Takeaway: Another negative data point on Consumer Credit this morning. Retail's credit risk is much greater than the last cycle.

Retailers are more exposed to credit risk today at the tail end this economic cycle, than ever before in history. That’s a long time. And, it’s not just about slowing consumer demand as the credit quality wanes. We think there are at least 8 companies with underappreciated risk to the credit cycle because of the earnings power associated with private label credit cards (which is recognized as an offset to SG&A). The doomsday scenario happens if we see consumer spending dry up (sales weaken – down 5-10%), gross profit margins are down 3-5 points due to excess inventory, SG&A grows in the high single digits due to credit income (which is booked as an offset to SG&A) eroding. But, in the interim even a reversion from all-time lows (which a number of sources have indicated) dries up the credit tailwind stretching the leverage points on the P&L for a group of companies who are already facing demand constraints on the top line.

The most to lose: Macy’s with 38% of EBIT coming from credit card income. The most at risk: KSS – slightly lower than KSS in EBIT generated from credit card income ~30%, but without the real estate kicker. These two alone have seen EBIT growth of over an 8 year time period (’07-’15) of 12% and -14%, respectively. If we eliminate the credit benefit, the EBIT growth rate for comes down to -8% and -32%, respectively. That’s a 15-20 percentage point benefit from credit expansion alone.

Additional details:

This morning CarMax reported a 7.7% decline in financing income despite an increase in loan receivables year over year. The decline was driven largely by an increased provision for loan losses, which is yet another data point in a string of signals that the consumer credit cycle is inflecting negatively. We highlighted Retail credit in Friday's The Macro Show. For a Replay: CLICK HERE

Trough Credit Risk

We hit all-time lows in charge off rates in 2015, and have seen a gradual increase in charge off rates since. Recent events and commentary have indicated that this is not likely just near term turbulance, but seemingly the end of an expansionary consumer credit cycle. As Hedgeye Financials Co-Sector Head Josh Steiner likes to say, "when the credit cycle turns, it’s like a battleship – once it starts, it doesn’t stop."

Retail | Too Much Credit 2 - 6 21 2016 chart1

Recent Events Signal Inflection

1) In November the Fed's Senior Loan Officer Survey showed that Commercial and Industrial lending inflected to net tightening. Why does this matter? Because ultimately credit easing = economic expansion and credit tightening = economic contraction. The 1Q survey showed an inflection in Commercial Real Estate lending to net tightening. Consumer lending had stayed net easing, but continues to trend towards net tightening, as it has since 2011.

2) On the 4Q15 call in February Macy's CFO warned that delinquencies were rising within its credit portfolio.

3) And, most recently, last week Synchrony removed all doubt when management revised guidance to include a higher charge-off rate than previously expected and included commentary suggesting that they are not alone, as the lending industry is over extending itself in credit card, auto finance, and student loan vehicles. And oh by the way, SYF has 22 private label credit cards in its portfolio.

Retail | Too Much Credit 2 - 6 21 2016 chart2

Retailer Credit Exposure - Its Different This Time

The risks associated with an inflection in the credit cycle we believe are still underappreciated because of the exposure that more than a handful of retailers have to the private label credit card business. That leverage looks a lot different than it did 8 years ago at the end of the last economic cycle.

For example, in 2007 credit made up 22% of Macy's EBIT – today it’s 38%.  For Kohl's we estimate credit income made up 11% of EBIT in ’07 – today it’s up to 30%.  That happened at the same time that the Kohl's credit card sales a percent of total sales increased 1700bps, which also leads to topline risk. That translates to serious negative pressure on comps and margins when the retailer who has been driving comp sales through the extension of credit (and to a lesser extent promotion) no longer has that luxury.

Below we have highlighted retailers with high or unique credit exposure. There are undoubtedly others that we will uncover as we continue to get in the weeds.

A few notable callouts:

  • SIG credit sales make up 37% of total sales and 62% of its Sterling division (Kay and Jared). It fully owns the portfolio of $1.85bn in receivables, and will see the full downside of increased default rates.  SIG’s average FICO score is just a bit above the 640 subprime level at 662.
  • JCP just became profitable again on a consolidated basis, with the help of $367mm in Credit EBIT in 2015… a $54mm increase vs 2014.

Retail | Too Much Credit 2 - 6 21 2016 chart3 2