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.
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.
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.
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.
Target reported 3Q18 comp sales of 5.1% (vs. Wolfe 5.8% and Consensus 5.5%) and Adj. EPS of $1.09 (vs. Wolfe $1.09 and Consensus $1.11). Sales were ahead of the company’s previous guidance for 4.8% but appear light of expectations. Guidance for 4Q18 comp sales is approximately 5%, in-line with our 5% estimate and ahead of Consensus 4.4%. Guidance for full year Adj. EPS of $5.30 to $5.50 is unchanged and implies 4Q18 Adj. EPS of $1.42 to $1.62, bracketing our $1.47 and Consensus at $1.52. The significant takeaway from the quarter is that gross margin declined approximately 90 bps, well in excess of what we were forecasting. While there are multiple contributing factors, it is clear to us that Target’s omni-channel initiatives are pressuring margin significantly. The challenge as we see it, and one of the major reasons we downgraded the equity to Peer Perform after last quarter, is that any sales slowdown from the current pace is likely to meaningfully pressure results. Call at 8:00am ET.
Investors are anticipating that higher pricing rolls through the consumables complex. However, outside of household chemicals, we are not seeing evidence this is truly taking hold. In fact, looking at our pricing work across the country suggests the opposite may be taking place. A combination of Walmart’s increasing market power, falling farm product prices, ALDI’s aggressive stance on fast-turning items, and a seemingly more promotional stance of late from operators such as Kroger and Meijer appear to validate the notion put forward by Walmart U.S. CEO Greg Foran that the environment has gotten more competitive lately. Given our research, we are reiterating our Market Underweight stance on Food Retail/Food Producers and our Underperform ratings on Kroger, Campbell Soup, and Smucker’s.
Your business weaknesses come to light and your equity is likely down. Indeed, to continue to channel Billy Squire, there’s no one left to call and the writing is on the wall. The latest PPI and CPI numbers from the government do not bode well for the pricing environment in Staples Retail, with PPI for Farm Products and Processed Foods falling y/y in September (-5.1% and -0.6%, respectively) and now seemingly CPI Food at Home wants to follow (September growth of 0.4% slowing from August growth of 0.5%). Our latest pricing survey work in our Notes from the Road (Fooling Yourself) shows that Walmart is continuing to press down on price and take market share. We fully expect that this strategy will continue and we’re likely to hear as much at the company’s analyst day next week. But it’s not just Walmart that is pressuring more traditional consumable retailers, such as Kroger.
Our latest research from around the country shows a further escalation in the competitive climate in consumables retailing. Following our significant pricing survey work over the summer that Walmart was maintaining its aggressive pricing stance on branded consumables, our latest round of surveys continues to show this pattern. Walmart is also continuing to drop pricing on private label items. However, it’s not just prices where Walmart is getting more competitive. The company is enticing consumers to use its free click-and-collect service through trial discounts, while also providing special click-and-collect promotions. Not to be outdone, Target has also become quite aggressive in its omni-channel efforts in consumables, with many of the services offered at low or no cost. In our opinion, this is causing a significant share shift in the consumables industry to mass merchants from the supermarket channel and is reminiscent of what happened in the late 1990’s and early 2000’s.
Media reports last week indicated that Amazon is planning to build 3,000 Amazon Go stores by 2021. The Go technology eliminates the checkout process, removing a store bottle neck and potentially allowing labor investment elsewhere and/or lower prices. We would anticipate Amazon to bring the technology into Whole Foods stores over time as well. Perhaps most important are Amazon’s intentions in the consumables industry more broadly. Our research, highlighted in Amazon 2028, suggests that Amazon wants to build a much larger presence as demonstrated by its purchase of Whole Foods, PillPack and now what appears may be an aggressive buildout of Go stores. Becoming larger in consumables is vitally important, as our research indicates that consumers that use Amazon for the preponderance of their consumable needs also increase purchases in other areas. On the flip side, given the slow growth of the consumables industry, if Amazon is successful we believe traditional supermarkets like Kroger have the most to lose. Regardless, the battle for the hearts and minds of shoppers in consumables is just getting underway and is likely to pressure pricing and returns.
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