Leisure Products

Chinese tourism will continue growing, but investors should be mindful not to overpay for Chinese tourism stocks by extrapolating their past double-digit revenue growth into the future.

Highlights Long-only investors with a minimum horizon of two years should buy the interactive entertainment sector. Hedge fund investors with a minimum horizon of two years should go long interactive entertainment versus technology. Despite a trebling of sales since 2014, interactive entertainment comprises just 0.2 percent of world GDP, and just 0.3 percent of US consumer spending, providing scope for substantial further growth. Looking ahead, we identify four specific drivers of growth: cloud gaming, e-sports, 5G, and ‘gaming as a service’. After this year’s sell-off, the sector’s relative valuation has fallen below its long-term average. Even more striking, the sector now trades at a record 20 percent discount to the tech sector. Yet we think we can do better than the sector index and reveal our preferred basket of interactive entertainment stocks. Feature In the future, a typical day will be divided into three. A third we will spend sleeping and dreaming; a third we will spend in reality; and a third we will spend in virtual reality. Parents of teenagers may already recognise this pattern, and will certainly do so over the coming holiday season! But many people in their twenties and thirties are also spending more of their time in the virtual world entered through the portal of interactive entertainment (meaning video gaming, and we will use these terms interchangeably throughout this report). Since 2014, interactive entertainment has experienced explosive growth. Since 2014, interactive entertainment has experienced explosive growth. Sales have trebled, outperforming even the tech sector whose sales have doubled, and far outperforming the total stock market’s sales (and global GDP) which are up a sedate 30 percent (Chart I-1 and Chart I-2). Yet despite this explosive growth, interactive entertainment comprises just 0.2 percent of world GDP, and just 0.3 percent of US consumer spending, providing scope for substantial further growth (Chart I-3 and Chart I-4). Chart I-1Since 2014, Interactive Entertainment’s Sales Have Almost Trebled… Since 2014, Interactive Entertainment's Sales Have Trebled... Since 2014, Interactive Entertainment's Sales Have Trebled... Chart I-2…And Its Profits Have More Than ##br##Trebled ...And Its Profits Have Quadrupled ...And Its Profits Have Quadrupled Chart I-3 Chart I-4…And 0.3 Percent Of US Consumer Spending ...And 0.3 Percent Of US Consumer Spending ...And 0.3 Percent Of US Consumer Spending Meanwhile, the interactive entertainment sector’s profit margin has also trended higher, to 14 percent. This compares with 16 percent for tech, and around 10 percent for the total stock market (Chart I-5). Chart I-5Interactive Entertainment’s Profit Margin Has Trended Higher Interactive Entertainment's Profit Margin Has Trended Higher Interactive Entertainment's Profit Margin Has Trended Higher The combination of explosive sales growth and higher margins has resulted in spectacular profit growth. Interactive entertainment profits have skyrocketed by 250 percent, outperforming tech profits which are up 150 percent, and far outperforming total stock market profits which are up 50 percent. We expect this strong outperformance in profits to continue. Cloud Gaming, E-Sports, 5G, And ‘Gaming As A Service’ Will Drive Sales Growth Looking ahead, we identify four specific drivers of growth: cloud gaming, e-sports, 5G, and ‘gaming as a service’. Cloud gaming (gaming-on-demand) streams high quality interactive content that is running on remote servers, akin to how remote desktops work. Thereby, gamers can play using just a device and an internet connection. Cloud gaming displaces physical disks, powerful hardware, and the need to download games onto a platform – analogous to how the on-demand streaming of media and entertainment has displaced DVDs and cable TV. Cloud gaming benefits both content developers and players. Developers do not have to worry about piracy, illegal downloads or digital rights management. Players benefit from a high (and equal) server processing power, creating a level-playing field in games. Which brings us nicely to the second driver of growth: e-sports. E-sports refers to competitive video gaming, a sector which is experiencing massive growth. 