UE - Challenges Facing The Retail Sector And Top Ways To Invest

2023-06-09 12:14:55 ET

Summary

• Shrinkage, unfavorable product mix, and poor weather were some of the most highly cited headwinds amongst those in the retail sector that have reported first-quarter results.
• The eventual restarting of student loan payments could add another hurdle for future sales and earnings growth.
• Despite the headwinds, the outlook appears positive, given low unemployment rates, a surplus of job openings, and a generally resilient consumer.
• Consumers, nevertheless, are hesitant to spend and choosier when they do.
• For investors, overweight exposure to discount retailers, dollar stores, and retail-focused landlords may prove most rewarding over the medium-long term.

Recent reports highlighting store traffic levels over the Memorial Day weekend provided a positive boost to those invested in the retail sector. Looking ahead, investors will likely receive additional clues following Juneteenth/Father's Day weekend and the Independence Day holiday shortly after.

Aside from the consumer trade down effect, which has impacted most retailers, as well as the pullback in overall discretionary spending on goods, which hit some, such as Foot Locker, Inc. ( FL ), harder than others, retailers face a number of unique challenges in the current market environment.

While some may argue that these challenges are too much to overcome, the overall outlook appears positive, though more so for some than others. The threats, however, cannot be discounted. And at present, there are four that seem to be commanding the most attention among retailers.

Rising Retail Theft (“Shrinkage”)

One of the most pressing and most documented issues facing retailers is shrinkage, or, said more plainly, theft. According to recent reporting, retailers have noted collective losses of nearly +$100B attributable to this ongoing threat.

In several instances, companies have closed stores in response to both the losses and for personal safety reasons. In addition, many are incurring additional costs to beef up security. Outdoor retailer, REI, for example, spent nearly +$1.0M on extra security over the past year.

And on their recent earnings release, Target ( TGT ) Chief Executive Brian Cornell stated that shrinkage could reduce profitability by more than +$500M this year. This rising cost burden and bottom-line hit was also echoed by others, such as by The TJX Companies ( TJX ) and Macy’s ( M ). One analyst at Bernstein had also stated that the rate of growth in theft is surpassing the growth rate in sales at many of these retailers.

Even the perceived notion of theft is creating planning challenges. On Walgreens Boots Alliance's ( WBA ) recent release, CFO, James Kehoe, noted that they may have “cried too much last year.” This was regarding the significant amount spent on theft prevention, which contributed to higher overall costs during Q1.

With shrinkage now a lower percentage of sales than last year, the company is making the necessary adjustments. But whether this can hold remains to be seen. For investors, the uncertainty adds another hurdle to existing forecasting challenges.

Unfavorable Product Mix

While retailers are continuing to report positive sales growth, overall margins are being held back due to greater sales of consumables over other discretionary offerings. This is important to note since these goods generate lower margins than their discretionary counterparts.

As an example, for four straight quarters beginning in Q2 of fiscal 2022, the sale of consumables has represented a greater share of Dollar Tree’s ( DLTR ) namesake unit’s sales. And as a result of this mix, operating margins for the period came in at 13.6%.

This is compared to 20.2% in the same period last year. And of the 660-basis point (“bps”) decline, 420bps was attributable to headwinds stemming from mix and initial mark-ons, which more than offset the tailwinds in the freight environment.

CEO, Doug McMillon, at Walmart ( WMT ) also said that a higher mix of sales in their food and consumables categories negatively impacted gross profit in their most recently completed quarter.

This phenomenon was also seen in bargain outlet, Ollie’s ( OLLI ), who reported a significant increase in overall gross margins, but reported that overall growth was negatively impacted by lower margins on merchandise, due in part to a combination of shrinkage and a greater composition of sales in consumables.

Poor Weather

Though less evident at the surface level, poor weather conditions proved to be a thorn in the side of more retailers than one would normally expect.

Home Depot ( HD ) and Lowe’s ( LOW ) are two that come to mind quickly due to the importance of their outdoor Spring seasons. A late start to Spring or overly wet conditions could deter most from engaging in landscaping-type projects. These delays had been reported in prior years.

