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.
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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.
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).
This morning (4/18/2018), Amazon and Best Buy announced an expanded partnership to launch new Amazon Fire TV enabled HD and 4K TVs exclusively available at Best Buy. Best Buy will launch more than ten models from Toshiba and Insignia beginning this summer. The TVs will have the Fire TV experience built in and have connectivity with Alexa voice controls and can be paired with any Echo device. Additional models will be released later this year. The models will be available at Best Buy stores, at BestBuy.com, and on Amazon.com with Best Buy as a third party seller.
Last week, BBY reported a monster 9% comp for the fourth quarter, the highest quarterly comp has been since 2004. The company’s revenue benefitted from multiple factors, including a strong performance in gaming with the Nintendo Switch, Samsung Galaxy Note availability which was recalled last year, the calendar shift of iPhone sales into the quarter from a later launch, and the inclusion of the Superbowl weekend in the 53rd week. BBY is benefiting from a positive macro backdrop with the Consumer Confidence Index the highest it has been since 2000, tax reform benefiting consumers, and from market share gains from competitor closings. We believe the management team has made tremendous progress in improving product availability and leveraging stores with a competitive online presence.
This weekend, we took the leap of trust and let Alexa into our home with the entry level Echo Dot. The smart speaker was certainly intriguing, and while there are some features that have a strong appeal, we see the likelihood of some limitations in the near term in terms of practicality and seamlessness of integrating smart speakers into everyday lives and existing devices. Anecdotally, compared to other voice recognition devices we have used in the past (such as Siri and Xbox One Kinect), the Alexa does seem better at understanding natural language outside the confines of preset commands. We go into further detail on our weekend experience with Alexa on page 2, but our biggest takeaway is that the smart speaker may lead to increased Prime subscriptions and frequency of ordering, but the integration to “smart home” devices is not a seamless experience, which may limit broader adoption.
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.
BBY put up another solid quarter to say the least, with comps of 4.4% and earnings growth of 30%, despite the negative impact from hurricanes and the iPhone X launch falling into 4Q from the typical 3Q. However, with the stock under pressure today (11/16/2017), guidance seemed lighter than hoped for, with comp sales bracketing the Street and EPS below consensus. With the current management team that has made significant strides in changing the trajectory of the business, we’ve found ourselves more positively inclined towards the equity, however we remain Peer Perform rated as we have struggled to see the catalyst for stronger sustained comp growth.
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