Bottom-Up Economics

What comes after earnings season? More earnings! Many consumer companies, especially retailers, have fiscal years ending in January. As such, they typically report earnings a month after companies using a calendar year. Several consumer companies on my buy list, along with high-profile market leaders, reported earnings last week. For the most part, results were similar to last quarter and in-line with the Q2 management commentary I recently summarized.

Before we review consumer results, did anyone notice Amazon’s bond offering last week? As brick and mortar retailers struggle to maintain market share and traffic, Amazon issued $16 billion in debt with ease. According to Bloomberg, Amazon sold “the longest portion of the offering, a 40-year security” 145 bps above Treasuries. Who is more generous, buyers of Amazon’s debt or its equity? And what is more frightening to Amazon’s competitors, the fact Amazon can borrow so much at such low rates, or that the company hasn’t been required to generate an adequate ROIC for the majority of its existence? It’s no wonder Amazon is taking market share and threatening profit recessions in a growing number of industries.

The current market and credit cycle has created an interesting tug of war between inflation and deflation. On the one hand, extremely aggressive monetary policy has created record asset inflation and easy credit, artificially supporting demand. On the other hand, overabundant capital has contributed to overcapacity and margin pressure in a variety of industries (see energy and retail). While these conflicting forces are interesting to ponder, I’ll stop here before I make an unqualified statement on what it all means for investors. Plus, does the world really need another fundamental value investor making top-down macro observations and predictions? Probably not. Instead, let’s get back to viewing the economy through the eyes of businesses – or as I like to call it, bottom-up economics.

Before we begin, I wanted to point out that while my focus is on small cap stocks, I also follow several mid and large cap businesses. Although larger companies are not on my possible buy list, I often review their results to gain information on certain industries and the economy. With that housekeeping item out of the way, let’s move on to what’s happening in the real world.

Wal-Mart (WMT) reported a 1.8% increase in same-store sales (1.4% last quarter) and a 1.3% increase in traffic (1.5% last quarter) at its U.S. stores. Ticket was up slightly while inventory per store declined 3.8%. Consolidated gross margins declined 11 bps due to “strategic price investments” and growth in e-commerce. Apparently the market wasn’t satisfied, as Wal-Mart’s stock declined on the report. Investors may have been disappointed with Q3 guidance, which did not indicate an acceleration in growth.

Target’s (TGT) comparable sales were also in the low single-digits, increasing 1.3% (digital channel sales contributed 1.1%). For the year, management expects comparable sales of plus or minus 1%. Gross margins declined 40 bps due to higher e-commerce fulfillment costs and “efforts to improve pricing and promotions”. Higher compensation costs contributed to an increase in SG&A. Management called the competitive environment “choppy” but was pleased with its 2% increase in traffic. Lastly, similar to Wal-Mart, inventory declined (more than 4%) versus a year ago.

Although Wal-Mart and Target were only able to generate low single-digit comps, they were positive and showed signs of stability. Other more discretionary retailers were less fortunate. For example, Foot Locker (FL) reported second quarter comparable-store sales declined -6.0%. The company’s gross margin declined noticeably to 29.6% versus 33% a year ago. Management blamed the shortfall on top styles falling short of expectations along with the “limited availability of innovative new products.” Management isn’t expecting a change in the near-future and believes comparable sales will decline 3-4% for the remainder of the year. Commenting on the industry management said, “The disruption taking place today in our industry, and in retail in general, is the most significant I’ve seen in my quarter-century in the athletic business.” Foot Locker’s stock declined 28% on the results and guidance.

Foot Locker is a good example of the risks associated with extrapolation. It’s a cyclical consumer business that was being priced as a consistent grower. As I wrote in April (Living the Minivan Dream), “I’m currently not assuming Foot Locker’s 13% operating margins are perpetual. In fact, when a mature retailer in a competitive market generates such high margins, the first thing that comes to my mind is their customers are paying too much. Instead of asking how management will expand margins further, as an investor, I’d question how a mall-based retailer can sustain mid-teens margins long-term.” Since April, Foot Locker’s stock has declined from $72 to $33.

Sticking with the athletic theme, Dick’s Sporting Goods (DKS) also disappointed investors last week. Specifically, earnings and same-store sales came in below expectations, with comps only increasing 0.1% (up 2.4% last quarter). Management stated the retail industry is in flux and highly competitive. To protect market share, Dick’s is turning to promotions and lower prices. As a result, the company lowered full year EPS guidance to $2.80-$3 from $3.65-$3.75. Same-store comp expectations are now flat to negative low single-digits versus previous guidance of 1-3% positive comps.

Commenting on the industry management noted, “There’s a lot of people right now, I think, in retail and in this industry in panic mode. There’s — it’s been a difficult environment. I think people — I’m not going to speculate what they’re thinking, but they seem to be in panic mode with how they’re pricing product. And we think it’s going to continue to be promotional and at times, irrational going forward. And I think that’s going to be across a number of different sectors.” Considering the number of $20 off coupons I’ve been receiving from them in the mail, I should have seen this one coming!

