This custom model provides a template for calculating the impact of a 25% tariff on goods from China imported into the U.S. including average unit cost increase, margin hit in basis points, earnings reduction and average unit retail necessary to offset tariff impact.
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Use our Tariff QuikCalc Model (click here) to quickly calculate the impact to a retailer's cost, margins, earnings, and, most importantly, to determine the percent increase in prices needed to offset the tariff. We have done this work for our coverage universe, but this is only a small sample of the retailers, vendors, and manufacturers impacted. Therefore, we developed a "quick and dirty" model to give you a general sense of the impact. For the average specialty retailer, we estimate an average unit cost increase of 4.2%, which if entirely unmitigated through price increases results in an average earnings reduction of 35%. The average unit price increase necessary to offset the higher tariff is 2.1%.
The April reading was the fourth consecutive month at 1 or the worst score possible. In April, 50% of retailers posted a short position >15% (up from 47.8% in March). We note the percentage of retailers with a short position over 15% continues to increase month-over-month. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
During 4Q18, inventory risk continued to increase as sector inventory grew at a faster rate than sales. Given a macro backdrop that is no longer fueled by tax stimulus, we believe this is harbinger of margin pressure in FY19. Note that this is a snapshot entering 1Q19, so any top-line weakness in 1Q will result in even greater inventory excess. We expect this inventory risk to build progressively throughout FY19 as retailers try to “comp the comp” but lack pricing power and must simply drive unit volume to deliver positive comps. Simply put, sector wide business and performance risk has materially increased.
Although we believe RH has superior brand equity, differentiated product, and can avoid operating deleverage due to their flexible operating model, we believe the weakening housing backdrop and stock market volatility will continue to negatively impact financial results. As a result of this macro backdrop, the company lowered their FY19 guidance, partly due to a ($0.36) impact from ASC 842. In addition, despite the company reiterating their long-term guidance of revenue growth of 8%-12%, adjusted operating margins in the mid-to-high teens and adjusted earnings growth of 15%-20%, we view the housing and volatile stock market backdrops as skewed to downside (despite the stock market rebound year-to-date). For these reasons, we are moving to the sidelines and downgrading to Peer Perform from Outperform.
Heading into RH earnings, we want to point out the impact of the implementation of Accounting Standard Change 842 – Lease Accounting (“ASC 842”). For most retailers this change has little to no impact on the income statement. However, RH has a portion of build-to-suit leases which ASC 842 eliminates and therefore has a direct impact on the income statement. While this change does not impact EPS, it is a reclassification of build-to-suit interest expense to the rent line in COGS. As such, we estimate ~100 bps reduction on both GM and OM, offset by a roughly $28 million reduction in interest expense. Per RH’s 10-K, “certain of our store leases are accounted for as build-to-suit lease transactions which result in our recording a portion of our rent payments under these agreements in interest expense on the consolidated statements of income.” Please see Exhibit 3 for detailed analysis on the ASC 842 impact. RH will report 4Q18 earnings after market close on 3/28/19; dial in (866) 394-6658.
The January reading plummeted, falling two rankings from December’s reading of 3/10, suggesting investors started re-shorting stocks during the January rally after being sidelined at year end. In January 45.7% of retailers posted a short position >15% (up from 39.1% in December). Since we last published this report on 12/17/18, the XRT is up 1% vs. the S&P 500 +4%. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
Heightened supply risk for 2019. During 3Q18, retailers took a turn for the worse, as inventory increased modestly at a faster rate than sales. With no ability to raise prices to drive comp, retailers must rely on increased unit volume to drive sales growth. Note that this is a snapshot entering 4Q18. Most results, save for a few exceptions (e.g., TGT – PP, COST – PP, covered by Scott Mushkin, and LULU-OP), have missed holiday sales. We expect inventory exiting 4Q18 to show even higher inventory-related business risk.
The December reading rose for the second consecutive month, suggesting with valuations pulling in short sellers may be derisking. The November reading was 2 out of 10. In December 39.1% of retailers posted a short position >15% (was 42.2% in November). Since we last published this report on 12/17/18, the XRT is up 6% vs. the S&P 500 +2%. We rank Sector Sentiment on a scale of “1” being the most negative sentiment to “10” being the most positive sentiment. The basis for the ranking is based on the number of retailers in the sector with >15% short positions.
We believe 2018 may have been “peak season” for retailers. We continue to believe in the Retail Death Curve phenomenon. The 2018 lift in mall traffic was against easy compares and pent-up demand. Despite clean inventory in 2018, there was no evidence of broad-based pricing power. Retailers were as, if not more, promotional than prior year and “bought the comp.” Tax reform savings were reinvested in store-related wages and deferred capital spending – both contributing to a higher fixed cost infrastructure than before tax reform – adding to greater deleverage risk.
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