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.
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.
Walmart reported a strong third quarter on Thursday morning driven by the strength of its U.S. business where comps remain robust. Looking forward into the fourth quarter it does appear that competition in the consumables portion of the business has been ramping up, according to our research. While households are experiencing a very strong economy, particularly those that frequent Walmart, the question this holiday period is whether the chicken in the pot will be driven by that strength or significant discounting done by retailers. We would extend this discussion to the general merchandise areas, where we believe competition could potentially erode profitability. With that said, the outlook for Walmart’s U.S. business over the next year remains favorable in our opinion. However, with the equity trading well-above historical valuation averages (both absolutely and relatively to the S&P 500), we remain Peer Perform rated.
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.
Would you rather own WMT, which we estimate next year will grow net sales at approximately 4%, shrink EBIT by approximately 2%, shrink EPS by approximately 3%, and is trading at a valuation of over 20x NTM P/E (around 5x above its 10-year average of approximately 15x)… or would you rather own HD, which (on a 52-week basis) we estimate next year will grow net sales at nearly 6%, EBIT by approximately 7%, EPS by approximately 9%, and is trading at a NTM P/E valuation of approximately 18x (in-line with its 10-year average). Both companies have similar FCF yields of just below 5% next year. However, the shift to omni-channel is profit eroding and capital destructive for WMT, whereas HD is implementing changes in its store base while also improving profitability and returns. Conventional wisdom tells us that Staples Retail is a defensive sector with stable cash flow in times of market volatility, but the big question in our mind is whether the structural disruption in the industry (with omni-channel investments) changes the narrative for WMT. HD, on the other hand, is more exposed to Consumer Discretionary, which could slow in a down market. With rising interest rates eating into record high affordability index rates and lackluster housing starts in September, we see the recent slowdown as a return to the norm, and the fundamental drivers for home improvement retail in the U.S. to remain strong longer-term (Climbing the Wall of Worry). To us, the underlying fundamentals for Home Improvement retail are on more solid footing than Staples Retail. On a company specific basis, HD is growing earnings at a much faster rate, while simultaneously investing in its business for the long-term in a way that doesn’t destroy capital today. All this, coupled with a relatively lower P/E, makes HD our clear pick of the two.
At Walmart’s Investment Community Meeting today (10/16/18), it was clear that the company was prioritizing share gains and investing for the future over current profitability. Indeed, our research suggests that the U.S. operations continue to gain momentum, with expanding price leadership and a renewed focus on improving its fresh offerings. The company is also, in our opinion, in a unique position to gain market share by utilizing its expansive omni-channel offering. With that said, the equity is likely to perform in-line with the market, as both profitability and returns continue to fall with no tangible end in sight. Outside of Walmart itself, we believe Walmart’s strategy is likely to pressure both retail competitors and suppliers alike, and we are reiterating our Underperform ratings on KR, SJM, and CPB, as well as our Market Underweight rating on the Food Retail/Food Producers industry.
Not only is Walmart remaining aggressive with low prices on consumables, but we wouldn’t be surprised to see Walmart invest more in its fresh business. Our research across the country showed a recent improvement in execution at some stores as Greg Foran and team have made it an area of focus. Nevertheless, execution remains inconsistent and there is a large opportunity for improvement. If Walmart can become a best-in-class fresh food retailer, we would expect a large positive halo effect on its business. Indeed, during a store tour ahead of its Investment Community Meeting tomorrow, Walmart management highlighted its ongoing improvements to fresh and the push for more quality products, including doubling the shelf life of items such as strawberries, increasing assortment and introducing new signage in meats, and offering hyper-localized fresh food sourced from vertical farms.
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