Monday, August 13, 2012

Costco, Wal-Mart and Target are Great Places to Hide from the European Slowdown

In the current environment I think the warehouse retailers are a good place to look for outperformance. The market seems to agree, with Wal-Mart (NYSE: WMT), Target (NYSE: TGT) and Costco (NASDAQ: COST) all doing better than the S & P 500 in recent months.

They look well placed because of the US-centric focus and the potential for marginal gains in revenue coming from ongoing improvements in US employment and consumer credit issuance. In addition, if China’s growth is going to slow then we can expect downward pressure on gasoline prices, which benefits them because it increases consumers’ discretionary incomes and, encourages more trips to stores.

On the other hand, the challenges will come from the necessity to expand an online presence and dealing with a US consumer that is stubbornly resisting price increases. Once consumers get used to discounts, it is very hard to increase prices as they are usually psychologically perceived as being ‘surcharges’. Moreover, whilst non-food inflation looks set to slow, the same cannot be definitely said about food costs.

What is Happening to Gross Margins?

Higher input costs have pressured the big box retailers just as much it has with so many other companies in the retail space in the US. On the other hand, revenue growth over the last four reported numbers has actually been quite impressive.

However, the revenue growth has to be put in the context of rising gasoline costs. So for example, with Costco in the data above, total comparable company sales (excluding gasoline & FX) were actually up 7% in the first quarter shown.  So gasoline prices boost revenues but they do not boost margins.
Another issue is the strengthening competition from online merchants. The argument that companies like Best Buy (NYSE: BBY) are effectively shop fronts for Amazon is well worn, but it is also compelling. Fortunately for the warehouse retailers, Amazon and the like, will not be able to compete across all their product lines. However, as with Best Buy, they will be able to restrain margin growth in selected lines

As such, whilst sales have been going up, margins have been declining.

As the graph demonstrates, the last quarter was the only on in the last four where any of these companies reported a year on year improvement in gross margins. The good news is, I don’t think it will be the last!

If we go back to the revenue graph, there is a clear pick up in both Target and Wal-Mart in their last quarters respectively. Meanwhile, Costco’s revenue growth slowed but margins improved. In other words, one man’s revenue growth is another man’s margin growth. I think this is positive news. Alas, my cheery disposition over the trends displayed here is not shared by the management of Costco, who used words like ‘fragile’ to describe the economic environment.

Management are cautious and for good reason. The global economy is facing challenges and the US consumer is getting used to its own brand of self imposed austerity. Many consumers are still deleveraging, but if you consider what is happening on a global basis than the US consumer is set to do relatively better.China’s growth rate is slowing and,Europe will slow as it deals with the next round of its Sovereign Debt crisis. This should result in an easing of global demand for commodities, which in turn, will reduce input costs for the warehouse retailers.

So What Next?

Of course, this prognosis relies on the US ‘decoupling’ and, with the increasing correlation of the global economy it is hard to believe that this is about to happen right now. But should we care? It strikes me that the investment world has become obsessed with the idea that the global economy will oscillate between the polemics of strong growth and near total recession.

I think a much more likely scenario –failing a complete collapse of the EuroZone- will be that growth trends higher but at the same low rates that it has been for the last few years. Such an environment will see winners and losers and whilst the story of the last few years was the relative outperformance of the emerging market world, there is a case to be made for an outperformance of the US consumer. At least I think so, because I happen to hold it!

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