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.
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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.
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.
Best Buy continues to exceed top-line expectations with an impressive 7.1% comp for 1Q19, but profitability was somewhat muted for such strong sales, and guidance for the full year was unchanged. BBY is benefiting from a positive macro backdrop, higher consumer spending driven by tax reform, and competitor closures. The difficulty that we continue to have with BBY is balancing the positive near-term sales outlook with long-term sustained comp and the ability to grow EBIT in an inflationary environment with intense competition. With that said, BBY, in our opinion, is an exceptionally run company with a fairly reasonable valuation and we are maintaining our Peer Perform rating.
Lowe’s reported comp of 0.6% in 1Q18, which had a significant negative impact on earnings. The company did indicate that comp was negatively impacted by 300 bps from the late Spring.
Sherwin-Williams hosted its analyst day this morning (5/22/2018) and provided an update to its long-term FY20 financial targets as well as updates on the macro climate, how the Valspar acquisition is trending, and the overview and outlook for the company’s three divisions and supply chain initiatives. On the guidance front, SHW raised its long-term FY20 EPS 4-year CAGR (from pro-form FY16 EPS of $16.57) to 11%-14%, up from 9%-12% outlined in October, driven by the lower tax rate. The company also raised its FCF margin outlook to 11% of sales from 10% of sales and reiterated that it will utilize cash on its balance sheet, targeting long-term leverage ratios of 2.0x-2.5x, and buying back shares absent M&A beginning in FY19. The stock was down ~3.8% today.
This morning (05/22/18), Lowe’s announced the hiring of Marvin Ellison as President and CEO of LOW effective July 2nd, 2018. Mr. Ellison will succeed Robert Niblock. Mr. Ellison is the current Chairman and CEO of J.C. Penney, having previously been with Home Depot as the EVP of U.S. Stores.
HD reported EPS of $2.08, ahead of Street estimates, but below our $2.14, with comps of 4.2% held back by an unseasonably cold April impacting the gardening category. Excluding gardening, comps for HD would have been 6.5%. HD should make up for lost April sales in 2Q18, as the company disclosed that May comps are trending positive double-digits. We would take any weakness from the quarter as a buying opportunity for HD, as we believe the housing fundamentals remain intact and below historical peak levels. That said, affordability indices will need to be monitored as potential red flags. Though we are lowering our EPS estimates, this is primarily due to our estimate for SG&A growth and leverage which may have been too optimistic, and are now modeling SG&A for FY18 in-line with guidance. Our price target moves to $215 from $225 and we are reiterating our Outperform rating.
Tractor Supply reported 1Q18 earnings before the open this morning (4/26/2018) that generally met street expectations, but fell short of our estimates. Nevertheless, we continue to believe that TSCO is uniquely positioned to gain market share through investments in its omni-channel offering, expanded credit offering, and by better understanding the needs of its core consumer through enhanced data analytics. Our research further suggests that TSCO is in an enviable position given its unique consumer base and fragmented local competition. While management is clearly focused on many of these strategic initiatives that should result in higher same store sales, asset turns, and ROIC, the company’s management incentive program is still a throwback to a more pure-play store growth strategy. From our perspective, the company needs to embrace improving asset productivity and returns to fully realize the underlying value of the equity. We are reiterating our Outperform rating on TSCO.
Over the next few weeks, a number of our Hardline related companies will report 1Q18 results, and while we expect first quarter sales to be okay (albeit not great) we believe the start of the second quarter could be downright slow as the winter winds have taken longer to abate across the country. Indeed, as pictured below from Chicago last week, the spring foliage products at Home Depot were clearly feeling the unusually cold weather, as temperatures fell into the 20s. The unseasonably cold start to the spring was not just a phenomenon in the upper Midwest, but was experienced in the entire country east of the Mississippi. Our expectation is that when TSCO reports tomorrow that the company will likely discuss the cold weather as a near term headwind, as was the case with SHW yesterday where the painting seasons was off to a slow start.
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