Winners and Losers in the Current Retail Landscape
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“It’s nice to have nice things george, are you happy?”
- Ray Liotta speaking to Johnny Depp in the movie Blow
I found the quote timely due to the recent passing of Liotta, but also very relevant in terms of the current state of the retail market.
It seems we’re having more and more of a bifurcation in the haves and have-nots.
The wealthy don’t seem to have much slow-down in spending while lower-income households are more adversely impacted by the effects of rising inflation and starting to feel the squeeze.
There is also a bifurcation when it comes to the recent performance and revisions of discretionary vs. non-discretionary retailers with winners and losers starting to emerge.
In the wars of Gucci flip-flops vs. bulk toilet paper or a can of tuna, who is buying what and why?
This week, in <5 minutes, we’ll cover the recent retail rollercoaster:
The Retail Industry 👉 Simple mechanics
State of the Consumer (Demand Side) 👉 Stimmies, recessions, disposable income
State of the Retailer (Supply Side) 👉 Raw material & shipping costs rising, wage inflation
Cracks Starting to Show 👉 Target & Walmart
Let’s get started!
1. The Retail Industry 👉 Simple mechanics
We buy things we don’t need with the money we don’t have to impress people we don’t like.
The innate desire to buy things is built into the human social construct. To paint broad strokes, the “things” we buy as material goods can be classified into discretionary (want) and non-discretionary (need).
Whether it’s buying out of necessity to live/eat or buying the coolest in-trend product to status signal to your friends, we spend money as a medium of exchange in order to obtain goods.
This exchange of goods is done trillions of times, over and over across thousands of industries that make up the free market economy. An enterprising individual uses labor and capital to create a product which they then in turn sell for a profit.
Just like any other free market, price is set at an equilibrium where supply meets demand.
The supply side of the equation of the goods market is created by taking raw materials and undergoing a manufacturing process to arrive at a finished good. Labour, capital, and productivity are the key inputs on this side.
The demand side is made up of end consumers that are willing to spend their money on this good. This money comes mostly from two sources: disposable income or credit.
Decades of globalization have shifted manufacturing to the locations with the highest relative competitive advantages (after shipping fees).
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2. State of the Consumer (Demand Side) 👉 Stimmies, Disposable Income, Recessions
First, let’s take a look at the current state of the demand side of the equation - the consumer.
As many as 60% of US consumers live paycheck to paycheck, with spending roughly equaling savings on a monthly basis. If you think about an individual’s cash flow profile you have:
Money In (wage) - Money Out (expenses) = Savings Contribution (disposable income)
As savings are contributed year over year, they are added to a balance that is the consumer net wealth. However, when spending exceeds savings, credit can be used to fund the gap instead of drawing down on savings.
When the US government stepped in to provide direct stimulus payments three different times, they wrote cheques directly to end consumers, affectionately known as “stimmies.”
Let’s take a look at the savings rate when each stimulus check hit:
Now, the spikes can be explained because when you think of the individual’s cash flow profile above, on a monthly/quarterly basis the relative amount of the stimulus checks far exceeded the typical savings contribution for that period. So these spikes make sense and are clearly anomalies.
However, we’re now seeing a drastic normalization back down to levels not seen since 2008. So the questions to ask are why is this happening, and where is the money going? Is it going to pay down debt or is it more likely a squeeze from inflation?
We saw headlines of consumers in the first rounds of stimulus using these checks to pay down credit, does that check out? Looking at consumer credit on a YoY basis, this is the right conclusion to draw as the shrinking in consumer credit growth lines up with the stimulus timing.
Here’s a clearer chart that supports this as well…
However, this also means that this recent drop in the savings rate is NOT going to pay down consumer credit, as we’re now seeing a tandem of spiking consumer credit growth YoY AND a lower savings rate.
Although there are many moving pieces, it would be reasonable to conclude that higher prices are eroding savings rates and making consumers use more credit to purchase goods.
Takeaway: Although the consumer has been strong recently, we are now seeing cracks in the system. Purchasing power may remain strong, but it is now being funded with credit rather than a drawdown in savings as wage increases are not enough to offset the rising price of everything.
