TGT - Big Lots Stock Soars After Q2 Earnings Still Not A Buy

Summary

• The falling real disposable income arising from the shrinking consumer purchasing power will negatively affect consumer spending.
• Big Lots relies more on discretionary categories, accounting for 70% of its sales, placing additional downside risk on the retailer.
• Last year’s supply chain disruption has pushed the retailer to stock up, leading to higher markdowns.
• The challenges for BIG are not over yet, and we will revisit our investment thesis later in the year when the retail outlook gets clearer.

Investment Thesis

In the previous analysis, we discussed why Big Lots, Inc. ( BIG ) stock price is still reverting to its mean and why there was additional downside risk. Fast forward to today, we go through the company's most critical operational updates and outlook to reaffirm our hold rating despite the plunge in the stock price by 53% year to date.

Pullback In Consumer Spending

High inflation has had a significant impact on consumer spending in the U.S as consumers have started to pull back on spending as the FED continues to raise interest rates, causing a decline in real disposable income. As a result, consumer balance sheets have been depleted, putting discretionary purchases into the rearview mirror.

Many U.S. retailers have recently issued profit warnings as consumers get squeezed by higher prices. For example, Target Corporation ( TGT ) reported a bigger-than-expected 90% fall in quarterly earnings and missed estimates for comparable sales. Higher inflation levels are starting to pressure consumer spending in the discretionary and general merchandise categories.

Much like Target, BIG relies more on discretionary categories, which account for an estimated 70% of the company's sales, and is prone to take a bigger hit during more challenging times as daily necessities start eating up more of household budgets and leaving shoppers less money to spend on discretionary items, such as new furniture.

Not surprisingly, the management, in the latest earnings call , pointed to the increasing difficulties faced by the company's lower-income-group customers stating:

Things remain tough with high inflation making it more difficult for her to afford daily living expenses and causing her to pull back on discretionary purchases. We serve customers across a wide range of like income levels, but our lower-income customers have been hurt more than others.

Retailers Struggle With Excess Inventory

Big lots ended Q2 2022 with Inventory at $1,159 million , up 22.8% compared to $943.8 million in the same period last year. Even though the inventory was down QoQ, the company is still struggling to bring it to a normal level due to higher unit costs and a significant increase in in-transit Inventory. In addition, big Lots is among a list of retailers that faced supply chain issues due to port congestion, shortage of labor, and other disruptions this year. As a result, the company has seen inventory piling up as demand for discretionary items fades due to FED's hawkishness.

As American households begin to pull back from a two-year buying spree, U.S. retailers that stockpiled products to buffer against supply-chain headwinds find inventory reductions difficult and expensive. The big retailers have been working hard to clear out the excess Inventory, offering steep sales discounts to eliminate slow-moving discretionary items. It's a reverse problem of last year, when retailers didn't have enough supply to meet the demand, leading them to accept late shipments to avoid inventory gaps. Fearing a repeat of the supply chain delays that burnt their last holiday season, several companies, including Big Lots, had been stocking up early this year.

For example, Mattel (MAT), the manufacturer of Barbie dolls and Hot Wheels vehicles, announced that its inventories were up 43% YoY. At the same time, competitor Hasbro (HAS) also reported abnormally high inventory levels as it stockpiled up for the toy industry's peak season. Despite heavy discounts, Target's inventory rose 1.6% to $15.3 billion at the end of the quarter from the prior quarter.

Last fall, massive backlogs at U.S. and Chinese ports delayed shipments for several merchants, resulting in higher freight prices and occasional shortages. In addition, late shipments resulted in surplus inventory, which merchants had to dump cheaply in the spring or store for resale this December. As a result, ocean shipping rates have declined from their high last year but remain much above pre-pandemic levels. According to Freightos , shipping a 40-foot container from Asia to the U.S. west coast cost on average $6,593 recently. This is a two-thirds decrease yearly, but it is still more than four times what importers paid in 2019.

More Square Feet Are Needed To Accommodate Inventories

Few retailers are betting on congestion ending any time soon, as labor shortages have perpetuated delays, unions remain in negotiations with California's ports, and labor unrest threatens truck and rail disruptions. Prologis, Inc. ( PLD ), the world's biggest warehouse owner by square footage, stated in a recent report that retailers would require an additional 800 million sq. feet of warehouse space to handle excess inventories, with tenants already leased approximately 300 million square feet.