175 colleges and universities have already become members of the National Association of Collegiate Esports (NACE), offering varsity e-sports programs, and recognizing student gamers through scholarship awards. E-sports are hugely popular not only for their competitive element but also for their opportunity for social engagement, albeit virtually. The third major driver of interactive entertainment profits is the widespread rollout of 5G cellular networks, which makes cloud gaming accessible to mobile devices, rather than just to consoles and PCs. Mobile gaming revenues have become the most powerful engine of growth. This is significant because revenues from mobile gaming have now overtaken the combined revenues from the console and PC platforms. As such, mobile gaming revenues have become the most powerful engine of growth (Chart I-6 and Chart I-7). Chart I-6 Chart I-7 The fourth driver of profits is the ‘gaming as a service’ (GaaS) revenue model, which is analogous to the software industry’s standard ‘software as a service’ (SaaS) revenue model. Instead of a one-time sale, revenue comes from a continuous stream of in-game sales and subscriptions. For example, Activision Blizzard’s doubling of revenues since 2014 has come mostly from in-game subscriptions. Product sales now comprise less than 30 percent of total revenues (Chart I-8). Chart I-8 As well as being a major contributor to strong sales growth, GaaS boosts profit margins by lengthening the sales derived from the fixed costs of developing a given game.  But Isn’t Video Gaming An Unhealthy Addiction? In 2018, the World Health Organization recognized 'gaming disorder' as an addictive behaviour and has officially defined it in the 11th Revision of the International Classification of Diseases (ICD-11). Then in August this year, the Chinese government imposed harsh restrictions on video gaming for minors. Under-18s can play video games for a maximum of three hours a week, one hour each on Friday, Saturday, and Sunday. These developments beg the question, is the interactive entertainment sector exposed to significant regulatory risks? The crackdown and regulation of illicit activities should be welcomed, not feared. China’s crackdown on video gaming for minors is consistent with its other crackdowns – for example, on cryptocurrencies – that decree that ‘the Chinese government knows what’s best for its people.’ However, libertarian western economies are unlikely to follow suit. In any case, even the World Health Organization concedes that gaming disorder affects only a small proportion of people.   Another regulatory issue is so-called ‘gamblification’. Popularly known as loot boxes, or mystery boxes, the contents of some in-game virtual goods are unknown to gamers who purchase them in the hopes of attaining rare items that boast high in-game utility. The features resemble gambling and raise concerns of predatory monetization. Calls for regulatory action refer to gamblification as a contributing cause to gaming disorder. Still, such features are not significant enough in most games to change the structural outlook. A final putative concern is that in-game tradable virtual currencies create a haven for cyber criminals and money launderers. The solution could be know-your-customer (KYC) and anti-money laundering (AML) regulations akin to those in the online gambling/betting industry. Ultimately, just as in the cryptocurrency space, and indeed the internet space, the crackdown and regulation of illicit activities should be welcomed, not feared. As such, it strengthens rather than weakens the structural outlook. The Investment Case This year’s sell-off in the interactive entertainment sector provides a good entry point for long-term investors (Chart I-9). The sell-off was exacerbated by two bits of bad news: first, the revelation of a toxic and sexist workplace culture at Activision Blizzard – since when the company has suffered a wave of bad publicity, numerous resignations, and a 40 percent plunge in its stock price; then, the Chinese crackdown on video gaming for minors. Chart I-9Interactive Entertainment’s Recent Sell-Off Provides A Good Long-Term Entry Point Interactive Entertainment's Recent Sell-Off Provides A Good Long-Term Entry Point Interactive Entertainment's Recent Sell-Off Provides A Good Long-Term Entry Point Both items of bad news seem well discounted. The sector’s relative valuation to the market has fallen below its long-term average. Even more striking, the sector now trades at a record 20 percent discount to the tech sector (Chart I-10 and Chart I-11). Chart I-10Interactive Entertainment Now Trades At A 20 Percent Discount To Technology… Interactive Entertainment Now Trades At A 20 Percent Discount To Technology... Interactive Entertainment Now Trades At A 20 Percent Discount To Technology... Chart I-11…And Its Relative Valuation To The Market Is Below The Long-Term Average ...And Its Relative Valuation To The Market Is Below The Long-Term Average ...And Its Relative Valuation To The Market Is Below The Long-Term Average Given that the structural outlook for the sector’s sales and profits remains intact, long-only investors with a minimum horizon of two years should buy the interactive entertainment sector (Table I-1). Hedge fund investors with a minimum horizon of two years should go long interactive entertainment versus technology. Chart I- Yet we think we can do better than the sector index by filtering out the riskiest stocks, based on overvaluation, commercial risk, and regulatory risk. For example, we exclude the Chinese stocks that are most exposed to the Chinese government crackdown and future whims.  