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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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.
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).
Market sentiment of a global slowdown aside, from a fundamental perspective, we see AMZN as strong as ever. Though sales are slowing to a degree and 4Q18 guidance underwhelmed, the parts of Amazon’s business that are generating higher profits are growing much faster (Subscription services over 50%, AWS over 40%, and advertising well over 100%). Within retail, 3P continues to comprise a higher portion of total units sold, and these sales come with greater profitability than 1P sales, which we believe helped drive North America profitability and reduce International losses. The bottom line is that Amazon is more than compensating for slowing sales with its growth in earnings as well as cash flow. To us, this will only provide Amazon more ammunition to do what it does best: expand offerings to its consumers in terms of products and convenience or disrupt new sectors to fuel the growth engine. The upcoming holiday season will be cutthroat at retail (frankly, it always is), but this year we think Amazon will be able to use its newfound profitability and a fully integrated Whole Foods to increase promotional activity earlier and drive share. As such, we are reiterating our Outperform rating on AMZN and Market Underweight ratings on Food Retail/Food Producers.
Amazon once again trounced operating income expectations, generating EBIT of $3.7bn and exceeding our estimate ($2.2bn), Consensus ($2.1bn), and guidance ($1.4bn to $2.4bn). Sales were slightly below estimates for the quarter, with North America higher, AWS in-line, and International below (which appears partially driven by calendar shifts). However, guidance for 4Q18 fell short, with sales guidance of $66.5bn to $72.5bn (vs. our $74.8bn and Consensus of $73.8bn) and EBIT guidance of $2.1bn to $3.6bn (vs. our $3.8bn and the Street’s $3.9bn).
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.
After substantially raising its minimum wage to $15/hour for all U.S. employees November 1st, Amazon came under pressure to do more for workers that were already being paid above that level. In response, Amazon is increasing the promised wage hike to workers making above $15/hour from $1 to $1.25. In our opinion, this was a necessary step to retain key workers ahead of the holiday season. Our research would also suggest that Amazon’s decision to raise wages will have implications for other retailers, as labor availability going into the holidays is likely to be an issue (see our note Mo Money, Mo Problems). As the competition for low-skilled labor gets even more intense, we believe the recent wage hikes are a significant move by Amazon to attract employees and puts competition under pressure to raise wages faster than expected, likely further pressuring operating margins. For Amazon, which has seen its equity drop with the market over the last week or so, we see only limited financial implications, as its EBIT will likely continue to grow rapidly due to profits from AWS, advertising and fees. As such, we are strongly reiterating our outperform rating and $2,350 price target.
Today(10/11/18), BJ’s announced its “Welcome One and All” free event running from 10/15/18 through 11/4/18, which allows anyone to shop at BJ’s without a membership and with no fee or commitment. Shoppers can also sign up for a free three-month trial membership or join for $25 (normally $55) with a commitment to auto renewal. Shoppers who sign up during this time will also receive a single free same-day delivery order.
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.
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