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.
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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.
The Staples Industry remains deeply troubled as a resurgent Walmart, an aggressive Amazon/Whole Foods, and the growing success of the deep discounters significantly disrupt the industry. At the same time, consumers are re-evaluating what, where, and how they want to shop for everyday items and companies in the industry are more than willing to give away higher levels of service. Yet, in our opinion, most of the pressure being felt by manufacturers and retailers alike is due to an empowered Walmart. Indeed, Walmart U.S. has seen its fortunes soar under the leadership of Greg Foran and his team who have vastly improved execution and re-established Walmart as the price leader in the U.S. This has resulted in large volume gains and has caused pain for the rest of the industry. However, this story of success is clearly being threatened by Walmart’s decision to buy a controlling stake in the significant loss-making Indian company, Flipkart. Our concern, and we believe that there are already subtle signs, is that the U.S. business will be called upon to bolster profits for the company as losses mount in the e-commerce operations. If correct, this is clearly a case of taking defeat from the jaws of victory and would be celebrated far and wide by other industry participants.
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.
Kroger’s deal with Ocado looks smart, but Amazon remains in the driver’s seat. In our opinion, Kroger’s decision to tip-toe into true consumables e-commerce, with an option to jump in if the market proves-out, seems wise strategically and from a capital deployment standpoint. It is very unclear from our research what model or models will ultimately win out in the U.S., so a measured approach does seem appropriate. With that said, Amazon has significant advantages in the omni-channel world including Whole Foods, one of the best and most trusted brands in food, approximately 70 million Prime households, as well as a growing installed base of Alexa-enabled devices. As Amazon integrates Whole Foods, Prime, Prime Now and Fresh into a seamless offering, we believe it will continue to gain share as we outlined in our Amazon 2028 report.
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.
A modestly positive CPI/PPI spread offers some potential relief, but the competitive climate remains a wild card. Wholesale prices are falling and CPI for April was modest, but the spread between CPI Food at Home and PPI Farm Products and Processed Foods/ Feeds should help retailers. With labor costs and transportation costs rising, it would appear less likely that retail sees deflation given the strong economy. However, for Staples Retailers, the competitive climate remains the wild card, particularly with Walmart either keeping prices steady or even lowering prices in some areas, as evidenced by our note The Jury is Out on Pricing… Waiting For May.
The overall climate remains challenging for Staples Retailers, but the jury is out on whether the industry has entered a new round of heightened price competition, according to our research. Our April pricing data was generally a bit more constructive than what we saw in March, albeit the March data was negatively impacted by an earlier Easter. What that said, there continue to be clouds over the industry including an aggressive price stance by market-leader Walmart, rising costs for goods, labor and logistics, and an increasing need to add click-and-collect/delivery services. This suggests to us that the May data will be important in determining whether a strengthening economy is helping Staples Retailers.
Last week, we conducted a consumer survey of over 1,000 people which we highlighted in our upgrade of TGT, Target 2028 - Kro-zhay - Upgrading to Peer Perform. While our survey indicates that Amazon is 55% penetrated in U.S. households (or ~70mm paid U.S. memberships), we believe there remains significant opportunity to increase its market share. The largest potential growth area appears to be increasing wallet share of its current Prime members. Our survey indicates that even before Amazon offers a seamless consumables experience, Prime members are shopping Amazon between 3 to 4 times per month, on average. This strongly suggests to us that as Prime, Fresh, Now, and Whole Foods are integrated, Amazon is likely to see significant incremental revenues from its core customers in both consumables as well as other categories (see Amazon 2028 for more thoughts on the company’s long-term growth opportunity).
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