Long-only investors with a minimum horizon of two years should buy the interactive entertainment sector. On this basis, our interactive entertainment basket comprises: (Table I-2). Chart I- Nintendo Activision Blizzard Electronic Arts Zynga Konami Capcom Square Enix   This is the final Counterpoint report of the year. We wish you all a very happy and restful holiday season.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Mohamed El Shennawy Research Associate mohamede@bcaresearch.com

Highlights This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded Hotels is a sound tactical and cyclical investment, and we recommended an overweight. Airlines Less profitable trip mix and excess capacity: Domestic travel has rebounded to 2019 levels, while international and corporate travel are still lagging due to government and corporate restrictions (Chart 1). Some of the excess capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Airline cargo growth is a saving grace. The cost side of the airline business has its own challenges. Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns. The price of jet fuel has increased to pre-pandemic levels. Labor costs are high due to the unionized work force and rising wages. Profitability is elusive: With airline revenues down 27% YoY in August 2021, and costs on the rise, it is hard to envision profitability without a return of international and business travel. Too much debt: Airlines’ net debt has risen significantly since the pandemic. Without positive cash flow generation, it will become harder and harder for them to meet their debt obligations. We have a negative outlook for airlines and are underweight the S&P Airlines index. Restaurants Defensive: Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive as it is dominated by fast-food chains. Profitable and resilient: Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable (Chart 2). With any new Covid variant scare, restaurants will just go back to their “drive-throughs” playbook. Over the course of 2021, restaurant spending has risen by more than 40%. We have a positive outlook for fast-food chains and are overweight the S&P Restaurant index. Feature This is the second part of the publication, in which we provide an in-depth overview of Hotels, Restaurants, and Airlines, or the “travel complex” as we dubbed it. These industries share many drivers of profitability as each provides in-person experiences. They are also highly dependent upon public sentiment regarding the potential dangers and likelihood of Covid infections. Further, consumer confidence and financial wellbeing are at the core of this group’s profitability, as the travel complex is a quintessential discretionary spending category. The recovery of the group was coming along quite well until the Delta variant derailed it in late summer, with reports pouring in about dining rooms closing, airline bookings flagging, and hotel occupancy dipping. What is next? In last week’s report, we provided an overview of the macroeconomic backdrop, the Delta variant trajectory, and a “deep dive” into the hotel industry. We concluded that the Hotels, Resorts, and Cruise Lines industry has significant potential to return to its former “glory”: Delta is cresting, financially healthy US consumers are choosing to spend their money on services and experiences, sell-side forecasts are pointing to surging sales, and hotels have substantial pricing power. The industry is a sound tactical and cyclical investment, and we recommend an overweight. This week we will continue with a deep dive into the Restaurant and Airline industries. Sneak Preview: We like restaurants (overweight) but airlines, not so much (underweight). Chart 1Airline Majors' Traffic Still Has Not Recovered To 2019 Level Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 2Profitability Is Resilient To Downturns Profitability Is Resilient To Downturns Profitability Is Resilient To Downturns Airlines “To suggest that the airlines should have better prepared for this environment seems akin to suggesting Pompeii should have invested more heavily in firefighting technology.” (JP Morgan, Mar. 22, 2020) Having avoided bankruptcy in 2020 thanks to federal payout support, US passenger airlines recorded $4.3 billion more in pre-tax losses in the first half of 2021. Clearly, this industry’s woes are far from over. Unsurprisingly, airlines have had the