When all is said and done, I think that 2019 will go down as the year where Brick & Mortar pushes back against pure-play online – most notably Amazon – which will ultimately be to the detriment of margins across the board. This is not an overnight phenomenon – as it’s been building for the past two years, but it’s been simply masked by two factors – 1) a multi-year acceleration in US Retail sales, and 2) an 18-month period where incremental dollars broke a long-term trend and accrued particularly to high-margin B&M as opposed to online. In other words, there’s been more than enough growth to go around – and more of that occurred at the (highly profitable) store-level than the consensus thinks, and more than most management teams will admit. If you talk to the CEOs of Walmart and Target, they’ll tell you that leveraging the store as de-facto DC infrastructure while layering on home delivery tops the list of strategic initiatives by a country mile – and we’re seeing the capital deployment back that up. Their mindset isn’t about hitting numbers in a given year – but is about long-term survival in #retail5.0 and should ultimately lead to tempered margins for particular pockets of retail.
To put some numbers behind the premise -- US retailers grew in 2018 by about 4.9%, and that translated to an EBIT decline of near 1% by our numbers (see retail model below in Exhibit 1). Think about that…in a year where we had accelerating sales that accrued to high margin B&M, EBIT still couldn’t find a way to grow – despite the highest top line rate we’ve seen since 2011. The consensus is looking for another 5% top line year in 2019 – we see something closer to 2.5-3% as we take into account our Macro team’s call of Quad4 in 1Q19, followed by 2 quarters of Quad3. Translation, 3 quarters of real US GDP slowing. Naturally, the consensus is also looking for nearly 100% margin protection in that context, with 4% EBIT growth – the highest level in 5-years -- despite a shift we’re already seeing towards margin-dilutive e-commerce, higher input costs, and meaningfully higher wages.
Our model is for EBIT dollars to contract by 5% on 2.5% sales growth – the worst year Retail will have seen in a decade – and a phenomenon that AMZN has never faced in its modern-day state. I’d argue that we already started to see some margin degradation in 2018, but the frothy top line environment protected an otherwise respectable earnings and cash flow stream. Cut growth in half in 2019 and that story changes dramatically. Big retail won’t be playing nice in the sandbox, and I think we see some downward earnings revisions, and perhaps more importantly multiple risk as we cycle accelerating revenue and accelerating gross margin expansion with slowing revenue growth and declining gross margin expansion.
We’re making several changes to our Best Ideas list accordingly…
1. Moving TGT to the top of our Best Ideas Short list. The biggest loser here is Target. We’re getting a taste in 4Q as to how leverage cuts both ways with TGT, as it comps ~5.5% and still likely won’t put up positive EBIT growth. In fact EBIT in 4Q will likely be down 2-4%. On top of that, TGT is the most aggressive retailer with using free shipping as an incremental promotional driver, and is relying on (dilutive) Shipt to accelerate its home delivery initiative – charging $99 per year for an asset-based service that WMT will ultimately employ an outsourced (variable cost) network to do for free. All in, we’re looking at 18% earnings downside for TGT this year and 34% over a TAIL duration. Additionally, the worst macro Quadrant for staple-like multiline retailers like TGT (and WMT) is Quad 3, where we should be for at least 2Q and 3Q 2019.
2. Moving AMZN to Best Idea Short. I know, I know. Amazon is going to take over the world. I get the defendability of AWS, as well as Advertising dollars as an incremental profit driver. But check out my note on the latest quarter below (AMZN | A 70x PE Deserves Better). Growth is slowing as the business model faces a different stage of its maturation curve, and we even saw the likes of TGT challenge it in 4Q with free shipping deals that incrementally pressured AMZN’s GM. In fairness, Gross Margins still went up, and will likely go up again in 2019. But as recently as 2-years ago WalMart and Target could do virtually nothing to derail AMZN’s momentum or even put a ding in its P&L. It’s finally falling subject to at least some competitive forces such that we have to at least consider that this thing called valuation exists, especially in the context of slowing fundamentals. Immediate-term @Hedgeye Risk Range = 1 (bearish). Check out AMZN comments in detail below.
