UNFI hosted its analyst day on 1/16 with a detailed overview of the rationale and outlook for the SVU acquisition and provided its long-term guidance for sales, earnings, and leverage. The difficulty we have with the equity is that the risks are tremendous, and the outcomes are binary. In one scenario, the company could execute on its integration, divest its retail assets, recognize its synergy targets to hit the FY22 goal of $875mm to $925mm in Adj. EBITDA, and pay down its debt to 2.9x leverage, in which case we think the stock has very meaningful upside from today. In the other scenario, further execution difficulties integrating SVU’s distribution centers, the inability to divest retail assets, and the potential loss of key customers such as Whole Foods/Amazon could lead to a scenario where the equity value is not worth anything behind the heavy debt burden. While on paper the acquisition strategically made sense, the company is now very far on the risk curve, in part due to the price paid for SVU. While we view the chances of a downside scenario as more likely, we remain Peer Perform rated as the equity could have significant upside if goals are met.
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SHW announced preliminary, unaudited sales and earnings results for 4Q18 before the market opened today (1/15/19). Sales were lower than expected across all three segments, and our research suggests that weather drove a significant portion of the revenue miss in the Americas Group (TAG). Leaving weather aside, we are reducing our 2019 estimates as SHW continues to be over-indexed to new home construction and has a higher industrial end-market revenue base post the Valspar acquisition – both these factors could make comps and earnings more volatile if an economic slowdown were to materialize. That said, we continue to view SHW’s scale and vertical integration as a key differentiator and see SHW as a core hardlines-retail holding for investors that are looking for cyclical exposure. Even with a reduced target multiple reflecting the earnings uncertainty, we see a compelling risk/reward opportunity in the equity and are maintaining our Outperform rating.
With bankruptcy proceedings ongoing since October, we have seen reports that CEO Eddie Lampert’s hedge fund ESL is continuing negotiations with a bid greater than $5bn. While we do not know when a resolution could be finalized, we view liquidation or continued asset disposals as likely outcomes. In this note, we analyze the potential impact to what we view as the four key beneficiaries from our coverage (HD, LOW, WMT, TGT) from a potential total liquidation of Sears and Kmart. While liquidation would likely be a headwind temporarily, it would likely drive incremental sales longer-term. The estimates below are representative of the high-end of the potential benefit and are not specifically included in our current forecasts, as many of the sales could be outright lost, could shift to other retailers not considered in this analysis (private or public), or could move online. Also, liquidation sales could serve as a headwind in the near-term as these locations close and discount merchandise
The calendar may have turned, but the challenges impacting the Food Retail and Food Producers industries remain unchanged. The groups are marred by slow sales growth, higher costs, falling returns and subpar balance sheets. We do not believe 2019 will see any deviation from these difficulties as they appear largely systemic and, as such, we continue to advise investors to underweight Food Retail and Food Producers. In our opinion, while a sharp economic slowdown would clearly hurt if it were to materialize, the Hardlines Retail industry still appears poised to see robust sales growth fueled by a strong consumer, stable margins, and higher ROIC. These companies also have solid balance sheets and a penchant to return cash to shareholders. With valuations reasonable, we continue to suggest investors overweight Hardlines Retail. Finally, the Broadlines Retail industry is seeing sales grow rapidly, in part due to the strength of the economy, but with labor expenses increasing and with the need for omnichannel investments, EBIT growth and better ROIC remain elusive for some. While this causes us to advise market weighting the Broadlines Retail industry, we do believe there are opportunities for outperformance (AMZN, DG) and underperformance (BJ) within the group.
The Kroger Co. (KR, Underperform) today (01/07/19) announced a partnership with Microsoft, using Kroger technology and Microsoft’s cloud service, Azure, to pilot two “connected stores” (in Monroe, Ohio and Redmond, Washington), and jointly market a commercial Retail-as-a-Service (RaaS) product to the broader retail industry. The goal is to combine Kroger’s EDGE (Enhanced Display for Grocery Environment) Shelf technology and Azure to help customers with a unique, guided shopping experience, use video analytics to improve employee insight and productivity, and leverage the EDGE Shelf to generate new advertising revenue from CPG manufacturers through personalized offers.
The Indian Ministry of Commerce & Industry’s Department of Industrial Policy & Promotion (DIPP) issued a new ‘Press Note’ on 12/26/2018, “in order to provide clarity to FDI (Foreign Direct Investment) policy on e-commerce sector”, with the update going into effect on February 1, 2019. Worded as a review of the FDI in e-commerce policy, the press note essentially laid out four additional rules.
Our latest three surveys in December showed mixed results with the Chicago market continuing to deteriorate, while Philly and D.C. remain relatively calm. Overall, sequential and year-over-year pricing throughout the U.S. appears to be largely deflationary, with a couple exceptions, signaling that the tough competitive environment of flat to falling prices and rising costs for operators is unlikely to ease anytime soon. The biggest takeaway for us is whether Walmart will need to increase its price investments, or whether the company is taking profits by allowing prices to remain flat in deflationary categories such as coffee. With this note, we are removing our industry rating on Drug Retail (previously Market Weight) following the transfer of coverage of WBA to Justin Lake (see his note here). We are also separating our rating on Food Retail / Food Producers as well, though we continue to rate both industries as Market Underweight.
Costco’s 1Q19 report demonstrates the company’s continued sales strength despite mounting pressures facing the Staples Retail industry. Core merchandising gross margin ex-fuel was down 22 bps; however, we do not view this as too much of a surprise given the company’s investments in merchandise and commitments to price. Costco did note increased competition and no inflation in fresh as having a slightly negative impact on margin. Further, while Costco has advantages in its ecommerce operations due to its ability to ship directly from supplier as well as the membership fees it collects, COST is certainly not immune from the cost pressures associated with expanding delivery, especially as some of the third-party products shift to being shipped directly from Costco. Balancing our view of Costco as a best-in-class retailer growing sales at a rapid clip with a valuation which seems full, we are maintaining our Peer Perform rating with a fair value near $220.
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