worst performance of any industry in the travel complex, underperforming the S&P 500 by 5% over the past year (Chart 3 & Table 1). Importantly, the performance of the industry slumped at the end of the summer, triggered by the Delta variant scare: After several months of steady increases, new ticket sales have dipped. As we noted last week, several major airlines have warned in regulatory filings that their third quarter may not look as rosy as was hoped. American Airlines, Southwest Airlines, and United all noted a deceleration in near-term customer bookings in August and elevated trip cancellations, even in leisure.1 All three have suggested that the Delta variant is having a dampening effect on business. We believe that the Delta variant is cresting. Our base case is that herd immunity is not far off. Of course, the travel complex is vulnerable to any new virus scare (Table 2), and this is a risk that investors need to keep in mind. However, unlike hotels, airlines face multiple other challenges. Chart 3The S&P Airline Industry Index Is Still Under the Pre-pandemic Level The S&P Airline Industry Index Is Still Under the Pre-pandemic Level The S&P Airline Industry Index Is Still Under the Pre-pandemic Level Table 1Performance Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Table 2Airline Industry Composition Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Competitive Landscape The US airline industry generated total operating revenues of $92.7 billion in 2020, down 48.3% from $179.4 billion in 2019. The industry is dominated by five majors, that are included in the S&P 500 index). Macroeconomic Backdrop For Airlines The airline industry is highly cyclical, and its wellbeing is tightly tied to economic growth. As economic activity improves, business travel tends to increase (except when Covid-related restrictions change the normal course of things). As economic growth translates into higher wages and stronger employment gains, leisure travel also takes off. So does the transportation of goods. As we discussed in Part 1 of the report, the economy is currently in a slowdown stage of the business cycle: Growth is slowing but off high levels. As such, even in the absence of Covid-19 or the Delta variant, Airline sales would continue to grow but at a slow pace. US consumers are financially healthy, and while most of the stimulus money has been spent, more and more people are returning to work. Recently, consumer confidence has soured on the back of a resurgence in Covid infections and rising prices (Chart 4, panel 2). However, domestic airline tickets are still cheap, and only fear of infection is keeping Americans grounded. With Delta cresting, people will go back to flying. Chart 4Airlines Are Highly Cyclical Airlines Are Highly Cyclical Airlines Are Highly Cyclical Key Drivers Of Profitability: Revenue Vs Expenses Revenue While many industries have been hit hard by the pandemic (brick-and-mortar retail, hotels, restaurants) most have turned the corner and are now profitable. Airlines, however, are still struggling (Chart 5). The good news is that losses have been declining, but the bad news is that the financial situation of most airlines is still precarious. Airlines rely on diverse sources of revenue, and thanks to that, business is starting to recover. The following are the key streams: Fares charged to customers In-flight entertainment, food, and beverages Sales of frequent-flyer credits to hotels, auto rental agencies, credit card issuers Auxiliary charges: Baggage checks, choice of seat, extra leg room Cargo and mail Chart 5Airlines' Revenue Remain Airlines' Revenue Remain Airlines' Revenue Remain Chart 6Airline Majors' Traffic Still Has Not Recovered To 2019 Level Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Traffic Recovery: Domestic Travel Has Rebounded, While International And Corporate Travel Are Still Lagging Budget airlines are pandemic winners: As of October 2021 compared to October 2019, scheduled available seat miles are down for all the airlines in the S&P 500 index (AAL, LUV, DAL, UAL, and ALK) (Chart 6). Only the budget airlines such as Allegiant, Spirit, and Frontier have a scheduled number of flights above the 2019 watermark. The underlying reason for such a dichotomy is easy to explain. The successful rollout of Covid-19 vaccines in the US has unleashed material pent-up demand for domestic leisure travel, benefiting domestic budget airlines. US domestic seat miles and load factors have recovered to pre-pandemic levels (Chart 7) as consumers have eagerly spent their stimulus checks on travel within the US. Chart 7Domestic Load Factor Has Fallen Below Pre-Pandemic Levels Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Major airlines are bleeding cash due to high exposure to international and business travel segments: In the