Do results from Foot Locker and Dick’s Sporting Goods imply a fashion shift from athletic to more formal attire? Is full employment finally causing consumers to dress more professionally? Are sweat pants and sneakers being traded in for suits and dress shoes? For answers, let’s turn to Tailored Brands (TLRD), a market leading retailer of men’s suits. Although Tailored Brands doesn’t report results until September, with last quarter comps declining -2.4%, trends have not been encouraging.

My favorite apparel retailer for dress shirts and pants (also where I buy my $199 suits!), Stein Mart (SMRT), also reported weak results. Sales declined -2.7% last quarter, while same store comps decreased -5%. If consumers are spending less on athletic and more on other areas of apparel, Tailored Brands and Stein Mart do not appear to be benefiting.

Instead of buying $100 running shoes and $199 suits, maybe consumers are remodeling their homes. Home Depot (HD) reported another solid quarter with same-store comps increasing 6.3% (5.5% last quarter). Transactions increased 2.6% and average ticket was up 3.6%. Management noted commodity inflation in lumber, building materials, and copper (aided comps 68 bps). Big-ticket items (over $900) continued to do well, increasing 12.4% (22% of sales). Interestingly, transactions for tickets under $50 (16% of sales) were only up 1.5%.

Due to the “continued growth in the repair and remodel market as the U.S. has experienced solid wage growth, faster home price appreciation and the reemergence of first-time home buyers,” management raised its guidance and expects same-store comps of 5.5% for the year. While the Fed’s asset inflation policy may not be working for most retailers, it is clearly benefiting home prices and Home Depot – they are in the right place at the right time. However, as Foot Locker shareholders will attest, Home Depot investors may want to be careful extrapolating those healthy comps and margins too far into the future!

Briggs & Stratton (BGG) announced weaker than expected results with sales declining -5.6%. Although sales to commercial customers (includes lawn care for the 1%’ers) were strong, residential sales (consumers who cut their own lawns) were weak. Management blamed unexpected shifts in partner inventory and “pockets of suboptimal growing conditions”. Management continues “to see a cautious approach to reordering as channel partners have focused on controlling inventory to abnormally low levels.”

Advanced Auto Parts (AAP) reported flat same-store comps for the quarter and guided to negative -1% to -3% comps for the year. The company attributed recent softness in industry sales to economic uncertainty for low-income consumers and higher year-over-year gas prices, leading to a reduction in the growth rate of miles driven. Management also pointed to “a temporary trough in vehicles in the aged and maintenance sweet spot resulting from a substantial decline in new car sales in the 2008-2009 recession.” And finally, management believes a cooler spring and summer may have hurt results (less work on A/Cs).

TJX Companies (TJX) reported a respectable quarter with same-store comps increasing 3%. Positive comps were mainly a result of higher traffic and do not include the benefit of e-commerce revenue. Inventories on a store basis declined 6%. Wage increases reduced EPS by 2%, as anticipated. The company is expecting comps of 1-2% next quarter and in fiscal 2018. Management sounded confident in its off-price strategy and continues to expand its store count.

Restaurants continue to struggle. Zoe’s Kitchen (ZOES) comparable sales declined -3.8%. Zoe’s comps were aided by a 1.2% increase in price, while transactions and mix hurt comps by -5%. Wages increased 2% for hourly employees. Management also announced they expect to moderate store growth next year. Full year comps are expected to be flat to down -3%.

Brinker International (EAT) announced same-store comps declined -1.8%, which was “consistent with what we’ve seen in the industry over the last couple of quarters.” At company-owned Chili’s, comps were down -2.2% with traffic declining -6.6% (price was up 2.9%). Management expects comps for fiscal 2018 to be flat to 1%. Guidance for 2018 also includes wage inflation of 3% to 4% (meanwhile central bankers will fret about deflation at their Jackson Hole meeting this week???).

And finally, DSW Inc. (DSW) reported earnings this morning. I have not listened to their conference call yet, but the quarterly report showed signs of stabilization. As I noted in a post a few months ago (Retail Survivor), there will be survivors in retail and I expect DSW to be one of them. Comps stabilized and were up 0.6%. DSW’s balance sheet continues to look strong and liquid. With its stock up 20% this morning, investors appear pleased with the stabilization in comps (albeit at a low level).

In conclusion, the consumer backdrop is little changed since last quarter and remains sluggish. Apparently Dow 22,000 wasn’t enough to sufficiently stimulate consumer demand. Forget the Fed’s consumer inflation target, what is the “appropriate” level of asset inflation? Is it Dow 25k, 40k, or 100k? In effect, what level do asset prices need to reach for consumer comps to grow 3% to 4% instead of -1% to 1%?

On a more positive note, barring a recession, quarterly comparisons for many consumer companies should become easier later this year. The consumer slowdown I noticed last fall will soon reach its anniversary. However, as can be gathered from the results and outlooks of several retailers and restaurants, stabilization does not necessarily equal acceleration. Nevertheless, similar to DSW and Target, stocks of depressed retailers that transition from negative comps to slightly positive comps could see a lift.

Sorry for the long post today. I’m officially finished with earnings season and plan to refocus my efforts on more in-depth research. With the small cap market leaking and pockets of weakness in certain sectors — energy and retail in particular — there are actually some potential buy ideas to work on these days. It’s not much, but it’s something!