Image Source: Mike Mozart
Selling pressure across retail came after several notable operators reported earnings November 20. Let’s take a look at what is driving investor reaction within the space.
By Kris Rosemann
A number of high profile retailers (XRT) reported earnings before the open November 20, and selling pressure ensued due in large part to margin weakness across the space. Higher transportation and wage costs were common themes, but top-line performance held solid for the group, generally speaking. A number of retailers from a variety of segments within the sector are feeling the damage to sentiment from the flurry of reports as the implications of the margin pressures are not expected to be unique to those specific retailers that reported earnings. Wage growth has been a growing concern for some time now as a tightening labor force makes its presence felt on the labor-intensive retail space, and tight capacity, which is due in part to the rise of e-commerce, in the trucking market is forcing many retailers–and other shippers of goods–to pay significantly higher rates for necessary transportation.
These margin headwinds only add to the pressure we’ve seen around traditional retail in recent years as the space continues to battle with a long-term outlook that is clouded by the ongoing proliferation of e-commerce, which brings with it price battles. Online sales growth is expected to continue outpacing overall retail sales growth, and more companies are embracing the online selling channel. According to Moody’s, around 15% of total US retail sales are currently online sales, a figure that is expected to grow to 20% in the next five years. Improving consumer confidence and low unemployment are expected to be key top-line drivers for the retail space in the near term, but the aforementioned margin headwinds–as well as the potential escalation of the US-China trade dispute for retailers that import products from China–have the potential to mitigate bottom-line growth.
A Flurry of Earnings Reports
Target (TGT) turned in strong top-line growth in its fiscal third quarter report November 20 as year-over-year comparable sales growth of 5.1% was driven by a 5.3% traffic increase and digital sales leapt 49%. Adjusted earnings per share in the quarter advanced more than 20% from the year-ago period to $1.09, but both gross and operating margin faced pressure. The company’s gross margin contracted 90 basis points from the year-ago period to 28.7% as a result of higher supply chain costs driven by increases in digital fulfillment costs and expenses related to the size and timing of holiday-related inventory receipts, and operating income margin declined 40 basis points on a year-over-year basis to 4.6% as investments in hours, training, and wages were offset by continued cost discipline. Management maintained its full year guidance for comparable sales growth at 5% and adjusted earnings per share at $5.30-$5.50.
Off-price retail leader TJX Companies (TJX) delivered notable top-line growth in its fiscal 2019 third quarter report, released November 20, as comparable store sales increased 7% on a year-over-year basis thanks to strong traffic, and net sales advanced 12%. However, margin performance left a bit to be desired as gross profit margin fell by 90 basis points to 28.9% as a result of higher freight costs, costs related to its supply chain, and unfavorable year-over-year comparisons related to inventory hedges more than offset strong expense leverage. Adjusted diluted earnings per share advanced to $0.54 from $0.50, and management expects incremental freight costs and wage increases to negatively impact earnings per share growth by roughly 5% in the full fiscal year.
Fellow off-price retailer Ross Stores (ROST) reported a similar story to that of TJX in its fiscal third quarter report, released November 20, as comparable store sales growth of 3% on a year-over-year basis helped drive total sales growth of 7%. Both sales and earnings outpaced management’s guidance for the period, but the company’s operating margin contracted nearly 90 basis points from the year-ago period to 12.4% as an increase in merchandise margin was more than offset by higher freight costs and wages. The company continues to expect comparable store sales growth of 1%-2% in the full year, which comes on the back of an impressive 5% mark in fiscal 2017, and earnings per share guidance comes in a range of $4.15-$4.20.
Specialty retailer Best Buy’s (BBY) fiscal 2019 third quarter report, released November 20, revealed yet another strong top-line performance as comparable sales advanced 4.3% on a year-over-year basis, and domestic digital revenue as a percentage of total domestic revenue (domestic revenue is more than 90% of total revenue) advanced 110 basis points to 13.8%. Higher supply chain costs, which includes investments and higher transportation costs, helped drag the company’s domestic gross margin down to 24.4% from 24.7% in the year-ago period, while domestic SG&A expenses as a percentage of revenue expanded 20 basis points due to growth investments (including specialty labor), higher incentive compensation, operating costs related to the recent acquisition of GreatCall, and higher variable costs on increased revenue. Nevertheless, a materially lower tax rate helped drive non-GAAP diluted earnings per share to $0.93 from $0.78 in the comparable period of fiscal 2018, and management raised guidance for a number of metrics following the strong showing, including non-GAAP diluted earnings per share guidance now in a range of $5.09-$5.19 from $4.95-$5.10 previously.