meantime, many government and company-imposed restrictions on international and business flights are still in place. Companies are taking a very cautious approach to office re-openings and employee travel, and Zoom has become embedded as a viable corporate communications alternative and a cost-saving tool. As a result, the airline traffic of the majors with high exposure to international (Chart 8) and business travel (Chart 9), is still below the pre-pandemic level. Some of that capacity is being redirected to domestic leisure travel, which has higher volume but is far less profitable. Chart 8In August 2021, US-International Air Travel* Fell 54% Below 2019 Levels Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 9Since Mid-July, Growth Of Overall And Corporate Ticket Sales Has Slowed Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Corporate and international travel are the most lucrative revenue segments and are significant in size: Before the pandemic, business travel constituted 30% of all trips. The industry can hardly recover without these segments rebounding. Until that happens, companies will stay unprofitable, and cash burn will continue. Business travel is projected to recover in 2022 at best and 2024 at worst: The US Travel Association projects US business travel to return to the 2019 level in 2024. The Airlines for America Association (A4A) concurs. It projects that airline passenger volumes will return to the 2019 level in 2022 in the best-case scenario and in 2024 in the worst. Airline cargo is a saving grace: With passenger revenues still lagging 2019 levels, many airlines are focusing on the capacity of their cargo units. With global supply chains clogged and shipping costs increasing five-fold over the past few months, this is a profitable niche. Air cargo demand reached its all-time high in 2020 and continues to grow in 2021: US airlines posted a 20.5% increase in demand for international air cargo in July 2021 from the July 2019 actuals (Chart 10). Chart 10For US Airlines, Growth In Air Cargo Continues To Outpace Air Travel By A Large Margin Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Airlines Compete On Volume: Airfares Are Low Despite the inflationary environment, the price of airfares is still 18% below its 2019 level (-10% annualized), and that is after 7% YoY price increases in 2021 (Chart 11). These are price levels not seen since the 1990s. With all the spare capacity, former international and business travel is now competing to attract domestic leisure passengers. Making things worse, due to prior commitments, airlines continued to grow their fleets throughout the pandemic closures (Chart 12), further increasing capacity and exacerbating competition for passengers as business and international travel are likely to lag, making peak ticket prices and peak revenue elusive (Chart 13). There is also another matter to consider, which is hardly minor. Airline taxes and fees constitute about a quarter of the price of a ticket. According to an example put together by A4A, the base airline fare of $236 has $64 in multiple taxes and fees, making tickets less affordable. Chart 11Airfares Have Fallen by 10% A Year Since The Beginning Of The Pandemic Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 12Capacity Continues To Increase Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 13Airfares Are Down 18% From 2019 And 29% From 2014 Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Sales Growth Analysts expect airline sales growth to stabilize at 60% over the next 12 months. The base effect certainly plays a significant role, but this rate will help the industry to recover. Expenses Airlines have high fixed costs as they own or lease aircraft fleets. This creates a heavy financial burden during downturns, as costs can hardly be cut. Other expenses such as labor and fuel are also sticky. Price Of Jet Fuel Has Increased To Pre-pandemic Levels The cost of jet fuel is one of the most significant input costs for airlines, constituting anywhere between 10% and 30% of revenue (Chart 14). The price of fuel can make a significant difference for an airline’s razor-thin margins. Airlines therefore tend to hedge their fuel exposure. Jet-fuel prices have rebounded to their pre-pandemic level and are up 49% from January 2021 (Chart 14), no longer giving the airline any slack on the cost side. According to Zach Research, at United Airlines the average aircraft fuel price per gallon increased by 66.9% year-over-year to $1.97 in the June quarter. Owing to the uptick in air travel demand witnessed in the June quarter following increased vaccinations, fuel gallons consumed were up 206.4%. Chart 14Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Price Of Jet Fuel Has Increased To The Pre-pandemic Levels Chart 15Labor Costs Increased