Wolfe Research's Senior Consumer Research analyst, Adrienne Yih, hosted a webcast to elucidate her methodology for calculating deleverage.
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In our Omnichannel 101 primer (click here for report), we covered a broad range of high-level topics, including Millennial consumer behavior, The Retail Paradigm Shift, Amazon’s impact on retail, and why deleverage occurs. We introduced two proprietary concepts: 1) The Retail Deleverage, or “Death,” Curve (“D-Curve”), showing the margin-eroding math behind the shift from brick-and-mortar to e-commerce and 2) Operating Margin Return on Inventory Investment (“OMROI”) as an output metric and leading indicator for potential deleverage. In Omnichannel 201, we get into the weeds and provide investors a practical framework to assess a retailer’s company-specific deleverage risk. We bring together a set of comprehensive tools and metrics in a step-by-step process. With retailers now formally acknowledging potential e-commerce penetration of 40% to 50% over the next five to seven years, we present a model that can be used to assess retail deleverage. Retail analysts and investors need to understand the sales and margin implications as retail shifts from brick-and-mortar to e-commerce.
In our retail deleverage thesis, we believe department stores face the greatest challenges with omni-channel shift. In the mid-90s, department stores ceded share to the Specialty Retail channel. Now, 20 years later, Specialty Retail is ceding share to e-commerce, and department stores find themselves with significant capital investment in a mall-based channel that consumers are migrating away from. JWN remains the best of the department stores, with superior customer service and the latest in brand offerings, but we remain sidelined. Despite the positive surprise to comp for holiday and 4Q17, we remain concerned due to the slowing comp at Rack, potential for cannibalization of full-line, and ongoing margin deleverage as sales shift from brick-and-mortar to e-commerce. AMC on 1/9/18, Nordstrom pre-announced November and December combined sales. Net sales growth was +2.5% while comp sales were +1.2%. For Full-line Nordstrom, comp sales increased 1% and net sales increased by 0.7%. At Nordstrom Rack, net sales increased 8.2% while comp sales increased 2.9%. The company also updated their FY17 EPS guidance to the high end of their prior range to $2.90 to $2.95 vs. Cons. of $2.94. This assumes FY17 comp sales of +0.5%, continued stability in merchandise margins and SG&A deleverage due to their growth initiatives. Shares were off ~1% in the aftermarket.
Rare holiday miss in the sector. After early success in November, with a rising tide in mall traffic across the sector, EXPR lost momentum during the “lull” in early December. Weaker-than-expected sales and higher promotions needed to drive traffic were offset by management’s intense focus on average unit cost reduction and aggressive negations on rent reduction supporting GM. With our 4Q17 forecast of approximately -7% for brick-and-mortar comps, EXPR continues to experience material omni-channel deleverage. Management guided down 4Q17 comp to a range of -1% to -2% from prior guidance of +LSD. EPS is now expected to be in the range of $0.31 to $0.33 on 79.2 million weighted average shares outstanding vs. Cons. of $0.43. Full-year Adjusted EPS is now expected to be $0.33 to $0.35 on 78.9 million shares outstanding vs. Cons. of $0.46. The company bought back ~450,000 shares for $5 million during 4Q17 and has $145 million remaining on its most recent authorization. Shares reacted by trading off ~13%.
Buying market share with promos. The teen sector remains one of the most price competitive in apparel retailing, and we note another quarter of deeper promotions to drive comp upside. Throughout 2016 and 2017, AEO made great strides in reducing its average unit cost (“AUC”) and was able to subsidize the promotional activity that weighed on average unit retail (“AUR”). However, we believe the largest reductions to AUC have been captured. With one of the more significant accretive EPS boosts from tax reform, AEO must now prove it has pricing power in order to keep the tax-driven earnings power upside. AEO reiterated 4Q17 EPS guidance in the range of $0.42-$0.44 (Cons. at $0.43) on a holiday comp of +8% (4Q17 Cons. at +5%). The company noted positive traffic in both stores and online. QTD, we noted deeper promos as the teen sector remained ultra-competitive. Although AEO is capturing teen share of wallet, we believe the cost is high in terms of merch margins and brand equity. This, combined with the run-up in valuation, leaves us on the sidelines until we see clear signs of pricing power (fewer promotions) and sustainable positive brick-and-mortar comps (we estimate brick-and-mortar comps are up about 4% in 4Q17E from -1% in 3Q17 – see Exhibit 3). The stock was flat in after-market trading.