Big Lots expects to reach a normalized inventory level by Q4 as it continues through the promotional activity. The effect of high purchases during Q4 2021 is to level out with the current purchasing season. The management stated that the seasonal inventory the company has worked through in Q2 was predominantly the patio lawn and garden furniture , which the company stocked up big in last year's purchases, which the company expects will be able to comp. Since there was a pullback in customer spending early in Q1 and into Q2 this year, most of the inventory bulge and markdown, as well as promotional activity, was to move that product (patio lawn and garden furniture) in Q2. As the management continues ramping up promotional activity in Q3, the margins are expected to remain under pressure soon.

Big Lots - Operational Progress

Big Lots Inc.'s Q2 2022 net sales were reported at $1.346 billion, a 7.6% decrease compared to $1.457 billion a year ago. The decline in 2021 was driven by a drop in comparable sales by 9.2%, which was within the guidance range provided by the company.

At the start of the Q2 in May, sales started strong with a mid-teen three-year comp, spurred by a strategic decision to increase promotional activities to reduce inventory levels. As the company reduced inventory levels during the quarter, it reduced the promotional activity as the quarter advanced.

Big Lots suffered from the broader slowdown in July's retail environment, and consumers felt the effects of rising inflation. The management stated that high inflation drives lower-end customers to postpone or reduce discretionary purchases, particularly of high-ticket products. However, Since July, the company has seen one-year comp sales trends stabilize.

Higher markdowns and freight substantially impacted the company's profitability in Q2 2022 as the gross margin reduced to 32.6% , roughly 700 basis points lower than the previous year. However, the company expects continued significant promotional activity in Q3, resulting in a quarter gross margin rate into the mid-30s.

Operation North Star Update

Big Lots continues to see great traction in the e-comm business, up 35% in Q2, representing over 7% of its total business. In addition, the company has seen an improvement in the conversion rate online by 50 basis points in Q2. Operation North Star remains a critical part of the company's long-term strategy. The management stated in the latest earnings call that the company continues improving its supply chain and tech capabilities to enhance its business model and provide more convenient customer solutions.

We are moving faster to provide even better deals and assortments for our customers by leveraging our vendor relationships and excellent private label brands. We are also building additional capabilities to grow our e-commerce business. We remain highly confident in the enormous value creation opportunity from Operation North Star, and I've never been more excited about the future.

Impact Of Rising Interest Rate

Although a higher interest rate environment has had a significant impact on the company in terms of demand destruction, it also has had a direct impact on the operations. Following the restructuring with sale and leaseback , Big Lots had $252.6 million of Long-term Debt as of July 31 ^st , 2022. In addition, they reported a 70% YoY interest expense increase to 3.9 million from 2.3 million in the same period last year. Last but not least, the management stated in the earnings call that the company saw a decline in credit card penetration of sales in Q2.

It's Not All Gloom

Despite the headwinds, U.S. retail sales unexpectedly remained unchanged in July, providing an encouraging sign for a GDP growth rebound in the third quarter, after two-quarters of contraction. In addition, the decreasing fuel prices provided much-needed relief to consumers, allowing them to free up some cash to be spent elsewhere. Nonetheless, widespread and consistently high inflation erodes workers' incomes and poses a long-term barrier to consumer resilience in the months ahead.

Concluding Thoughts & Near-term outlook

BIG faces significant demand pressure due to its high discretionary mix (70%+) in the wake of a softer consumer backdrop, especially for low-income consumers. Moreover, the retail sales environment remains uncertain as the recent FED minutes revealed further pain in additional interest-rate hikes.

BIG has soared following yesterday's earnings announcement after beating Wall Street expectations; however, the bull run might be short-lived. Nevertheless, the management expects one-year comps to be down in the low double-digit range and continued pressure on gross margins from elevated promotional activity to reduce excess inventory levels. To conclude, the challenges for BIG are not over yet, and we will revisit our investment thesis later in the year when the retail outlook gets clearer.

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