Again Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Labor Costs Are Fixed Due To The Unionized Work Force Labor is another significant line item on the expense side of the airline’s income statement. Normally labor costs constitute 30-40% of sales. During the darkest days of the lockdowns, labor expense soared to 60% of sales (Chart 15). With a highly unionized labor force, layoffs and furloughs require significant payouts. There are also many other conditions in the labor contract that must be met. As a result, as sales tanked, labor costs did not change in the same proportion. Even so, airlines reduced their workforce from 458,000 people in 2019 to 363,000 in November 2020 (Chart 15). Now, with sales growing again, airlines have started rehiring. However, with recent wage rises, new employees are more expensive. Profitability With revenue challenged by a less profitable trip mix, excess capacity, and rising fuel and labor costs, airlines have been losing money for over a year now (Chart 16). While the increase in leisure travel and cargo units is helping, it is hard to envision profitability without a return of international and business travel. With airline revenue down 27% YoY in August 2021, and costs on the rise, profitability is still a long way off (Chart 17). Chart 16Airlines Are Unprofitable… Airlines Are Unprofitable… Airlines Are Unprofitable… Chart 17…And Are Burning Cash …And Are Burning Cash …And Are Burning Cash Net Debt Airlines’ net debt has risen significantly since the pandemic, driven by their need to support fixed costs (Chart 18). The increase in net debt was also stimulated by large government support and a low interest-rate environment. The problem is that since airlines are unprofitable, and are burning cash, it is becoming harder and harder for them to meet their debt obligations (Chart 19). While there have not been any high-profile bankruptcies in the US, some European and Asian carriers, such as Norwegian Air and AirAsia Japan Co., had to file for bankruptcy protection. As airlines are expected to continue to burn cash through 2022 their credit ratings have been downgraded (Table 3). We would not be surprised if more bankruptcies or industry consolidations take place in the near term. Chart 18Debt Levels Have Increased Significantly Debt Levels Have Increased Significantly Debt Levels Have Increased Significantly Chart 19Airlines Have Difficulty With Interest Payments Airlines Have Difficulty With Interest Payments Airlines Have Difficulty With Interest Payments Table 3All Airlines Credit Ratings Have Been Downgraded Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) When Will Airlines Thrive Again While revenue lags, the industry will remain vulnerable to shocks and cost headwinds. However, once international and business travel recovers, sales will pick up, and companies will generate positive cash flow. Cash generation is a necessary condition for financial recovery – once airlines arrest the cash burn, they can shift their efforts towards rebuilding profitability and, eventually, repairing their balance sheets. Valuations And Technicals Airlines are trading at 36x forward earnings, which is optically high. However, the Valuations Indicator suggests that airlines are not expensive relative to their own history (Chart 20). The industry is also modestly oversold (Chart 21). Chart 20Airline Are Not Expensive Relative To Own History… Airline Are Not Expensive Relative To Own History… Airline Are Not Expensive Relative To Own History… Chart 21…And Are Oversold …And Are Oversold …And Are Oversold  Investment Implications Airlines are slowly recovering from a malaise induced by the pandemic lockdowns. However, the road to recovery will be long. While domestic leisure and cargo traffic has picked up, it will be another couple of years before international and business travel rebounds to the pre-pandemic levels. With fuel and labor costs on the rise, profitability is elusive without those segments. And, even when airlines return to profitability, it will take them years to repair their indebted balance sheets. What is worse, with current levels of debt burden and negative interest coverage, bankruptcies may not be out of the question for some. While airlines may rally with rates rising and cyclicals outperforming, we are negative on the industry on both a cyclical and structural basis. However, if any of our clients wish to trade this industry, there are several liquid ETFs that represent this space (Table 4). If investors chose to be granular and pick individual stocks in this space, they need to be aware of the individual challenges of each airline and their levels of indebtedness vs cash burn. In short, we have a negative outlook for airlines and are underweighting the industry. Table 4Airline ETFs Are Readily