Conclusion: The cadence of earnings growth in 2015 is more critical to retail than we’ve seen in a long time. We constructed a bottom-up financial model of key players in the industry to plan a quarterly playbook. The punchline is that near-term, Retail still has a quarter of opacity left which will keep names like KSS trading at seemingly ridiculous multiples -- but the clock is ticking. By quarter; 1Q is a slamdunk, 2Q should show the real (i.e. less favorable) earnings power of the group, and 3Q/4Q should show accelerating cost pressures on top of tough margin and working capital compares – which will pressure growth and returns. All in, we’re looking at mid-teens earnings growth today slowing to perhaps 300-400bp by year end (and all of that 300-400bp is driven by today’s financial engineering that will carry throughout the year).
Names To Own: RH, KATE, (and less enthusiastically) WWW. Also KORS, NKE, RL, CROX, MW, ANF, VNCE on our Bench.
Names To Short: KSS, HIBB, FL, JCP, TGT, M. Bench names include: WSM, GPS, DKS W, CRI, GES
Expectations By Quarter
There should be a meaningful bifurcation in the financial model for the softline brands and retailers as 2015 progresses – more different than we could recall in recent memory.
- 1Q: Specifically, the growth algorithm in 1Q15 should be simply outstanding -- a tenet that few people (and a 22x multiple for retail) would debate. We’re looking at easy margin compares on top of trough working capital headed into the quarter, which is very bullish for gross margins.
- 2Q: Growth normalizes – this should be the most ‘normal’ of all the quarters through the year. If you want to see what a company like KSS, M or RL is really capable of, this should be it (we can’t wait). It should also be a quarter where reported earnings growth decelerates by at least 500bp to the high single digits.
- 3Q: Margins get difficult due to higher wages (thanks to WMT) and pressure to offer free shipping (or lower ‘free shipping’ spending hurdles) during back-to-school. Earnings growth falls to the mid-single digits – half of which comes from financial engineering.
- 4Q: Tough revenue AND margin AND working capital compares at a time when retailers just had a tougher than expected back-to-school should result in a lot of itchy trigger fingers headed into holiday. In what will likely be an extremely promotional holiday – we’ll see ‘free shipping’ as the most commonly used offensive weapon. We think that retailers will opt to hold the line on market share and will view weaker margins as a customer acquisition cost while most components of the retail landscape are dropping the gloves online.
Details Of Our Analysis
In the analysis below, we reconstructed an income statement and balance sheet based on a group of 15 companies that we consider to be representative of the US Softline retail space. Note that quarterly numbers for 2-years are represented on the left side, and the corresponding annual numbers for the past decade are on the right. Here are some key points to consider (each numbered point refers to the corresponding chart in the Exhibit below).
- Sales Slowing, Margins Peaking. 2014 marked the worst top line growth rate in 7-years, and yet the group put up its highest operating margin ever.
- Financial Engineering Taking Place of Margin Expansion. EPS grew at 9.8% last year, the first time it was not double-digits since 2009. Maybe a more appropriate way to look at it is that we had our big earnings recovery year in 2010 (45% growth), then two very strong years of low-20s growth in ‘11/’12, and then growth was roughly cut in half again to around 10% for ‘13/’14. The interesting thing to us is that sales grew 5.5% last year, and margins were about flat at peak levels hit in 2013, but yet earnings grew at nearly 10%. Taxes helped by about half a point, but the major delta came from financial engineering – most notably in stock buyback.
- One More Quarter Left… Looking at things on more of a near-term basis…we see that the group grew at a mid-teens rate in the quarter just reported. Respectable by any stretch, but this comped against a mere 1.3% growth rate in 4Q13. In fact, on a 2-year run-rate, this represented the second 300bp sequential decline in earnings growth. The good news for retail is that the market could probably care less about a 2-year run rate. It’s looking at one more quarter of very easy earnings compares. 1Q14 sales were up about 5%, which is fine. But margins were down 60bp y/y which is huge for such a big group of companies, and drove 1.3% growth in earnings in 1Q14. The bad news is that starting in 2Q, the group goes up against a mid-teens comp – and numbers look consistently tough throughout the year.
- Working Capital Looks Unusually Good. Point number 4 below shows how working capital trended down as a percent of sales so meaningfully throughout 2014. That definitely helped merchandise margins overall, and sets up 1Q to look especially good – especially in conjunction with the weak margins we saw in 1Q or last year.
