Old Navy posts first negative comp in 11 consecutive quarters. AMC on 5/30/19, GPS reported a miss across all key metrics, largely due to continued slowdowns at Old Navy and Gap brand. While the Gap weakness has been a known issue for years, Old Navy’s negative comp performance is materially disappointing as we estimate ON makes up over 70% of GPS’ earnings. The company noted that merch margin was down 120 bps primarily due to ON but was partially offset by Gap brand. Said differently, the company promoted heavily at ON, while they actually pulled back on promotions at Gap brand, presumably off of historically low levels. They expect a continued promotional environment in 2Q19 and then a recovery in 2H19, which is difficult to give benefit of the doubt given recent trends. Given the level of uncertainly and disappointing performance at Old Navy, we remain PP. Shares are down 15% in pre-market trading.
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This custom model provides a template for calculating the impact of a 25% tariff on goods from China imported into the U.S. including average unit cost increase, margin hit in basis points, earnings reduction and average unit retail necessary to offset tariff impact.
Use our Tariff QuikCalc Model (click here) to quickly calculate the impact to a retailer's cost, margins, earnings, and, most importantly, to determine the percent increase in prices needed to offset the tariff. We have done this work for our coverage universe, but this is only a small sample of the retailers, vendors, and manufacturers impacted. Therefore, we developed a "quick and dirty" model to give you a general sense of the impact. For the average specialty retailer, we estimate an average unit cost increase of 4.2%, which if entirely unmitigated through price increases results in an average earnings reduction of 35%. The average unit price increase necessary to offset the higher tariff is 2.1%.
The April reading was the fourth consecutive month at 1 or the worst score possible. In April, 50% of retailers posted a short position >15% (up from 47.8% in March). We note the percentage of retailers with a short position over 15% continues to increase month-over-month. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
During 4Q18, inventory risk continued to increase as sector inventory grew at a faster rate than sales. Given a macro backdrop that is no longer fueled by tax stimulus, we believe this is harbinger of margin pressure in FY19. Note that this is a snapshot entering 1Q19, so any top-line weakness in 1Q will result in even greater inventory excess. We expect this inventory risk to build progressively throughout FY19 as retailers try to “comp the comp” but lack pricing power and must simply drive unit volume to deliver positive comps. Simply put, sector wide business and performance risk has materially increased.
Unsure yet of value creation. AMC on 2/28/19, GPS, in addition to 4Q18 earnings, announced a plan to split into two publicly traded companies, Old Navy and "NewCo" that consists of the other brands. We believe Old Navy stand-alone operating margins are in the mid-to-high-teen range, BR in the high-single-digit range and Gap currently in the negative low-single-digit range. Once Gap closes 230 worst performing stores (comp, 4-wall, and cash flow), we expect Gap brand margins to be in the mid-single digits. We understand the rationale to extract the proper valuation for a standalone Old Navy but are uncertain about the recovery strategy for the NewCo brands. Given the level of uncertainly and recent disappointing holiday performance at Gap and Old Navy, we take a sidelined position. What we are certain of is the immediate comp lift and margin impact of the 230 store closures. Though there will be annualized sales loss of $625M and pre-tax (mostly cash) costs of $250-$300M, EBIT will lift by $90M. After the closures, the company expects 40% off sales coming from online. Shares are up 16% on the day.
The January reading plummeted, falling two rankings from December’s reading of 3/10, suggesting investors started re-shorting stocks during the January rally after being sidelined at year end. In January 45.7% of retailers posted a short position >15% (up from 39.1% in December). Since we last published this report on 12/17/18, the XRT is up 1% vs. the S&P 500 +4%. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
Although many companies posted sales upside for the holiday season, we think the upside is the result of deeper promotions (despite clean inventory) in order to coax consumers to shop. CPRI and TPR reported quarterly earnings last week that echoed this sentiment. Both companies cited a promotional environment, among other issues, that resulted in misses on the top-line and on gross margin vs consensus. We expect general misses to gross margin and sales given the trend of deeper promotions over the last four quarters from a peak score of 43 or “Flat” in 1Q18 to 33 or “Deeper” in 4Q18.
Heightened supply risk for 2019. During 3Q18, retailers took a turn for the worse, as inventory increased modestly at a faster rate than sales. With no ability to raise prices to drive comp, retailers must rely on increased unit volume to drive sales growth. Note that this is a snapshot entering 4Q18. Most results, save for a few exceptions (e.g., TGT – PP, COST – PP, covered by Scott Mushkin, and LULU-OP), have missed holiday sales. We expect inventory exiting 4Q18 to show even higher inventory-related business risk.
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