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State of the Industry: Beware the Sucker Punch

Step 1 was ‘State of the Consumer.’ Step 2 is ‘State of the Industry,’ which is outlined herein. Step 3 is nailing who wins, and flushing out my list of who goes bankrupt. That one is growing.

From an industry standpoint, the conclusion is that looking forward, the year/year trajectory in sales and margins might start to look like an intriguing ‘Trade,’ but tread lightly as the ‘Trend’ is headed lower, and does not synch with the consensus 40bp improvement in margins next year. Let’s look at the key profitability components…

Revenue: In aggregating the top line the industry is still humming at about +5% vs. last year – despite a sharp sequential deceleration. Comp store sales are running down low-single digits, but yy compares don’t start to get easier until December, and then more meaningfully so in June. That might be good under most circumstances, but go back and read my ‘State of the Consumer’ postings. This is precisely the point when the yy delta in spending for the consumer in aggregate will intensify. My point? Don’t get suckered into the ‘comps are getting easier’ argument.

EBIT Margin: Margins troughed in 1Q, and while still off -175bp vs. last year, they are clearly ‘less bad’. That’s good at face value given that margins drive stocks in this group. But there are two factors we cannot ignore. 1) Working capital in this industry is at its lowest level in 8-years. There’s not enough working capital to drive operating profit growth even if the consumer did rebound. Historically, higher margins on top of normal working capital levels resulted in a meaningful pop in growth. It’s very difficult to get the math to make that work today. 2) Margins are still sitting at 8-9% overall – right in line with where they were before margins raced higher in ’04-’07. No reason why they can’t go lower. In fact, they will.

Lastly, the SIGMA chart below ties it all together (triangulating sales growth and inventory growth on the vertical axis, with the change in gross margin on the horizontal). The picture this paints is one that has been healthy over the past 1.5 years – especially the last 3 quarters. My sense is that we’ll see this trajectory head down and to the left. Never a good event, and one that clearly does not synch with the consensus expectation for margins to head higher by 40bp.