Department store operator Kohl’s (KSS) also reported relatively solid top-line performance in its fiscal third quarter report, released November 20, as comparable sales increased 2.5% on a year-over-year basis, but its operating margin contracted roughly 55 basis points from the year-ago period as slight gross margin expansion, which was largely thanks to recent inventory initiatives, was more than offset by an increase in SG&A expenses as a percentage of revenue. The company’s less than ideal margin performance coupled with a full-year outlook that disappointed Mr. Market led to material selling pressure following the earnings release. Despite being raised to a range of $5.35-$5.55 from $5.15-$5.55 previously, Kohl’s diluted earnings per share guidance came up shy of market expectations.
Home improvement retailer Lowe’s (LOW) reported slowing comparable sales in its fiscal third quarter report, released November 20, but growth in average ticket was able to offset a 0.8% decline in comparable transactions and drove comparable sales growth of 1.5%, which was a notable disappointment relative to Street expectations. President and CEO Marvin Ellison noted, “However, continued challenges with inventory out of stocks, poor reset execution, and assortment concerns in certain categories pressured our ability to turn those visits into transactions.” The company now plans to exit its Mexico retail operations and is exploring strategic alternatives, and it will also exit non-core activities within its US home improvement business.
Margin performance at Lowe’s disappointed in the fiscal third quarter as well as its gross margin contracted more than 150 basis points to 32.5%, and SG&A spending as a percentage of revenue leapt 180 basis points from the year-ago period. The company now expects its operating margin to contract 240-255 basis points in the full fiscal year, though 135-150 basis points of this contraction is due to charges associated with its strategic reassessment. Total sales growth guidance for the full year was reduced to 4% from 4.5%, comparable sales growth guidance was lowered to 2.5% from 3%, and diluted earnings per share guidance has been lowered to a range of $4.08-$4.24 from $4.50-$4.60.
Wrapping Things Up
We’re not looking to add exposure to the traditional retail space as it continues to be threatened by a number of factors. We note the potential for continued top-line momentum across the space as consumer confidence in the US remains high and unemployment low. However, aforementioned margin pressures may continue to eat into the percentage of that revenue growth that is able to fall through to the bottom line, and the ongoing need for investments in digital capabilities have the potential to weigh on margin performance for some time as online shopping penetration rates have a nice runway for potential growth at only ~15%.
Income-minded investors looking for dividend potential in the space may very well find some appealing yields and attractive Dividend Cushion ratios, but we remain cautious regarding the potential for secular pressures to weigh on the long-term income-generating potential of many in the space, including smaller, mall-based operators with high exposures to rapidly growing areas of e-commerce. The collapse of Sears Holdings (SHLD), while not typical by any means, is exemplary of some of the potential pitfalls in retail, and we would not be surprised to see other traditional retailers not make it through the next economic downturn, the timing and magnitude of which the only uncertainty.
Food Retailers: CASY, COST, CVS, GNC, KR, SVU, SYY, TGT, UNFI, VSI, WBA, WMT
Retail – Apparel (Teen-30yrs, Off-Price, Outdoor): AEO, ANF, BKE, COLM, GES, GPS, ROST, TJX, URBN
Retail – Apparel (Women’s, Men’s, Children’s): CHS, CRI, GIL, HBI, LB, PLCE
Retail – Multiline: DDS, JCP, JWN, KSS, M, SHLD
Retail – Shoes: CROX, DECK, DSW, FL, SCVL, SHOO, SKX, WWW
Retail – Specialty: AAN, BBBY, BBY, GME, HD, LL, LOW, ODP, PIR, SHW, SPLS, TSCO, WSM
Retail – Sporting Goods: BGFV, DKS, ESCA, HIBB, VSTO
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.