We had the opportunity to host some of Sprouts’ senior management in the U.K. earlier this week. From the company were Amin Maredia (CEO), Brad Lukow (CFO), and Susannah Livingston (VP, Investor Relations & Treasury).
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Indeed, the growing roll-out of click-and-collect services is causing the shopping experience to deteriorate for customers looking to shop the store, in our opinion. This was clearly evidenced in our visit to Bentonville a couple of weeks ago, where the supercenter was very busy during the late afternoon as items were being collected for pick-up. The challenge we experienced as a “regular” shopper was navigating around the carts (some advice…don’t look at your phone as you turn a corner), and also retrieving prices and items as the carts blocked areas of the aisle. As more consumers turn toward click-and-collect or delivery services, the thought crossed our mind that the traditional self-service shopping model for consumables could fade, perhaps rapidly, over the coming years. Our research highlighted last year in Millen-ageddon noted that a wide swath of consumers’ view shopping for consumables, even fresh foods, as a chore. This suggests to us that as delivery and click-and-collect services proliferate, consumer adoption is likely to grow quickly. The challenge for Staples Retailers is that the full cost of these conveniences is not being passed on to shoppers, which means it is likely to pressure margins and EBIT dollars of retailers that offer them. In fact, Walmart’s click-and-collect service is free. With all of the pressure on the retailer’s margins, we continue to expect that they will look to share the pain with suppliers. This dynamic makes it very difficult to invest in the Staples industry, retailer and manufacturer alike.
CPI Food at Home’s latest reading this morning (06/12/18) for the month of May is likely to give pause to investors looking for an inflation bump in the Food at Home sector. Nevertheless, with wages and transportation costs rising quickly, perhaps retail shelf prices will start to reaccelerate in the back half of the year. As we outlined in our Notes from the Road report last week (It All Runs Through Bentonville), we believe the fate of the industry currently goes squarely through Walmart and how the company approaches the market/inflation, dictating the fate of other retailers. Walmart’s current stance also makes it more challenging for CPG companies to push pricing through, in our opinion. If Walmart, which continues to be fairly aggressive on price in many markets, decides to let the rising costs flow through (outside of the food complex where deflation still exists in certain commodities), this would likely be welcomed by other industry participants. For the month of May, CPI Food at Home is now only up 0.1% when compared to May 2017. Looking back over the last year, CPI peaked around the start of calendar 2018, up about 1% y/y, and has been decelerating so far in 2018.
We are updating our outlook for CPB with Snyder’s-Lance fully integrated and are lowering our fair value to be in the low $30’s. CPB continues to face significant industry headwinds, namely rising cost inflation and the difficulty of passing on prices to retailers, but the story is further complicated by company specific issues such as mounting losses at Fresh and a pile of debt from the Snyder’s-Lance acquisition that we estimate will put FY19E Net Debt / Adj. EBITDA at 5.0x, all with the CEO seat vacant with the retirement of Denise Morrison. While the case could be made for further downside, we view risk-reward as balanced given the potential for the near-term positive catalysts such as the divestiture of Fresh, the hiring of a CEO with a proven track record, or even industry consolidation. As such, we are remaining Peer Perform.
We are updating our COST model for the close of 3Q18 and for May monthly sales reported on 6/6/18. We believe that COST continues to be a best-in-class operator and is distancing itself from brick-and-mortar peers while growing sales at an impressive rate. We believe that COST’s customer base is benefiting from tax reform, with much of the benefits accruing towards middle and higher income demographics, which we highlighted in our note Skewed Benefits. While we believe that Costco is in a virtuous cycle that is leading to very strong sales on the back of an accelerating economy, we believe that COST’s equity has long reflected this and commands a premium multiple. As such, we find it is difficult to see significant upside in the shares and we remain Peer Perform rated.
As we hypothesized back in December 2017 in our note Consumer Discretionary Wins, our research suggested that the companies that would see the biggest benefit from the tax law changes would be those that were exposed to more discretionary categories like Home Improvement and Electronics, especially in industries that had less competition. On the other side of the docket were the companies catering to everyday consumables, where the marginal propensity to spend is lower and competition tends to be more intense. Taking stock on this initial analysis six months later, so far it has been a good framework for what has transpired. With the consumables industry, however, we believed the acceleration in nominal growth and the need to merge would provide at least a more neutral backdrop, although the industry challenges have thus far overwhelmed these factors. Our analysis continues to point in the direction of accelerating nominal growth and the need for further consolidation, but as we noted last week in It All Runs Through Bentonville, better pricing in the consumables industry is very dependent on Walmart’s strategy in 2H:18 and whether the decision to purchase loss-generating Flipkart leads Walmart to take a more balanced approached between growing volumes and profits. As for our more discretionary coverage, our three favorite names are Amazon, Home Depot, and Target, all of which we believe will see an outsized benefit from an accelerating economy and also have company specific catalysts to drive revenue growth.
Amazon’s private label brands are an important piece of its retail strategy. In last week’s A to Z, The Kraken, we analyzed the various ways Amazon generates fee income and how it is a significant competitive advantage, helping to expand services and support profitability, and this week we are looking at private label. We searched Amazon’s “Our Brands” and found that the company has around 7,000 SKUs of private label items across categories and an additional 1,400 SKUs under the Whole Food’s Everyday 365 brand. Most of the private label brands owned by Amazon are in women’s and men’s apparel (we estimate about 46% of SKUs belong to private label apparel brands). AmazonBasics offers a private label option across multiple categories, and we estimate has over 1,000 SKUs available in categories such as electronics, office supplies, automotive, and pet supplies.
In our initiation of SJM earlier this year, we wrote that the company in many ways was the poster child for the challenges impacting the food-at-home landscape, and that the company was over-represented in center-aisle brands with lower value add products in categories that are generally declining. While we brought this into our estimates through declining sales and lower margins through the life of the model, it seems like we weren’t thinking big enough after looking at the 4Q18 report. After spending time in Bentonville last week at Walmart’s analyst day and speaking with Target this week, it seems that there is incremental pressure on manufacturers from retailers to help fend off the enormous pressure they are feeling as consumers continue to reevaluate what, where, and how they want to shop. While SJM is pedaling hard to address these issues, it may find it even more difficult to just stay in place. Balancing this dynamic with a valuation well below historic levels, we remain Peer Perform rated.
After the market closed today (6/6/2018), UNFI reported third quarter results, highlighted by stronger-than-anticipated sales growth, particularly in the company’s supernatural segment. The rub, which appeared to cause much confusion and consternation on the earnings call from the analyst community centered on an approx. $21mm benefit to gross profit related to a change in accounting estimate for its accrual for inventory purchases. This benefit significantly boosted third quarter earnings results and full year guidance, without which our math suggests deterioration in underlying profitability. While the topic is clearly complicated, it is hard, in our opinion, not to look at the quarter as an EPS miss and full-year EPS guidance much weaker than it would otherwise suggest at face value. Moving beyond the quarter, we believe there is a building cloud over the company’s long-term growth outlook, as certain of its facilities are reaching capacity due to growth at Whole Foods/Amazon. Yet, there doesn’t appear to be a large scale build-out of additional capacity by UNFI, suggesting Whole Foods/Amazon may need to look beyond UNFI to fulfill its needs. Balancing the fairly strong near-term outlook against the future growth uncertainty, we remain Peer Perform rated.
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