Available Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Restaurants: Defensive Cyclicals Industry Composition Although the S&P Restaurant Industry resides within the pro-cyclical S&P Consumer Discretionary Index, its composition is nothing but defensive. In fact, a more appropriate name would have been the S&P Fast-Food Industry, with MCD and SBUX accounting for 70%+ of the industry market cap (Table 5). Table 5Industry Composition Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Performance Restaurant Industry performance has been tracking the performance of the S&P 500, lagging the benchmark by only 8% since January 2020 (Chart 22) Chart 22Restaurant Performed Almost In Line With The S&P 500 Restaurant Performed Almost In Line With The S&P 500 Restaurant Performed Almost In Line With The S&P 500 Restaurants Are “Defensive Cyclicals” Since fast-food prices are generally low, fast-food restaurants tend to be what economists call “inferior” goods, i.e., goods whose sales rise when the economy is in a downward spiral. Restaurants tend to outperform in the slowdown stage of the business cycle (Chart 23), are flat during contraction, and underperform during expansions. Consistent with these expectations, fast-food restaurants also came out as winners of Covid lockdowns: Although sales initially dipped, they quickly recovered as fast-food chains reoriented their business toward drive-throughs and other forms of take-out (Chart 24). Chart 23Fast-Food Restaurants Are Defensive Travel: Airlines Are Not Ready To Take Off (Part 2) Travel: Airlines Are Not Ready To Take Off (Part 2) Chart 24Sales Growth Is Recovering Sales Growth Is Recovering Sales Growth Is Recovering Covid While the restaurant business was coming along quite well, concerns emerged at summer’s end that the Delta variant would further delay industry recovery. Chains like McDonald’s and Chick-fil-A announced that they are slowing their dining room re-openings. As data from restaurant analytics firm Black Box Intelligence demonstrates, sales that had grown steadily earlier this summer have fallen.2 We believe that the reaction to the Delta variant is transitory as new infections are cresting. And, in the worst-case scenario, fast-food restaurants in the index will just switch back to their Covid “drive-through playbook,” and will maintain their level of profitability. Restaurant Spending And Profitability Over the course of 2021, US retail sales releases reveal that restaurant spending rose by more than 40%, outpacing the headline number (13%) by a wide margin (Chart 25). While restaurant spending is likely to decelerate over the coming months as pent-up demand for services is satisfied, earnings will continue to improve. This is in line with analyst expectations (Chart 26). Chart 25Restaurant Sales Skyrocketed In 2021 Restaurant Sales Skyrocketed In 2021 Restaurant Sales Skyrocketed In 2021 Chart 26Earnings Will Continue to Grow But At A Slower Pace Earnings Will Continue to Grow But At A Slower Pace Earnings Will Continue to Grow But At A Slower Pace Despite the havoc wreaked by Covid, the restaurant industry has not stopped being profitable, and although margins dipped in the midst of the lockdown, they swiftly rebounded. The 83% YoY print in restaurants FCF is nearly an all-time high reading since the history of the data going back to the 1990s (Chart 27). Debt Is Low Net debt to total assets also echoes the upbeat message highlighting that US dining stocks remain in good financial health (Chart 28). Chart 27Free Cash Flow Is At All-Time High Free Cash Flow Is At All-Time High Free Cash Flow Is At All-Time High Chart 28Debt Is Low Debt Is Low Debt Is Low Valuations And Technicals Valuations are not demanding while technicals suggest that the industry is oversold (Chart 29). Chart 29Restaurants Are Oversold & Undervalued Restaurants Are Oversold & Undervalued Restaurants Are Oversold & Undervalued Investment Implications The current slowdown stage of the business cycle is favorable for the fast-food industry. This industry is profitable and resilient in downturns. It is also attractively valued. The industry is oversold, which represents a favorable entry point for an overweight position. In short, fast-food restaurants are a sound “cyclical defensive”: They are resilient to downturns, highly profitable, and have healthy balance sheets. We have a positive outlook on the industry and are overweight. A Quick Aside: Toast IPO Before we conclude, a brief note on the new Toast (TOST) IPO is in order. While the stock became public only last week and is not a part of the S&P 500, it is an important newcomer to the stock market. The company is a market leader in cloud-based restaurant management software. Toast’s performance is tied to the health of the overall US restaurant industry. Many of the popular restaurants and fast-food chains are among Toast’s clients. Bottom Line We have a negative outlook for Airlines: This highly cyclical industry is on a long-winding path towards recovery, profitability, and deleveraging. Airlines face multiple challenges and headwinds: Fuel and labor costs are rising, while their most profitable revenue segments, international and business travel, are missing in action. Cash burn is still acute, and profitability is elusive despite all the progress made. We are much more positive on the outlook for the Restaurant Index, which represents some of the largest fast-food chains in the nation. This industry thrives during economic slowdown, is resilient to shocks, and is highly profitable.