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.
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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.
The December reading rose for the second consecutive month, suggesting with valuations pulling in short sellers may be derisking. The November reading was 2 out of 10. In December 39.1% of retailers posted a short position >15% (was 42.2% in November). Since we last published this report on 12/17/18, the XRT is up 6% vs. the S&P 500 +2%. 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.
We believe 2018 may have been “peak season” for retailers. We continue to believe in the Retail Death Curve phenomenon. The 2018 lift in mall traffic was against easy compares and pent-up demand. Despite clean inventory in 2018, there was no evidence of broad-based pricing power. Retailers were as, if not more, promotional than prior year and “bought the comp.” Tax reform savings were reinvested in store-related wages and deferred capital spending – both contributing to a higher fixed cost infrastructure than before tax reform – adding to greater deleverage risk.
It’s preannnouncement season. Post-holiday preannouncement season is here. With up to 85% of sales completed, retailers know their 4Q fate. As such, we are publishing a post-holiday promo tracker update with our call outs on upside and downside performance for the quarter. Often, the holiday success or disappointment translates into a similar outlook for the forthcoming year. With valuations pulling back in 4Q, we believe our positive call outs are worth a look ahead of 4Q18 preannouncment season and as long-term outperformers in the sector. We expect preannouncements from at least the following companies: ANF, AEO, PLCE, EXPR, CPRI, LB, LULU, ULTA, URBN, W.
Sector Sentiment 2, on a Scale of 1 (worst) to 10 (best): The November reading rose from the October reading of 1 out of 10 with 42.2% of retailers posting a short position >15% (was 44.4% in October). Since we last published this report on 11/14/18, the XRT is down 11% and therefore investors may have taken some money off the table. 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.
3Q18 Consumer Sentiment Poll scores 5. 1 out of 10 (vs 6.2 in 2Q18). Each quarter, we send out a brief survey to gauge investor sentiment prior to earnings, where 1 is “Terrible” and 10 is “Excellent.” Thanks for replying, if you did! Survey results are completely anonymous, and the greater the response rate, the more conclusive the results, so please consider participating next time.
Gap brand is now comping in the negative mid- to high-single-digit range. It is not hard to interpret the fact that Gap brand is “underperforming” expectations means that Gap Global is a negative operating margin business. With 30% of the Outlet business profitable, we believe Gap Brick-and-Mortar Retail is dangerously close to cash burn territory should it deteriorate further. The company discussed three parts of the Gap business: 20% of revenue consists of the growing and healthy online business, 30% of revenue consists of the profitable outlet business and the other 50% of revenue consists of the 775 specialty stores. The company said that addressing the bottom half of the 775 stores represents a $100M EBIT opportunity. The plan is exit these stores quickly. We think this is the correct action for management to take but also urge management to think broadly about exactly who the defined target market is for the Gap brand and its ability to appeal to the buying power of the next decade – the Millennial. Valuation embeds known earnings risk, thus we remain Peer Perform until we have reason to believe there is material change to our estimates. Shares traded down slightly in the aftermarket.
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