Great Numbers. Don't Get Used To It.

Not much negative to say about today’s sales numbers.  Even though we can say “yeah, everybody was expecting June to be great,” the fact of the matter is that retail is trading up nearly 3x the rest of the market.  

On one hand, we need to look back to May, where the number of misses outweighed the number of beats by a factor of 2 to 1. With that, we’d argue that company-set expectations were on the low side. But on the flip side, we cannot ignore the fact that actual sales activity (which could care less about expectations) accelerated on a 1, 2 and 3-year basis.

Staying true to our process, anytime we get new datapoints we need to go back, challenge and stress test our thesis. That thesis – which we’ve been quite vocal about – is that margins will be down 4.5 points for the industry for 2H11 into 2012, and that this is not represented in estimates.  

When all is said and done, our answer is that there’s no change to our thesis. We’re still negative on this group, and as more bears throw in the towel, we think that it’s a better shot to short bad businesses at better prices.

Why? As we outline below (our Retail Fuel note from Tuesday), 2H10 saw a meaningful improvement in the Consumer’s bill of health (not cured, but out of the ICU). Average weekly earnings rose materially, unemployment – though still high -- posted a 150bp improvement in its delta. And despite the fact that raw material prices were going ballistic, it wasn’t represented in the price of the product that we buy at the mall or online. In 2H11, we’re unlikely to see the same improvement in unemployment – in fact the yy delta has started to erode. Inventories at retail are rising out of necessity, as retailers simply cannot grow their respective top lines anymore after 3 years of taking down inventories to unsustainable levels. Most importantly, these inventories will represent the raw material costs we started to see in 4Q of last year.  Are there companies who are ‘locked in’ at better prices? Yes. But that’s the most common rebuttal I hear about our JCP call. Margins have two components, my friends. When a company thinks that they’re ok because of certainty on the cost side, that’s when we should worry. Costs are manageable. Lower demand, stiffer competition, and forced promotional activity to clear inventories are not. With 9 out of 10 earnings misses, it is the latter that spurs the guide-down.

SSS Callouts: 

• The higher-end luxury stores continue to outperform. Within the department stores, JCP +2%, SSI +1.8%, and BONT -0.9% underperformed the higher-end with Neimans up +12.5%, Saks +11.9%, JWN +7.9%, M +6.7%.
• Discounters were again the strongest performing segment of retail for the fifth consecutive month as expected against easier compares on a relative basis a trend that reverses in July. Additionally, the 2-year trends by channel reflect a significant contraction in the performance spread suggesting that the value gap present in recent months may be deteriorating putting significant pressure on margins in the process.
• JCP was the clear negative callout coming in below expectations. While the rest of the retail reported strong June sales, JCP cited a softer environment resulting in higher promotional activity. Brand highlights were scant for the second consecutive month with Sephora the key callout and a mention of Liz Claiborne as a strong driver in women’s apparel. Internet sales continue to slow sequentially to 2.2% from 2.8% in May. Inventories remain a primary callout. After failing to mention inventories altogether last month, the company noted levels are “appropriate for expected sales trends,” a comment that holds little credibility made in the same month the company just missed expectations.
• Category performance shifted towards a higher propensity for discretionary spending in the quarter with more retailers highlighting jewelry and accessories (SKS, JCP, COST, SSI, ROST, KSS). Consistent with last month, grocery/food was highlighted as the top performing category at both COST and TGT in addition to positive mention at BJs. Women’s apparel (JCP, COST, ROST, KSS, TJX) was another particularly strong category during June.
• TGT was one of the standouts in June coming in well above expectations with comps accelerating on both a 1yr and 2yr basis driven by continued strength in the critical grocery category. We continue to expect a reacceleration in the top-line over the next 12-months. The sole question mark for us revolves around how much of this is driven by the 5% Rewards program, or an increased shift to consumables (P-Fresh). Fortunately, the extreme bearishness we come across on the Street is thinking the same. After being negative on TGT for most of the past year, we continue to incrementally warm up to it.
• COST confirmed that inflation continues to creep higher with both fresh foods and food and sundries both now up in the MSD range. Gas also contributed just over +3% and +3.8% to SSS for both COST and BJ respectively. Our view is that this will continue to add to the pain as the retailers choose to capture consumables inflation costs at the expense of discretionary product margins. (i.e can’t take up price on milk, eggs, and chicken – so look to extract margin in categories like underwear, shirts, toys, etc…).
• Weekly trends were largely positive across all five weeks with few individual callouts. Due to the timing of Independence Day, which added an extra selling day COST highlighted a 2%-3% benefit in June and the expectation for a negative 3%-4% impact in July.
• On a regional basis, results were consistently strong across the Northeast (GPS, Neiman, TJX, KSS, JCP) and Southeast (BJ, Neiman, SSI, COST, JWN) with Texas receiving several callouts alone from ROST, COST, and Neimans. Similar to last month, the Midwest was the most varied with TGT, KSS, SSI, and COST noting stronger sales while GPS and TJX highlighted weaker trends likely driven by specific geographic exposure to floods and tornadoes that occurred in June.