- WC looks good for the quarter, but not much room left for the year. The point here is that working capital as a percent of sales is sitting at a 5-year trough. If it goes any lower it will need to come by way of inventories. That’s possible. But we think it’s unlikely while everyone is building out e-commerce operations. To that end, capex as a percent of sales has been climbing year after year since it washed out to 2.3% of sales in 2009. Now it’s sitting at historical peak levels of 3.9%. Our bet is that when we tabulate 2015 numbers, we’ll see that the group broke through the 4% mark – perhaps by as much as 20 or 30bps. We have to look back to 2010 to find a period where so many companies are taking up capex so materially.
Something To Keep In Mind as it Relates to Margins
Aside from the ‘tough compares’ argument (which is usually thin on its own), there are other factors that we think will temper margins in 2H. Those are a) wages and b) shipping.
a) We all know how Wal-Mart announced that it is taking up wages by 40% for its store-level employees. Target has since increased wages, and we think other retailers will follow. So many retailers seem to have blown this off thinking that it’s really not a big deal, but rather a WMT PR stunt that won’t affect them. It may be a stunt, but when the biggest retailer in the world raises wages by $1,800 per employee, it is a big deal for everybody. We’ve heard half a dozen CEO’s say “We already pay above minimum wage, so it’s not a big deal.” Or in Kohls’ case, “Our employees love to work, so we don’t have to pay them more.” We understand that the companies can’t negotiate wage increases with employees through Wall-Street conference calls. But there will be an impact to almost everyone who sells to the low/mid-level consumer. The reason why we haven’t seen it yet is because we’re now at a seasonal lull for retail. By July, retailers will start beefing up temporary workforce ranks for ‘Back to School’ and then they kick it up a notch again in October as they prepare for Holiday. With the exception of grocery retailers, they ALL follow that pattern. That’s precisely when we’ll see the biggest wage pressure.
b) The other big issue is ‘free shipping’. Target went ‘free shipping’ last holiday, and just cut its free shipping threshold in half to $25. We suspect that it will go Free again this year, and would not be surprised in the least to see several other retailers use this as an offensive weapon. Unfortunately, for almost everybody except the bullet-proof content-owners of the world (i.e. Nike) such a move will be dilutive to margins. Even worse news is that if they don’t play ball, then there’s risk to the top line (i.e. if either KSS or JCP opts-in to the free-shipping game, they both lose). We still think that by the end of FY16, all of retail will be 100% Free Shipping, 100% of the Time.
Other Considerations On the Group
6. SIGMA Looks Outstanding. This is exactly what we’d expect to see given the easy margin compares and solid working capital trends outlined above. As a reminder, this analysis triangulates sales, inventories and margins, and has a 0.92x r-squared with stock movements of the underlying security. In this instance, the Retail Softlines group is sitting in the upper right quadrant – Quadrant 1 – which we call the Sweet Spot. Simply put, sales are growing faster than inventories, and margins are expanding. It really does not get better – unless it happens again, and again. We think we’ll get one more move higher into the upper right. After that, any possible move results in the group trading lower.
7. The RNOA Map Is Really Peaky. Think of this analysis as a longer-term SIGMA. Margins are on the Y Axis, and Operating Asset Turns are on the X. It’s like a SIGMA including all elements of working capital and capex instead of just inventories. When we see a stock or index trading at new highs, we expect its’ RNOA Map to look precisely like it does below. Moving up and to the right. Could we see improvement in asset turns from here? It’s unlikely given that working capital is already troughing, and we’re seeing capex trend higher in 2015. In that case, could we at least see margins head higher? Again, we don’t think so…especially with the cost pressures emerging in the back half.
8. RNOA. The components of RNOA broken in #7 matters most to us. But the simple math is that you multiply tax adjusted margins by operating asset turns to arrive at RNOA. If a company has 6% margins and 3x asset turns, it results in 18% RNOA. The group is sitting pretty today at about 28%. We’ll be surprised to see this group above 28% (and even above 27%) at the end of this year. We think that both margins and asset turns will start to go the wrong way.
Companies Included: CRI, DDS, DKS, FL, GPS, JWN, KSS, M, NKE, PVH, RL, ROST, TJX, VFC, WWW
Hedgeye Retail Idea Summary