As earnings season winds down, a pattern is emerging in our coverage of improving sales performance for retailers that cater to households with higher incomes and that focus more on discretionary items, while those companies that focus on households on the lower-end of the income spectrum and consumable goods appear to be fairing a bit worse. Indeed, Amazon, Best Buy, Costco, Sam’s Club, and Target are seeing more robust growth, while Walmart, Dollar General, and Family Dollar (not covered) are seeing much more modest sales gains. Weather also played a big role in 1Q reports across retail, but especially for the Home Improvement chains, Home Depot and Lowe’s, as well as Tractor Supply. This is not all that surprising as incremental spending driven by an accelerating economy is much more important to these retailers and, as can be seen in the chart below borrowed from Wolfe Research’s Chief Investment Strategist Chris Senyek, the benefits of tax reform mostly flow to individuals with incomes between $100,000 to $500,000. With that said, we still believe that the improvement in nominal GDP will be strong enough to lead to modestly better sales performance at Dollar General, leading to good EPS growth. Beyond DG, we still prefer the Hardline retailers, with our top idea continuing to be HD. We also believe Target, with its high exposure to discretionary categories, is likely to beat sales expectations for the year.
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Amazon announced that it will introduce benefits to Whole Foods stores for Prime members to receive an additional 10% off of sale items throughout the store, as well as exclusive savings to Prime members. The program is currently available in Florida and will expand to all Whole Foods stores nationwide starting this summer.
Indeed, with Amazon armed with Whole Foods, one of the most trusted brands in fresh foods, with a growing Whole Foods store base, with expanding Whole Foods delivery capabilities, with an increase in incentives at Whole Foods such as 5% cash back for Prime Visa card holders or with discounts through Prime membership, with the coming integration of the Now, Fresh and the Whole Foods platforms, the competitive atmosphere for Staples Retailers will likely grow more difficult over time. Our research suggests that this is especially true for traditional multi-regional unionized supermarket companies, which lack the scale to compete nationally with Walmart and Amazon, have higher cost structures, and can be out maneuvered by strong local competitors.
NGVC reported comps of 7.1% vs. our estimate of 6.5%, raised FY18 comp guidance to 3.5% to 4.5% from 1.0% to 3.0%, but only raised the low end of their FY18 guidance by $0.03 as margins continue to experience pressure from discounting and promotions. While it is good to see comp sales and traffic accelerate in the quarter, we struggle to see how margins will stabilize through the year unless comp meaningfully accelerates, especially as rent flows through expenses. As such, we do not see much earnings growth for NGVC and are reiterating our Peer Perform rating as the risk reward for the stock appears balanced.
We came away from NGVC’s 1Q18 conference call somewhat confused by management’s plan for FY18. As the company reported a 4.7% comp in the quarter, the highest it has been since 4Q15, and management indicating that 2Q18 so far is trending above this, we question whether the company should further invest the benefit from tax reform in price promotion through the year, eroding margins while sales accelerate with market share gains and a stronger economy. To us, the company should be capitalizing on accelerating sales base, capturing profits, and using the benefit from tax reform to create a stronger financial foundation. We see continued growth for sales through FY18 especially against easy comps in 2Q17 and 3Q17, but are maintaining our Peer Perform rating as upside in the equity appears limited if the company cannot expand margin with this growth.
Our research indicates that the tax bill winding its way through Congress, if passed, should accelerate growth which would be most beneficial to our Hardline companies such as Home Depot. The basic mechanisms that cause higher growth include a reduction in income taxes that should drive near-term consumption and encourage individuals to work more, and a large cut in the corporate tax rate which economists almost universally agree should spur investments in capital and, to a lesser degree, labor, driving productivity improvements. As consumption and investments ramp-up, near-term growth should accelerate. Over time, economic growth potential is governed by the accumulation of capital, additional labor and, most importantly, improving productivity. This legislation checks all the boxes suggesting a higher level of growth is probable.
As highlighted by Wolfe Research’s Accounting and Tax Policy’s note, Tax Policy: Marching On and Tax Reform Spreadsheet, tax reform should have a greater impact on high tax payers with a U.S. focus, such as many staples retailers. Indeed, when looking at our coverage universe and the potential EPS impact assuming a proposed 20% U.S. corporate tax rate, many of our covered companies could see a 20%+ boost to EPS. Though the corporate tax rate provisions may not come into effect until 2019, there could potentially be the impact in FY18 from a pull-through of additional CapEx spending as companies may accelerate purchases to take advantage of higher tax write-offs. In our opinion, the shift of CapEx into FY18 could benefit companies that provide IT services near term, specifically AMZN given its market leading AWS position, as it will be the seller to customers who move their purchases from 2019 into 2018.
NGVC reported 4Q17 earnings yesterday (11/16/17) after the close, exceeding Street expectations with a 2.1% comp, the highest since 1Q16. While the team has taken actions to shore-up the financial condition of the company by cutting store growth and paying down debt, drive traffic through competitive pricing, and making continued investments in marketing, we believe that the company is far from out of the woods and the competitive landscape remains aggressive. With that said, it does seem to us that the rising tide of a strong economy is helping to a degree. Balancing a challenging industry environment with a strong economy leaves us Peer Perform as the risk/reward seems balanced at this time.
While there is no one smoking gun, we believe several trends are working in tandem to suppress demand for consumables. As seen below, population growth has ground to a crawl in the U.S. since the Great Recession, but it has continued to slip even recently with the Census Department pegging 2016 growth at 0.68%, the lowest since 1937. This is a 30%-50% reduction in what was seen 1990’s and 2000’s. At the same time, the number of births in the U.S. continues to fall according to the CDC and has been down for the last several years, never recovering from the Great Recession. Of course, households with children are a big driver of consumables demand. And while the number of households in the all-important demand-driving 35-54 age category will finally turn positive as the Millennials start to age in over the next couple of years, the total number of households in this age range will continue to shrink for the next two years. Beyond that, the prospects of a baby-boom, according to our research, remains limited as Millennial women don’t seem all that enthralled with having children. Finally, the Pure Food Trend (the desire to eat, fresh, minimally-processed and local foods) remains vibrant, and this is pulling demand away from traditional Consumer Packaged Goods (CPG) companies.
The pressures being experienced in both our Hardline and Staples Retailing coverages are two-fold: accelerating wage expenses as the labor market continues to tighten and the continuing need to invest in omni-channel offerings. On the labor front, we have spoken with both public and private companies that are sounding more concerned about the cost and availability of low skilled workers. If the economy continues with its recent strength, we would anticipate these problems to only get worse and could eventually put pressure on prices at the shelves as we are hearing that manufacturers are asking for labor cost-related prices increases. At the same time, the need for further omni-channel investments is accelerating and is being led by the arms race in Staples Retail to bring out click-and-collect services. Besides the up-front costs to set up the infrastructure, our analysis indicates having a consumer switch to click-and-collect significantly reduces profits.
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