continuing apparel retailing woes

I haven’t been watching publicly traded apparel retailers carefully for years.  For me, the issues/problems in picking winners in this area have been legion.  There’s the generational shift in spending power from Baby Boomers to Millennials, the move from bricks-and-mortar to online, the lingering effects of recession on spending power and spending habits.  And then, of course, there’s the normal movement of retailers in and out of fashion.

I’m not saying that retail isn’t worth following.  I just find it too hard to find solid ground to build an investment thesis on.  Maybe the pace of change is too rapid for me.  Maybe I don’t have a good enough feel for how Millennials regard apparel–or whether retiring Boomers are using their accumulated inventories of fashion clothing rather than adding to them.

Having said that, I’m still surprised–shocked, actually–at how the current quarter for apparel retailers is playing out.  It seems like every day a new retailer is reporting quarterly earnings that fall below management guidance, usually the latest in a string of sub-par quarters.  That itself isn’t so unusual.

But the stocks react by plummeting.

You’d think that the market would have caught on that Retailland is facing structural headwinds.  Or at least, that the retail area that made the careers of so many active managers over the past twenty or thirty years doesn’t exist any more.

 

Is it robot traders?  Is it an effect of continuing buying by index funds?  I don’t know.  But the continuing inability of investors to factor into stock prices the continuing slump of apparel retailers is certainly odd.

the Sears “going concern” warning

the auditor’s opinion

On my first day of OJT in equity securities analysis, the instructor asked our class what the most important page of a company’s annual report/10k filing is.  The correct answer, which escaped most of us, is:  the one that contains the auditor’s assessment of the accuracy of the financials and the state of health of the company.  The auditor’s report is usually brief and formulaic.  Longer = trouble.

Anything less than a clean bill of health is a matter grave concern.  The worst situation is one in which the auditor expresses doubt about the firm’s ability to remain a going concern.

a new financial accounting rule

In today’s world, that class would be a little different.  Yes, the auditor’s opinion is the single most important thing.  But new, post-recession financial accounting rules that go into effect with the 2016 reporting year require the company itself to point out any risks it sees to its ability to remain in business.

the Sears case

That’s what Sears did when it issued its 2016 financials in late March.  What’s odd about this trailblazing instance is that while the firm raised the question, its auditors issued an “unqualified” (meaning clean-bill-of-health) opinion.

what’s going on?

Suppliers to retail study their customers’ operations very carefully, with a particular eye on creditworthiness.  That’s because trade creditors fall at the absolute back of the line for repayment in the case of a customer bankruptcy.  They don’t get unsold merchandise back; the money from their sale will likely go to interests higher up on the repayment food chain–like employee salaries/pensions and secured creditors.  So their receivable claims are pretty much toast.

Because of this, at the slightest whiff of trouble, and to limit the damage a bankruptcy might cause them, suppliers begin to shrink the amount and assortment of merchandise, and the terms of payment for them, that they offer to a troubled customer.   My reading of the Sears CEO’s recent blog post is that this process has already started there.

It may also be, assuming I’m correct, that the effects are not yet visible in the working capital data from 2016 that an auditor might look at.  Hence the unqualified statement.  But we’re at the very earliest stage with the new accounting rules, so nothing is 100% clear.

breaking a contract?

Sears has complained in the same blog post about the behavior of one supplier, Hong Kong-based One World, which supplies Craftsman-branded power tools to Sears through its Techtronic subsidiary.  Techtronic apparently wants to unilaterally tear up its contract  with Sears and stop sending any merchandise.

Obviously, Sears can’t allow this to happen.  It’s not only the importance of the Craftsman line.  If One World is successful, other suppliers who may have been more sympathetic to Sears will doubtless expect similar treatment.

Developments here are well worth monitoring, not only for Sears, but as a template for how new rules will affect other retailers.

 

 

 

failed shopping malls

There was a local politician on Long Island a while ago who had an unusual campaign position on gun control.  He argued that guns don’t kill people; bullets do.   Therefore, we should not control the purchase or possession of firearms;  we should control the purchase/possession of bullets, the real culprits.  He lost–or at least I hope he did.

