parts retailers instead to purchase parts, or they can go to repair shops, which source many of their parts from the auto-parts retailers. As a result, auto-parts retailers have managed to grow profits tremendously over the past few years by growing their store bases and expanding their margins. Additionally, unlike many other retail sectors, auto-part retailers are relatively insulated from online retail competition, because the majority of consumers prefer to go to the retail shops to get assistance from associates before purchasing. Hottovy: In addition to that, a lot of the parts that auto-parts retailers sell are so specialized or technical that they aren’t carried by the mass the credit metrics are OK, since these 34 Morningstar Advisor February/March 2012

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012

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