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
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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 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.
This evening (12/6/2018), after the market closed, UNFI reported lower-than-anticipated 1Q19 earnings (Adj. EPS of $0.59 vs. Consensus of $0.73). In addition, the company outlined much lower-than-anticipated full year Adj. EPS as purchase accounting adjustments, higher-than-expected financing costs, and deteriorated performance at Supervalu eroded earnings. Guidance for FY19 moves to $1.69 to $1.89 (including Supervalu) from $3.48 to $3.58 (excluding Supervalu).
DG reported a somewhat disappointing 3Q18, as it does appear the near-term outlook is a little more subdued primarily due to tariffs, rising transportation costs, and unexpected hurricane expenses. With that said, we remain positive on DG’s outlook longer-term given the ongoing initiatives within its current asset base, such as introducing fresh foods and new format types (Dollar General Traditional Plus), the strong consumer backdrop, and the continued opportunity for new store growth (management indicated long-term opportunities for another 12,000 to 13,000 U.S. stores). While DG’s efforts in fresh food are in the early innings (adding fresh to 200 remodeled stores next year), when coupled with the remerchandising, DG may be in the advantageous position of accelerating both traffic and ticket growth. As such, we are reiterating our Outperform rating and $119 price target.
Our latest round of pricing surveys in Houston, Atlanta, and Southern California in November showed the pricing climate to have deteriorated further, led by traditional supermarket operators Kroger and Safeway/Albertsons. With price gaps to Walmart narrowing again in certain markets, the question in our mind is what will Walmart do? Walmart’s business became troubled near the beginning of this decade as a result of a need to fund its growth ambitions by milking its U.S. operations. This led to an erosion of its low-price advantage and a failure to adequately invest in its labor force. Fast forward to today and we wonder whether the financial pressure from Flipkart and the e-commerce losses prevent Walmart from lowering prices further in the U.S. to thwart resurgent competitors. Clearly, letting people back in the game would be a long-term negative for Walmart but a godsend to other retailers as well as consumables manufacturers, in our opinion.
BJ’s 3Q18 earnings yesterday (11/20/18) did little to change our view and Underperform rating on the equity. We believe that the management team has been making strides to improve the business, such as increasing retention and expanding the offering outside of consumables. However, our view remains that BJ’s is still in a very difficult position, not quite possessing the full club toolkit with ancillary services and the breadth of merchandising as Costco or Sam’s Club, but is also overly exposed to the potential for a further deterioration in the pricing environment for consumables. Our primary concern with 3Q18 is that even with the membership promotion during the last month, BJ’s was only able to comp a 1.9%, which although is “good” for BJ’s, simply pales in comparison to other retail operators enjoying one of the best consumer environments in years. As such, we are reiterating our Underperform rating and are raising our price target to $15 (from $13) primarily due to higher membership fees.
As we stated in our August note, TGT's Moved Up; We're Moving Out, the margin pressure from omni-channel and digital fulfillment appear likely to be higher than we had originally anticipated. Though robust, 3Q18 comp sales of 5.1% seem to have disappointed given the very strong 2Q18 comp of 6.5%, the ongoing remodel activity, and the opportunity in toys. Taking a step back, Target (and retail as a whole) is continuing a significant transformation, utilizing large store bases to expand fulfillment and delivery capabilities. While these initiatives seem to be growing sales (digital contributed approx. 1.9% to TGT’s 3Q18 comp), they are incrementally more expensive, and the path for sales growth in an omni-channel world appears to include a lower margin. With a strong consumer environment and positive sales outlook offset by the rising costs, we remain Peer Perform rated on TGT and are lowering our fair value estimate to the low $70’s.
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