3. Moving WMT to Short Bench. The only reason why I’m not outright short WMT is because it reset the earnings bar by $0.30ps to account for dilution associated with its Flipkart (India) acquisition. The business model can, and likely will, absorb slowdown/margin pain in the US and the company will simply blame it on Flipkart dilution – for which the market has already given the company a free pass. On top of that, I think that WMT will destroy Target as it relates to leveraging the store experience to merge on-line and B&M sales. To be clear, it is likely to be less profitable given extra headcount needed to fulfill orders in store, and should be a drain on inventory/working capital and capex. But WMT is at least on offense as it relates to disrupting the industry. Putting it near the top of Short Bench (just behind Wayfair) pending the 4Q release, which I think looks fine.
AMZN | A 70X PE DESERVES BETTER
Takeaway: If this is valued on earnings – the same earnings that the Street thinks will hit $40/share in 2-years, then it’s a short at $1,719.
At face value, this was a great quarter for a company in the business of retail. Sales +20%, gross profit +26% and EBIT +78%. Could we really ask for anything better? When your name is Amazon, the answer is a resounding “Yes”. Maybe the law of large numbers is starting to catch up…maybe there’s something company-specific (note – physical store strategy is #failing), or maybe it’s just grown too large to escape Mr. Macro…but the fact of the matter is that any way you slice it, growth is slowing at Amazon. The company can talk all it wants about Global Prime member adds and a record number of Alexa devices sold…ultimately I like to look at numbers. And the numbers tell me that this company has grown by 27% over the past 12 quarters, and it just squeaked by with a 20% top line growth rate. I know that’s a petty sacrilege given that we’re talking about the vaunted Amazon, but the fact is that we just saw a meaningful underlying slowdown in the business – and this stock still trades at a 70x multiple.
I get the whole ‘let’s DCF a game-changing business model’ thing…but in days of old a PM could trade this name based on an EV/Sales multiple on some theoretical/made up earnings number, and actually justify that to investors. The lack of earnings was actually an asset if you owned the stock. But let’s all acknowledge that this theoretical story has evolved into a ‘real’ company -- one with real earnings power. Yes… in 2019 it’s likely going to put up a better operating margin than Target. Let’s give Bezos all the credit in the world here. He got it done. But now that it’s done, lets appropriately value what we’ve got – and appreciate that rate of change matters.
In other words, the emergence of a ‘real’ company means that at some point sooner than later, we have to value it like a real company. In this quarter we saw underlying growth slow by 300bps ex Whole Foods, Gross Margins disappoint, and SG&A made up all of the beat. If this were some #oldretail name like WalMart or Target I’d be beating the company up for that. Fulfillment SG&A growth slowed to 12%, which appears to be the lowest EVER, from 29% last Q, leveraging 100bps. The growth compare was easier but the slowdown seems odd given the fact that Amazon’s min wage went to $15 on Nov 1, which I would think would mainly impact fulfillment (which includes the employees within DCs and Whole Foods). Seemingly a minor detail in the context of a generational growth story – but someone’s got to start paying attention to these things.
Let’s take it a step further…there’s this thing called cash flow, and its not going AMZN’s way. I know growth investors don’t care about cash flow, but I’m not a growth investor. I’m just an investor – one who likes to make money. I’m someone who likes to tear apart business models, and I just saw the cash conversion cycle erode by 5 days – entirely due to the worst payables change we’ve seen since 2014. I know the internet analysts that cover this name don’t like to talk about things like cash flow and cash conversion cycles – but they’re gonna have to start.
When it comes to 2019/20 modeling, we’re incrementally bearish on revenue, bearish on Gross Margins, and bullish on SG&A – not the trifecta you want to see to justify pushing new peaky earnings/cash flow multiples. In 2019 we’re modeling total GMV ticking down to the high teens. Yes, that’s still AWESOME – but even (especially) ‘awesome’ needs to respect RoC. SG&A leverage is likely to push this name to a 6-7% margin next year – something it NEEDS to print in order to justify current valuation.
The punchline here is that I’m completely on board with AMZN as the TAIL winner in retail -- no argument there – same way I wouldn’t have argued with WMT as being the winner 20-years ago. But I firmly believe that it’s at a point where we need to pay close attention to earnings and cash flow drivers that apply to the other 99% of companies out there. If this is valued on earnings – the same earnings that the Street thinks will hit $40/share in 2-years, then it’s a short at $1,719.
