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.
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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.
WBA reported 4Q18 results last Thursday (10/11/18) which, in our opinion, were somewhat underwhelming with sales largely in-line and Adj. Operating Profit below our expectations. Stepping back, WBA faces significant hurdles, as do other operators in the industry, in addressing changing consumer preferences, new competitive entrants, and the long-term relevance of the drugstore model. The veteran WBA team is aware of these challenges and for its part Walgreens is taking significant shots on goal by testing and expanding partnerships as it works to create more community healthcare hubs with its U.S. drugstores. While we agree with the premise of driving better productivity of the existing asset base, we believe the challenge is also going to be growing underlying operating profit as the company moves through this next phase of evolution. We see an outlook of higher investment and increased competition, all while continuing to deal with the challenges of reimbursement. Balancing a veteran team with cost-reduction acumen and a reasonable valuation, we remain Peer Perform.
CVS announced today (10/10/18) that it has received clearance from the DOJ to move forward with respect to its proposed merger with Aetna, subject to the previously announced divestiture of Aetna’s standalone Medicare Part D PDP business. In addition to the DOJ approval process, certain state regulatory approvals are needed, with many granted, according to the company, and some remaining. CVS anticipates the timing of the close of its transaction with Aetna early in the fourth quarter of calendar 2018.
LOW reported 2Q18 this morning (8/22/18) with comparable sales of 5.2% (vs. Wolfe 5.0% and the Street 5.4%) and EPS of $2.07 (vs. Wolfe and Street of $2.02). The company announced that it would close the Orchard Supply business which had approximately 100 stores at the end of FY17. LOW also lowered its outlook for the remainder of FY18, lowering full-year comp guidance to 3.0%, down from prior 3.5%, and lowering EPS guidance to $4.50 to $4.60, down from prior $5.40 to $5.50. The new EPS guidance is inclusive of approximately $0.60 estimated full-year impact from the closing of Orchard Supply, and excluding this, core EPS guidance appears to be lowered to approximately $5.15 at the midpoint, down ~5.5% from the prior $5.45 midpoint. Lastly, the company announced that it would hire David Denton as CFO. David Denton is currently the CFO of CVS, and will join Lowe’s upon completion of the CVS/Aetna merger.
The CVS story, in our opinion, hinges to a large degree on the company’s ability to remake itself and the consumer healthcare experience through its merger with Aetna. At the same time, the drugstore industry is in the throes of significant change and its future, along with the future of the drugstore model itself, has yet to be written. We believe these factors and uncertainties, as well as future actions by the likes of Amazon and other potential disruptors, are likely to continue to weigh on the industry for the foreseeable future. Balancing these factors with CVS’ strong management team and low equity valuation, we remain Peer Perform rated.
CVS reported better-than-expected 2Q18 results this morning (8/8/18), with Adj. EPS of $1.69 exceeding our $1.61 estimate (which was in-line with Consensus) and CVS’ prior guidance of $1.59 to $1.64. On a consolidated basis, revenues slightly exceeded our forecast while Adj. operating profit of $2,373mm exceeded our $2,293mm estimate by approx. 3%. CVS narrowed its full-year guidance for Adj. operating profit growth to -0.75% to +0.75% (from -1.5% to +1.5%) and Adj. EPS to $6.98 to $7.08 from $6.87 to $7.08. CVS noted that its announced acquisition with Aetna is anticipated to close in 3Q or early in 4Q of this year. CVS rose 4.2% today.
WBA reported 3Q18 results this morning, and while Adj. EPS for the enterprise was better-than-expected, performance from the U.S. business fell shy of our expectations. But that wasn’t as tough a pill to swallow for the equity as was Amazon’s acquisition of PillPack this morning, signaling Amazon’s entrance into the dispensing market and the likely disruption to ensue, something we anticipated and included in our Amazon upgrade (Amazon 2028). We continue to believe the retail drugstore model remains very much in question. While WBA and CVS aren’t resting on their laurels and are attempting to address changing consumer preferences through partnerships and other initiatives, and in CVS’ case transformative M&A, changing these boxes into healthcare centers may have unintended negative consequences too (see back for more) all while the front-end continues to erode driven by Amazon and Dollar General. Balancing these clear negatives with a very low historical valuation and a management team with a proven track record of cost discipline and the willingness to deploy capital in value enhancing ways, we remain Peer Perform on WBA.
Amazon this morning, (06/28/18) announced that they acquired PillPack for an undisclosed sum. PillPack delivers medication in pre-sorted dose packaging and handles the logistics of refills and renewals. PillPack holds a pharmacy license in all 50 states, has the appropriate accreditations, and is in-network with most PBMs including Medicare Part D plans. The service is free, shipping is free, and customers are only responsible for copays.
Amazon’s private label brands are an important piece of its retail strategy. In last week’s A to Z, The Kraken, we analyzed the various ways Amazon generates fee income and how it is a significant competitive advantage, helping to expand services and support profitability, and this week we are looking at private label. We searched Amazon’s “Our Brands” and found that the company has around 7,000 SKUs of private label items across categories and an additional 1,400 SKUs under the Whole Food’s Everyday 365 brand. Most of the private label brands owned by Amazon are in women’s and men’s apparel (we estimate about 46% of SKUs belong to private label apparel brands). AmazonBasics offers a private label option across multiple categories, and we estimate has over 1,000 SKUs available in categories such as electronics, office supplies, automotive, and pet supplies.
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