Another Reason to Be Bearish Retail. First off, a stunningly bearish chart – courtesy of Josh Steiner and our Housing team – that shows how the median after tax income level for US consumers is converging at a simply astonishing rate with the median monthly mortgage payment. We haven’t seen this level of compression between the two metrics since 1989. But it’s not just the level at which the two are converging – it’s the speed. This leaves a lot to be desired for anyone bullish on consumption over the next 2-3 quarters. The risk to multiple quarters of comping down with margins going negative is simply not in the Street's estimates -- with very few exceptions. As it relates to charts that show why we’re so outright bearish on retail, this one definitely makes the top three. Again, broken record time, we think we have line of sight to get ragingly bullish on retail, but not until we see misses in 4Q and FY23 guide downs that are 2-3x what even the average bear is thinking.
Floor & Décor Holdings (FND) | FND Added to Short list. FND is unique model with a large box fully dedicated to flooring and tile driving scale in a direct sourcing model creating a pricing advantage & differentiated offering. The flooring segment carries secular tailwinds as the continued turnover of existing homes often means a changeover to or renovation of hard surface flooring from the preferred soft carpeting of 20+ years ago, particularly as the millennial generation wave approaches the core home buying ages of low to mid 30s. The company leverages Pro relationships in what is a high DIFM business to gain share given no large scale competitors are as dedicated to this segment of home improvement. Still relatively young as a national retailer the company has a big square footage growth and share opportunity longer term. All in, this is actually a stock we’d be interested in owning longer term, but not right now. The problem is the PCE category with the highest slope and r^2 to home prices is carpet and floor coverings. The nature of the FND business is heavily project based, projects done often before a home sale, after a home purchase, or as part of refinancing to reinvest in the home. All of those demand drivers are severely under pressure at the moment as rising rates and inflation pressure the consumer wallet and the housing market demand. We see forward EPS downside risk to ~$2.40 (Street at $3.40 next year) and stock downside risk to $40 to $50 vs its current $67. We would look to own this on the other end of this housing price drop, but not yet.
Home Depot (HD) and Lowe’s (LOW) added to Short list. These are the juggernauts home improvement. Both carry a great consumer value proposition as one stop shop for everything home and garden while leveraging scale to provide good pricing on good quality products to meet homeowner or professional needs. The diversified assortment is an advantage in the current environment as larger home projects might be under pressure due to interest rates the consumer still returns for more seasonal items like holiday decorations and gifting while continuing to stock up necessities for each season, like shovels and rock salt for the coming winter.
HD is the best operator in the home improvement space – not a shocker to anyone watching the space. Pro exposure is both an asset and risk depending on the trajectory of the home/reno market. Pro’s will buy even when consumers might feel the inflation pinch, though rates are definitely going to be pressuring larger Pro facilitated home reno projects. The reason HD is being added short side is that expectations are too high, and not priced into the stock given the risk we see in the US housing market. In the last recession HD comped down for 14 straight quarters, yet the street doesn’t have a single down Q in its model. At ~17x street, the multiple is far from trough and current short interest sub 1% is far from peak. We could see the most rapid demand pressure ever in the space over 6 to 12 months which we think is not priced in and not in earnings expectations. We think you have about mid teens percentage risk to EPS expectations in 2023 and a 3-4 turns in PE multiple suggesting 40% downside risk.
LOW is like the “little brother to HD” as the models are generally very similar but LOW has never quite been able to match HDs execution and profitability in the past though trying to emulate it in many wats. LOW tends to draw in female consumers more, while having a lower penetration of Pro business historically. Trying to drive a sustainably better Pro business has been a goal of LOW for several years now, and its making progress on the margin investing in inventory availability. Driving higher sales productivity is the key to the bull case of margin expansion to close the gap with HD, and the Pro business is a critical piece to the productivity puzzle. LOW generally has higher sensitivity to consumer discretionary income driving more volatility in comps given the lower Pro penetration, which a risk in coming quarters as we think this US consumer wallet will continue to see pressure. Much like HD, consensus doesn’t have negative comps (other than -0.2% in 4Q22) in the forecast, despite over consumption and elevated prices in the core categories. Recent outsized leverage of SG&A at LOW is not what we want to see as it relates to forward revenue and margin expansion opportunity. Multiple looks a little ‘troughier’ than HD, but we see more earnings risk here as well close to 20% vs the consensus. That makes for about 30-40% downside risk.
Here are some key slides from our Home Retail deep dive this week that highlight the risk to demand in the home improvement space.
