Here’s why we’re downgrading this retail favorite

Bloated retailer inventories have been a concern. They rose significantly coming out of the April quarter, hitting highs that even exceeded expected inventory builds for the all-important holiday shopping season. Now, Foot Locker (FL) has released its quarterly results, and its inventory was also at rather high levels. Ralph Lauren (RL) net inventory rose 29% to one of the highest levels in several years, while Abercrombie & Fitch (ANF) inventory levels soared 45% from a year-over-year at the end of its April term.

While some companies try to portray increasing inventory as a smart move, given supply chain issues, the main concern we have – as we noted last week – is what is likely to occur as consumer borrowing costs rise and disposable income is under pressure from inflation. That combination along with consumer concerns about a slowing economy could dampen spending plans, forcing retailers to deal with higher-than-expected inventory levels. As we’ve seen in the past, retailers’ margins on clearance items tend to be a bit lower than on full-price items, and if they have to eliminate more inventory than expected, that means a deteriorating margin profile could weigh on net income expectations in the coming quarters.

As members know, our retail exposure is rather limited with Costco (COST), Amazon (AMZN) and Walmart (WMT). With Costco and Amazon, we have very different business models from the norm. As we’ve shared quite often, Costco’s membership business model makes it a standout while Amazon has its Amazon Web Services (AWS) business. While Walmart has a membership business, its influence on the company’s overall bottom line is much less than that of Costco given that it accounts for about 15% to 20% of total operating revenue, compared to 55% at 60% at Costco.

Walmart is the the biggest grocer in the United States and we appreciate that this tends to drive repeat visits and should continue to do so as consumers seek to weather rising food prices. But the company’s overall inventory levels were still at historic levels as it exited the April quarter. At $61.2 billion, Walmart’s inventory at the April exit was larger than all inventory at Target (TGT), Foot Locker, TJX Companies (TJX), Ross Stores (ROST), Home Depot (HD) , Kohl’s (KSS) and BJ’s Wholesale (BJ) combined. Another way to look at it, Walmart’s inventory at the April release was 75% higher than Amazon’s.

This raises new concerns about pressure on Walmart’s margins in the second half of 2022, especially given its operating model, while its impressive size and reach are still largely traditional. As we shared after Walmart announced its April quarter:

“Walmart is seeing flat operating profit and EPS in the current quarter, which more than likely means the worst of the margin pressure happened in the April quarter. Analyzing its guidance for the full year, management sees flat year-over-year operating profit, resulting in a stronger second half as it weathers the year-over-year declines in the first semester.

The same goes for its annual EPS, which is expected to be down 1% from a year ago, implying $6.40 versus consensus of $6.76 before the April quarter. . Given April quarter EPS of $1.30 and the company’s current quarter EPS guidance of “stable to slightly higher”, this means that Walmart now expects its EPS at second half to be something like $3.70 to $3.75, up more than 35% from the first half.

This would be the strongest levels of EPS growth in some time – tracing Walmart’s second half EPS growth to first half over the past few years, it ranged from 0% to 19.5% in 2015 We are somewhat skeptical the company can generate this level of EPS growth in the second half, particularly if fuel costs remain at elevated levels.

With the outlook for more challenges to traditional retail operating models, we are downgrading Walmart shares to a “Three” rating, which we alluded to in yesterday’s Daily Rundown. Consistent with what we said then, our plan will be to use near-term strength to exit WMT stocks, balancing repaid capital between portfolio cash position and companies with much more defensive business models.

We would also like to share with members that given the more difficult road we are on, we will continue to review the rest of the existing portfolio. Particular attention is paid to positions that continue to be under pressure even if the data is favorable. A good example is Airbnb (ABNB), which continues to hit new lows of late despite United (UAL) recently increasing its revenue outlook and travel numbers which remain strong from 2021 levels. According to our calculations, the number of trips to Transportation Security Administration checkpoints since the beginning of the quarter has increased by nearly 45% year over year. But we have to recognize that unlike several months ago or this time last year, we are now in a bear market and that means stocks of all types are being ‘swept away’ no matter what the fundamentals may indicate. As we said recently, that means bad news is bad news and good news is not enough. As we seek to limit further losses for the portfolio, we will continue to chew on the above for Airbnb as well as one to two other stocks that are in a similar boat.

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