More good news here than bad. Almost all of the holiday underperformance came from the Tech & Media category at the UO brand. After URBN reported a consolidated QTD comp in early December in the +MSD range, it was quite a disappointment to see holiday comps at only +2%. The bad news is that the UO brand was entirely responsible for the sales miss. The good news is that the underperformance stemmed from the Tech & Media category within Home at UO and that this category is largest in December and shrinks by more than 50% after holiday. More good news is that all brands posted positive merchandise margin expansion and drove positive comps with less discounting than LY. Anthropologie had the most improved merchandise margin, consistent with our checks. By brand, holiday comps were: Urban Outfitters +1%; Anthropologie +2%; and FreePeople +5%. Shares sold off as investors noted the comp deceleration from the early December 10-Q report of comp sales +MSD. Despite the surprise deceleration, our thesis on improvement in core product, particularly women’s apparel, at both UO and Anthropologie remains intact, and we reiterate our Outperform. URBN shares were down ~5% after-hours.
LULU was one of very few retailers that did not have to rely on heavy promotions to drive holiday sales upside. In addition, LULU has proven its ability to comp in both the brick-and-mortar and e-commerce channels in seven of the past eight consecutive quarters. We believe that only retailers with strong brand equity will be able to avoid omni-channel deleverage and promotional margin pressure over the next few years. Despite the solid fundamental margin drivers, we believe valuation reflects ongoing upside and look for a more attractive entry point in order to become more constructive. BMO on 1/8/2017, LULU increased non-GAAP EPS guidance from $1.19-$1.22 to $1.25-$1.27 (Cons at $1.22) excluding the impact of the ivivva restructuring. Updated net revenue is now expected to be $905-$915 million on a +HSD total comp sales (prior guidance of $870-$885 million revenue on a +MSD comp sales). Shares are down slightly during intraday trading.
We once again reiterate our Outperform of PLCE as management employs multiple levers to gain share and expand margins. BMO on 1/8/18, PLCE reported holiday comp of +8.5% through the first 9-weeks of 4Q17, as compared to consensus expectations of +3% for 4Q17. 4Q17 EPS guidance was raised 18% at the midpoint to a new range of $2.45 to $2.50 from previous guidance of $2.07 to $2.12 (4Q17 Cons is $2.14). Management noted a significant sequential uptick in store traffic and positive comp drivers in all major metrics including: average unit retail (“AUR”), units per transaction, and conversion. We also believe e-commerce sales (highly accretive to operating margins) continue to accelerate growing roughly ~25% YoY for the holiday period and reaching just under 24% as a percent of total sales. We continue to see share gain opportunities as Gymboree continues to struggle and closes stores. Despite the positive news, PLCE traded off ~1% during intraday trading, likely due to the stock’s recent rapid price appreciation in calendar 4Q17.
As we enter 2018, the set up for an LB recovery appears promising: 1) after self-inflicted disruption, VS comps are no longer against compares from the exited categories, 2) potential for 15%+ EPS accretion from tax reform, and 3) BBW & Pink continue their positive momentum. However, holiday season was a disappointment with higher-than-expected promos pressuring margins. Other than an improving VS comp on the back of discounting, there is sparse evidence of a turn at core VS. As such, given lack of tangible fundamental drivers, we remain Peer Perform. We would become more constructive if: 1) under current business trends, valuation were to pull in another turn on EV/EBITDA to the industry average of 7.6x, suggesting a low- to mid-$40 share price or 2) we see progress towards positive VS comps with less discounting.
Wolfe Research's Senior Consumer Research analyst, Adrienne Yih, hosted a webcast to discuss her Holiday Mall Monitor note.
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