The bull narrative on retail has become freight. Everyone knows that freight and corresponding supply chain issues have been a huge headwind to margins since early 2021. We’re hearing it come up in investor conversations more and more as a reason to be bullish on 2023 earnings. Much like bigger tax refunds in the spring, we suspect Old Wall Analysts (steered by management teams) are writing about a recovery opportunity. It makes logical sense as we have seen spot rates fall far below the highs, though still well ahead of 2019. We’re initially very skeptical about this being an earnings savior over the next 12 months in what we think will be one of the worst earnings environments retail has seen in at least a decade, if not a generation. We decided to put some numbers around the opportunity/risk on freight and retail margins. The punchline is that the consumer absorbed the majority of the freight headwind over the past two years in the form of higher prices. Gross margin expectations are up and accelerating over the next two years – using softgoods as an example. We ‘get it’ that freight pressures will ease in FY23 and FY24, but think that this will be overshadowed by increased promotional cadence and lower merchandising margins, and when netting it all out, gross margins will head lower, not higher. In other words, the consensus remains too bullish on Gross Margins, despite freight costs coming down. This ‘freight tailwind’ narrative should be faded – at least until we think management teams ‘kitchen sink’ guides when the consumer dries up in 1Q23.
We are running the math in softlines for illustration. In both cases here, a unit of clothing and a pair of shoes, the estimated percentage of sales for transport is ~2%. Obviously it varies depending on price point and level/type of transport required for a good.
Rate fluctuations have varied significantly between the various modes of transport, so we grabbed data to establish a dollar share by mode for that “2%” of sales that is transport.
These are the indices (yy change graphed below) that we used to assess the prices changes. Ocean saw the biggest change by far.
We then assess the 2019 to peak (late 2021 to spring 2022 depending on the mode), 2019 to now, and peak to now for each of the different modes. Weighting them by their percentage of transport we get to a weighted average impact on transport costs, and we then applied that back to our average unit economics to estimate the margin impact per unit from freight on the full softlines supply chain. At peak it is about 500bps of pressure, currently 185bps, suggesting a tailwind from the peak of 316bps. The margin pressure can be taken by any part of the chain post-import, i.e. brands, retailers, or the consumer. The next slide suggests the consumer ate most if not all of it.
Despite the big margin headwind implied by freight, the gross margins for pretty much every retailer we analyze were up in 2021, in many cases up big time. Sure there were higher revs so companies saw fixed cost and occupancy leverage, but as we breakdown the detail of specific retail margins, we are seeing the most common and most powerful margin driver was the implied merchandise margin with an absence of promotions and clearance while demand exceed supply and prices rose. Retail was very inflationary, even categories like apparel that are historically deflationary over the long term. We don’t see how the excess margin can be kept as the consumer weakens, inventories rise, and demand falls far short of supply with piles of excess inventory in the retail chain. The margin tailwind from freight may very well be real, but just as the opportunistic selling environment created margin expansion despite the freight problem, the challenging and promotional environment of the next 12 months will likely be one that gives back any freight tailwind and then some.