"Retail Fuel" (7/5/11)

For further context, here's our note from Tuesday:

Before looking forward, let’s set the context as to where we stand today, and what we’ve been fed over the past year at a Macro level.  

As important as things like weather and calendar shifts are, let’s start off with a couple of bigger picture points about the Macro climate ‘then versus now.’

1. Gross Personal Income was running at about 2.5% compared to about 4.5% today. That’s a function of slightly lower unemployment and marginally higher nominal wage. (positive point)
2. The two main levers that account for the delta between Gross Income and Personal Consumption pretty much wash each other out.
   1. The consolidated personal tax rate has risen above 10% vs 9.1% this time last year. (negative point)
   2. The personal savings rate, which had been running at 6.1%, has since trended back to 5%.
3. When we look at what we call ‘essential spending’ (food, energy, healthcare), we’ve seen growth go from 2.6% last year up in nearly a straight line to around 4.3% today.
4. All that’s left goes into the ‘discretionary spend’ bucket which is far more volatile.  This stood at a healthy 7.5% a year-ago – a level that remains today (at least for now).
5. Based on our read out of POS data (NPD, SportscanINFO), sales for the month of June were pretty much middle of the road. Apparel decelerated over the course of the month, albeit still positive. Footwear unit growth accelerated, though it the direct result of slightly lower price points. Overall there are nit picks here and there, but the trend overall is unremarkable.

What’s Next?

1. We think that sales day will be another domino to tip as it relates to giving additional datapoints to the Street about margin weakness – especially as it relates to earnings season beginning for the vendors in 2 weeks. This has been our call (4.5 Below – 450bos of margin weakness beginning in 2H) and we’re sticking with it.
2. The consumer’s top line – believe it or not – strengthened materially beginning in July of last year. Personal income growth accelerated over 3% -- -and hasn’t looked back. Now we go against that in 2H. Perhaps it stays at that level. But our point is that the yy delta helped out so many in retail – and that’s no longer there.
3. Could we get a few bps of tax relief to buoy spending? Maybe. But not over 100bp. It’s simply not there – even with the political calendar heating up.
4. Is the consumer going to draw the personal savings rate back down to 2-3% to free up a few points of spending? It’s possible – especially given US consumer spending habits. This is the biggest area where we could be wrong with our call in 2H. But that will make the setup for 1H12 very grim – i.e. low taxes, trough savings rate, with interest rates nowhere to go but up. That’s the ultimate defensive position for the consumer.
5. Check out the weekly average earnings chart below. There was a whole lot of nothing until May 2010, until growth accelerated meaningfully – peaking in October, and remained at healthy levels throughout year-end. We’ve got to comp against this.

MIND THE LAG!!!

We all know that ‘the cotton trade is dead.’ That’s been the consensus for 7 months now. But we still think that the ‘earnings trade’ is very much alive. Remember that cotton, oil and other raw materials generally have a 9-12 month lead time. That means that what is selling today was procured last summer/early fall of last year. That’s precisely when costs started their precipitous ascent. We’ll have to deal with this for the next year at a minimum. Likely longer. We still don’t think we’re looking at a recovery until 2013 in this space.