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. State of the Retailer (Supply Side) 👉 Raw material & shipping costs rising, wage inflation
The main process to bring a product to market whether you are a wholesaler or a retailer involves raw materials that are rising across the board (besides lumber - tough YoY comp).
When it comes to pricing power, retailers are only able to pass on the increased costs of raw materials to consumers to a certain degree. If you’re unable to raise the prices of goods enough to compensate for the increased costs, you get margin compression (more on this below).
Another directly related component is shipping costs. When supply chains are handcuffed, this further increases complexities and costs in the system. A frequently used proxy for this is container shipping costs:
We’re seeing a recent normalization as ports continue to open back up but levels are still far beyond pre-covid times.
Another key ingredient for retails is jobs. Walmart employs 2.3M people. When the labour market is extremely tight, what eventually comes is wage inflation. As famous as Walmart is for providing shitty pay, even they will have to increase wages.
Takeaway: A lot of trends are affecting retailers that could see earnings compression in the coming quarters even worse than originally anticipated.
4. Cracks Starting to Show 👉 Target & Walmart
Some mega-retailers are difficult to make broad-based generalizations on. What it ultimately comes down to amongst the retailers that have an enormous amount of SKUs is product mix. This was on full display when Target recently further decreased projections.
Last week, Target came out and revised numbers down even further after printing their most recent quarter with a dire outlook in terms of forecasts.
By the numbers…
Target down 8% on Investor update, cut outlook for 2nd time in three weeks
The big drop you’re seeing on that chart is a -29% day after printing a very weak recent quarter, mostly around forward projections.
Announced actions to right-size its inventory: cancel orders, mark down more goods
Blaming rising fuel and freight costs for margin hit (Supply chain problems!)
Q2 operating margin guide reduced to ~2% vs. 5.3% issued only 20 days prior
Full-year 2022 operating margin was cut to 6% (in line with prior reduced guide), down from 9.8% in 2021
Claiming that nothing wrong with Demand
Costs and margin are the short-term problems
These last two bullets are the perfect example of what I mentioned above when retailers cannot pass all of the rising costs onto the customer.
The biggest issue facing Target has been its selection of inventory, which grew 43% YoY in the latest quarter. Consumers have been shifting away from higher-margin goods such as kitchen appliances and TVs to basics like food and toiletries, as discretionary spending takes a hit from the current inflationary environment.
Walmart took a huge down day after printing the most recent quarter. The big story was margin pressure, split approximately evenly between:
Wage expense: Employees who were out due to Omicron came back to work faster than expected, which led to weeks of overstaffing.
Shift in mix: Walmart US merchandise mix shifted towards groceries as consumers cut back on discretionary spend. Inventories rose 33% YoY, causing increased storage costs. The company also had to increase promotions to clear the excess inventory, pressuring US gross profit by ~$100M.
Higher fuel costs: US fuel costs were ~ $160M higher than expected, rising faster than WMT's ability to pass through to consumers.
Again - common themes to all the macro headwinds as mentioned above.
Retailers are at the intersection of rapid shifts on both the supply side and the demand side. It is an industry with long lead times on orders and a heavy reliance on getting inventory optimization right.
Supply chain disruption and raw material inflation are a double-whammy when it comes to operating margin. Pricing mechanisms don’t seem to be evolving rapidly enough to keep up with rising costs.
A lot of these retailers were also beneficiaries of the recent rise in interest rates which triggered a sell-off in speculative growth stocks as a lot of capital rotated from growth to value.
Once the major retailers work through their inventories, I believe the strength will be restored in these stocks. From the recent CPI readings, we’re going to be in an inflationary period longer than anyone thought, and as the retailers rotate their inventory to non-discretionary items, they will stand to benefit.
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
P.S. Have you checked out our new crypto newsletter? Subscribe now to find out what I’ve been buying!
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BNPL. Apple announced a new buy now, pay later feature at its Worldwide Developers Conference. Shares of Affirm Holdings are down over 13% since the announcement.
FORECASTING. Inventory challenges are making forecasting sales difficult for retail CFOs. Many misjudged the speed at which consumers would change their spending habits.
CARBON. The carbon-removal industry is the fasting growing area in climate-finance. Look out for GRIT CARBON NEWSLETTER coming soon!
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