The Wall Street Journal ran an article yesterday, apparently based on a recent Wells Fargo research report on failed shopping malls.  Its conclusion:  dead shopping malls are being killed, not by online shopping, but by the proliferation of newer, larger, more glitzy, better-located other malls.

There is certainly something more to this argument than to the bullet one.  Commercial real estate is a boom and bust business.  Developers put up new structures with relentless fervor until the day the banks shut down their access to credit.  And that usually doesn’t happen until the first bankruptcies of failed projects begin to appear.  As the old banking adage goes, “You never get promoted by turning down a loan.”

So, yes, older, smaller, less well-located malls are losing out to newer ones.  And the loss of anchor stores is usually the signal that the party is over.

But if we do a little arithmetic with the Census Bureau data on retail sales in the US, we can conclude that although online retail sales represent less than 10% of the total, they account for half the overall growth in retail.  Bricks-and-mortar retail is advancing, if that’s the right word, at about 2% a year.  It may be that if we adjust for inflation, the movement of physical goods through the traditional retail chain is flat.  So because of the internet there is no need for any net new mall space in the US.

From a retail firm’s perspective, BAM revenue growth is probably only going to come by taking sales away from competitors.  In a mature environment like this, cost control becomes an increasingly important source of profit growth.  Both factors imply firms should have better control over floor space and adjust it frequently to be in the most attractive locations.

Who knows what mall developers actually do, but if it were me any new project would need to explicitly target aging malls in its vicinity.   Those would be the primary source of the revenues that would make the project viable.

Two conclusions:

–if half the growth in retail weren’t being siphoned off by the internet, I’d guess the tectonic plates of malldom wouldn’t be shifting as violently as they are now, and

–the idea that ownership of physical store premises is a hidden source of value for mature retail firms (think:  the attack on JC Penney) has passed its use-by date.

 

 

disappointing 4Q16 sales for Target (TGT)

TGT just announced that its 4Q16 sales (the fiscal quarter ends in about two weeks, on January 31st, which is normal retail practice) will fall below its previous estimate of +1/- 1%.  The company now figures that sales will be down by -1.0% to -1.5%.

Online sales grew year-on-year by 30%+ during November/December, while sales in physical stores fell more than -3%.

In its press release, TGT also gives a breakout by major categories.

The company doesn’t say explicitly what the split is between online and physical store sales, but a little arithmetic will will get an approximate figure.  And that’s the core of the company’s sales growth problem, in my view.

The Commerce Department hasn’t yet released its calculation of the percentage of retail sales in the US that occurs online.  We can safely assume, though, that the number–which continues a steady upward march–will be around 9%.  This is the portion of overall retail that’s growing, and carrying the waning physical store business.  The TGT online figure, in contrast, is just slightly over 1%.

are high margins better than low ones?

This post is indirectly about Amazon’s retailing business, although it has much wider implications.

My answer:  not necessarily.  It depends on what kind of company we’re talking about.  Note, also, that this is a topic that’s badly misunderstood, particularly in the financial press, which clings to the simple assumption that high margins, of themselves, are better than low ones.

 

The apparent virtue of having high margins is clear.  Companies that have, for instance, essential intellectual property protected by high patent/copyright/manufacturing-knowhow walls, can achieve selling prices that are much greater function of the usefulness of their products/services to customers than of their production costs (this latter is the functional definition of a commodity company).  Software firms can easily achieve 50%–or maybe 80% or 90%–operating margins for their wares.

 

Most distribution companies–both wholesale and retail–don’t work this way, however.  They thrive through low margins, high inventory turnover and careful working capital management to achieve superior financial results.  In fact, for these companies high margins are a threat, not a boon.  Why?    …because high margins attract competition.

the low-margin model

Here’s a (highly simplified) account of how the low-margin model works:

the simplest case

A warehouse holds inventory of $1 million.  It constantly replenishes its stocks, and pays cash immediately for new supplies, so that it always has $1 million invested.  It marks items up by 5% over its costs.

