For the most part, TGT and KSS were the poster children for what we have seen in retail broadly this reporting season… revenue decelerating -- was not as good as expected/needed, with gross margins disappointing and/or being signaled to not get better, while inventories building on the margin – setting the stage for a tougher Gross Profit picture in 4Q. A move toward Quad 4 of our SIGMA model (margins under pressure with inventories building) – which most retailers did – is invariably bad for the stocks.
The Apocalypse Was Always There…The Market Just Looked Through It
For TGT and KSS, it’s important to note that the slowdown in comps was all due to slowing Brick & Mortar performance. E-commerce growth was similar or better than 2Q.
Both companies commented that weakness around gross margins was at least partially driven by the strong ecommerce/digital growth. That syncs with comments for much of retail so far.
So what happens to margins when topline slows and higher portions of growth are coming from ecommerce… the “Retail Apocalypse” returns? Did it ever go away? The structural issues have always been there.
We have to take you back to our “Apocalypse Now” chart (below) from our Black Book in June – the same book that outlined our call for a Fall selloff in the group. The whole premise of this analysis was to demonstrate how the consumer acceleration from mid-2017 to mid-2018 had an outsized benefit to B&M vs online. That meant more high margin sales for retailers. If the consumer slows, that B&M benefit reverses, and then some. That’s exactly what we’re seeing today. Now the incremental sales are much more heavily driven by ecommerce, which means much worse incremental gross margins than we saw this year. Tack on that the slowdown would be happening with all of retail sitting on higher inventories after planning for a big holiday (TGT’s inventory is up 17%, and it has its worst sales/inventory spread in over a decade – this is Quad4 of our SIGMA model. See charts above).
*Future estimates for chart assume 2 year average for total retail (ex food gas and auto) is steady, and the 2 year average for ecommerce (proxy being non-store retail) is steady.
For a Replay of our Apocalypse Now Black Book: CLICK HERE
4Q 2018 Bearish
4Q set up for KSS and TGT is similar, both are very bearish, except that for KSS revenue is more bearish, and for TGT margins look more bearish. With few exceptions in retail – like Urban Outfitters, which looks stellar on both metrics – at least one of the two is challenged.
Both are facing a very tough 4Q comparison and need to see a meaningful acceleration in the 2 year trend to hit comps, while we expect US macro to slow and the calendar shift to have a clear negative impact.
Inventories are looking worse on the margin for each, and some major competitors are planning price investments, promotions and inventory clearance.
Outlook to 2019 Still Bearish
This isn’t a 4Q only catalyst setup either, top line compares are hard through mid-2019.
And let’s keep the cost pressure in focus. In a year of seeing the consumer just about as healthy as it can be, it looks like KSS will grow EBIT in the LSD range, and TGT will see EBIT down low to mid-single digits. So what could EPS look like if the consumer weakens?
Our Macro team has made the call of Quad4 (both real growth and inflation slowing) in Q4 and the market seems to be pricing that in – or at least getting close with certain names. Perhaps the bigger callout is the current Macro Team outlook (which updates as the data does), is for slowing real growth in the US over the next 4 quarters.
So you have slowing topline, with more ecom margin risk, merch margin risk from higher inventories, and the EPS tax rate tailwind subsiding.
Are there enough levers on SG&A? Probably not for TGT, it’s got 45 cents a share in higher wages baked in each year over the next 2 years, and has continued store investments planned. Maybe KSS has a little room to wiggle, but not enough to avoid earnings declines (for more detail on KSS trend and tail set-up see our note KSS | The Tail Risks Being Ignored at $80: LINK).
What’s the earnings downside for next year?
Our current estimates are on the tables below, but given the retail specific setup and the Macro setup, let’s do a little sensitivity analysis.
TGT – Down 3% store comp, up 25% ecommerce, means down 1% comp. Similar gross margin degradation to 2H18, down 50bps. SG&A up 2%, which could be almost all from wage bump, D&A up 5%.
That’s EPS of $3.70, or down 30%.
KSS – Stores down 2.5%, low teens ecom growth, equals flat comp. Other revenue down 10%. Gross margin finally negative, down 35bps, SG&A up 2%.
That’s EPS of $4, or down 25%
We’re not modeling those numbers yet, but they are well within the range of possibilities.