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Travel Investors Need More Drive, WSJ, Sep 12, 2021 2     Restaurants Close Dining Rooms Again as Delta-Driven Infections Spread, WSJ, Sep 13, 2021.     Recommended Allocation

Leisure product stocks have taken a beating this summer to nearly their lowest level since the GFC (top panel). The slide followed a tough Q2 earnings season that saw the industry miss top line and margin estimates. Unsurprisingly, forward earnings estimates have fallen off a cliff (second panel). We think there is cause to remain optimistic. Consumer spending on toys and games has been firmly in expansion mode since the '09 trough and industry sales have been growing steadily for the past four years (third panel). The result has been leisure gaining a growing slice of the retail pie (fourth panel). The collapse in forward earnings has caused a valuation spike (bottom panel). If higher outlays translate into increasing EPS as we expect, then a playable recovery rally is likely, similar to early 2015. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS. Leisure Has Been Absent This Summer Leisure Has Been Absent This Summer

After vaulting out of the gate at the start of this year, leisure product stocks have endured a steady bout of profit-taking. However, there are no signs of a change in trend. In fact, relative performance is starting to rebound at a key support line (top panel). Consumers continue to demonstrate a large appetite for expenditures on toys and games. Retail sales at toy and hobby stores continue to boon, far surpassing overall retail sales growth. Retail sales lead relative forward earnings momentum (second panel), underscoring that the path of least resistance remains up. Now that expenses are easing, profit margins should expand. Importantly, a hefty short position still exists, pointing to latent fuel for additional share price gains if covering occurs on the back of strong earnings results. We reiterate our high conviction overweight call. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS. bca.uses_in_2016_10_19_001_c1 bca.uses_in_2016_10_19_001_c1

Leisure product relative stock performance is setting up for another leg up. The share price ratio endured a brutal bear market, becoming extremely oversold as company-specific woes caused a short selling frenzy. However, a major trend change occurred earlier this year, with cyclical momentum moving from massively oversold to extremely overbought, as measured by the 52-week rate of change. Overheated conditions have been unwound, and rising relative forward earnings estimates argue for a resumption of the uptrend. As discussed in Monday's Weekly Report, consumer purchasing power has improved markedly, and is driving solid spending growth at toy and hobby stores (third panel). The surge in overall media spending reinforces that a tailwind exists for content-based merchandise sales. We expect ongoing earnings outperformance to propel a further re-rating in the S&P leisure products index, and reiterate our high-conviction overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5LEPR-HAS, MAT. bca.uses_in_2016_08_31_001_c1 bca.uses_in_2016_08_31_001_c1

Stronger-than-expected profit results have propelled the S&P leisure products group higher in recent trading sessions. Despite the sharp gains that have already accrued, we continue to see meaningful upside potential. Positioning had become exceedingly bearish on this group, as measured by the surge in the short interest ratio. The latter showed it would take roughly ten days to cover these bearish bets. Meanwhile, analyst profit estimates were challenging multi decade lows, in relative terms. However, the plunge in oil prices and rising income are growth pushing up spending on leisure products, and retail sales and toy and hobby stores are booming. Consequently, the stage is set for a major re-rating in earnings expectations (second panel), which should force ongoing short covering. We reiterate our high-conviction overweight. The ticker symbols for the stocks in this index are: MAT, HAS. bca.uses_in_2016_02_05_002_c1 bca.uses_in_2016_02_05_002_c1