Look past the good numbers that some companies are printing. Financial metrics are turning the wrong way. Shorts: JCP, HBI, GIL, M, COH. Longs: WMT, TGT, NKE, LIZ.
With the end in sight for Retail earnings season, let’s step back and take a look at its financial health. Many will argue that numbers were good overall, and they’re right. Companies like Wal-Mart and Target (names we like) definitely showed up to play the game. But as we’ve been saying, we don’t like the deviation between the different companies in the space (HD/LOW, KSS/JCP, JWN/SKS, to name a few). In looking back through history, such volatility has always preceded a big move up or down in the space. I bet down.
1) Take a look at this consolidated SIGMA chart for the apparel/footwear supply chain. Any way you cut it, this is simply bad. The sales/inventory spread has been drifting down for five quarters now, and is sitting today at -25%. Yes, I realize that this is needed for the industry to catch up on 3+ years of unsustainably low inventory levels. But the fact remains that Gross Margins are near peak for the space. Also, we’re facing a dynamic where the better companies ordered 10% fewer units and realized close to 10% higher prices. Mark my words, given the fragmentation of this business, many companies will have the mindset that says “Hey, if I sold X units at a 10% higher price, I bet that next season I can sell X+5% at the same price or higher.” Add on the fact that cotton prices are off so dramatically over the past few months, and this is luring the industry into a false sense of security. That’s bad.
2) Let’s look at the simple sales trajectory for the space. Q1 through Q3 of last year grew steadily between 7-8%, but then in the three quarters since, we saw a definite step-up. While it might only be by 200bp on a yy basis, the more appropriate way to look at this is on a 2-year run rate. That’s where it gets scary. We had sub 1% growth in 1Q and 2Q of last year, then we moved to 3%, and for the last three quarters (ending 2Q12) we’re had a range of 7-9%. In other words, top line compares start to get much tougher 1 quarter out. That’s not horrible if inventories are tight and margin compares are easy. But it simply is not the case.
3) When we delineate the companies we track by SIGMA quadrant and track their respective movement from 1Q, there was a disproportionate shift of companies out of the sweet spot (sales/inv spread positive and margins up) to the Danger Zone (sales/inv spread and margins both down). That’s not horrible if the market has already recognized it. But the market hasn’t. In addition, unlike quadrants 2 and 4 of our grid – which are transitory and usually house a company for 2 quarters or less – a company can be in quadrant 3 for a multiple of that. Note: companies like Sears, K-Mart and Foot Locker lived there for the better part of a decade.
Brian P. McGough