And the trend continued in Q1. CEO, Ted Decker, at HD mentioned that sales came in below their expectations due in part to extreme weather conditions in their California market. The poor weather events consequently contributed to an overall downward revision in their full-year comparable sales expectations. This ultimately sent shares flopping immediately following their release.

Big Lots ( BIG ) is another that had to bear the brunt of a poor start to the outdoor season. And in their case, the poor results sent shares down to all-time lows. Similar to HD, BIG noted that unfavorable weather negatively impacted their lawn and garden sales. This was compounded further by the general pullback in consumer spending on bigger-ticket items.

Outdoor-specific retailers such as Polaris ( PII ) also cited weather as one factor that held back their Marine division during the quarter.

More glaring problems were seen on the West Coast, as evidenced by the results of Big 5 Sporting Goods ( BGFV ), whose largest operating market is California. Sales predictably were negatively impacted by the later than usual start to the season.

Student Loan Restart

Shares of Target were recently downgraded by an analyst at KeyBanc due to the downside risk relating to the upcoming restart in student loan repayments, which was cemented following the bipartisan agreement regarding the debt-ceiling .

The one remaining uncertainty regarding the restart is the pending decision from the Supreme Court on President Biden’s debt cancellation. There is a wide consensus, however, that the cancellation will ultimately be nixed.

Granted, the administration may explore other ways of achieving their policy goals, and it’s likely they will. But the eventual reality of the pending restart is unlikely to change.

While the impact on retailers at present is uncertain, one can reasonably speculate that spending will fall among the younger cohort. At the end of 2022, for example, Americans 30 and under were 90 days or more behind on their credit card payments at a rate similar to in 2009. And according to reports , this group held more than 50% of all outstanding student loan debt.

With this group already behind on their credit payments even with the pause in place, it will be of interest to see what happens to the overall delinquency rate in future periods. To avoid digging an even deeper hole for themselves, this group will likely cut spending on non-priority retail purchases.

How To Invest In Retail In The Current Market Environment?

Retailers are contending with numerous headwinds. But the overall outlook still appears positive for most. The unemployment rate, for example, is still at historical lows. And this is paired with a surplus of job openings. While wage growth hasn’t kept up with inflation, a pullback in the overall inflation rate has helped many retain more of what they earn.

Despite this, executives continue to note that consumers have become choosier and more hesitant to spend on bigger ticket items. And looking ahead, this fact of life for retailers is expected to continue. I, therefore, remain bullish on off-price retail. In my view, stocks such as TJX and OLLI are prime candidates to outperform in the periods ahead.

What’s more, these two companies are also reporting attractive margin growth in the face of rising hurdles mentioned earlier. OLLI was, indeed, negatively impacted by their unfavorable product mix, but their overall margins were still up over 400bps. TJX, too, turned in pre-tax margins that exceeded expectations, resulting in a raise to their full-year guidance.

Dollar stores are also viewed favorably, particularly DLTR, which is under the leadership of a new and well-respected CEO. The stock pulled back significantly following their results, due in part to issues pertaining to shrinkage. But I view the pullback as overdone , given positive trends in traffic growth.

A more under-the-radar way to play the retail market is through the landlords. Fairly unknown real estate investment trusts, or REITs, such as Urban Edge Properties ( UE ) and SITE Centers ( SITC ) are two such examples. In the past, eCommerce was an oft-cited threat to brick and mortar. While this will always be an ever-present threat, the doom and gloom surrounding the thought is unlikely to ever come to fruition, especially in the current market environment.

From a profitability standpoint, storefronts remain the most profitable choice for retailers. And as evidence of this, one can tune in to the results of both UE and SITC, each of which are reporting record leasing volumes and future signing interest from retailers.

In fact, the demand environment is such that the two are running out of space to lease. This is providing them with unique opportunities to remain in control of rental rates. It should also be noted that TJX is SITC’s top tenant and UE’s second largest. This should make both stocks even more attractive, given the quality of their tenant base.

All considered, there remain numerous ways to profit in retail, despite the multitude of existing headwinds. For investors seeking new or further positioning, a second look into beaten down discount retailers, dollar stores, and retail landlords may prove rewarding over the long run.

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