Let’s say the company generates an average of $525,000 in sales per month.  That means it turns over about half its inventory (a turnover ratio of 6x/year) each month, earning operating income of $25,000.  $25,000 x 12 = $300,000 in operating profit per year.  Applying a 1/3 income tax rate, it produces $200,000 in net income.  That’s a 20% return on invested capital. Not bad.

a more favorable one

Let’s now imagine that the company can turn its inventory once a month (turnover ratio = 12).  This means it earns operating income of $50,000/month, or $600,000 per year. This translates into $400,000 in net income. That’s a 40% return on capital.

nirvana

Let’s say the company turns inventory once a month but is large enough or important enough to suppliers that they no longer ask for payment on delivery.  Instead, they are willing to wait for 30-45 days.

Now the company has zero/negative working capital, i.e., no capital invested in inventory.  It’s return on investment is now infinite.

 

Yes, this third case is probably too good to be true.  But it illustrates the enormous, badly-understood, power of high inventory-turnover companies.

 

A post on potential troubles in paradise on Tuesday.

 

 

the trouble(s) with the luxury goods industry

For most of the past quarter-century, the publicly traded luxury goods industry, both companies based in the EU and in the US, has been a source of almost continual outperformance.

the old pattern

Its appeal rested (and I do mean the past tense) on two major trends:

–the gradual aging of the working population in the US and EU.  A twenty- or thirty-something in either area typically aspires to own a work wardrobe, a car and a house.  A forty- or fifty-something, in contrast, wants to own jewelry and a vacation house, and to go on a cruise.

So the rising affluence of older workers in the US and Europe has meant increasing demand for luxury goods.

–growth in Japan and the development of capitalism in China, beginning with Deng’s turn away from Mao in the late 1970s.  Again, increasing affluence has sparked higher demand for globally recognized luxury goods.  In addition, in China “gifts” (read: bribes) of luxury goods have long greased the wheels of bureaucratic approval of new projects–until the ongoing anti-corruption crackdown there began a few years ago, that is.

What has been less well understood is that the unit profits from selling a given luxury good in either China or Japan has been much, much higher than elsewhere (double would be my first approximation).  This means that if Japan/China accounted for 25% of a company’s sales (and a sales figure would typically be all a luxury goods firm would announce), they would represent half the company’s profits.

the new

–the rise of Millennials (the suit, car, house people) in the US and EU and the gradual retirement–and loss of income–of Boomers are putting a crimp in demand for luxury goods in these areas.

–luxury goods sales in Japan have hit a brick wall in recent years.  This is partly demographics, partly the immense loss in purchasing power that the Abenomics-induced depreciation of the yen has caused.

–the China case is a little more complicated.  The main reason for the falloff in Western luxury goods sales there is, of course, the anti-corruption campaign.  But even before this, there was a clear trend of high-end consumers in China away from foreign luxury brands and toward domestic ones.   It also seems to me that years of economic stagnation in the EU have further undermined the image of European brands as cultural symbols of power and influence.  So my guess is that even as/when the anti-corruption campaign runs its course, the bounceback of traditional European luxury goods sales will be muted.

my bottom line

Studying stock performance patterns of the past twenty or thirty years suggests that major selloffs of luxury goods stocks are always buying opportunities.  I don’t think this will be the case any longer.   This is not to say the stocks won’t go up in market rallies.  They likely will.  Bur they won’t be leaders.   And the best-known names will lag firms that primarily serve Millennials, as well as companies that tap into growing consumption in China.

UPS survey of online shopping

A week ago, UPS released its fifth annual survey of online shopping.  The main results:

–for the first time ever, more than half of the purchases made by survey respondents are made online

–over three quarters use smartphones for their buys

–a third use social media sites to gather information; a quarter have bought things through social media sites

–a third start their shopping either at Amazon or eBay

half of online shoppers take delivery at a physical store.  Almost half make additional purchases when they go to pick their items up

–60% of returns go through physical stores.  Again, consumers frequently buy additional items once they’re inside

–almost a third of purchases in a store are smartphone-guided, meaning buyers use their phones for product information, price comparison or download discount coupons

–35% of packages not sent to a store go to non-home locations, a trend that has been steadily rising recently

pure physical-store shopping, meaning no online involvement in either search or purchasing, is down to 20% of all buys in the US.

 

No wonder traditional retailers, especially mall-based ones, are taking such a beating.  No wonder Amazon is aggressively beefing up its own shipping operations, while starting to tiptoe into opening physical stores (as a better way of processing returns?).