This Week's Key Earnings

The symbolic start to the new earnings season takes place this week when aluminum producer Alcoa (NYSE: AA  ) gives results. It's going to be a very interesting season of results, and the key stocks this week should give good color on certain sections of the global economy.

Tuesday

Alcoa always gives good guidance on the global economy, and last quarter's report was quite positive. In fact, the surprising thing was that it maintained its outlook for China, even while companies like FedEx have been lowering their global growth forecasts throughout the year.  Furthermore, FedEx recently lowered its U.S. GDP forecasts inline with economists' thinking. All of this suggests that an economically sensitive company like Alcoa could lower some of its end-market forecasts. We shall see. 

Two important things to look out for are its outlook for the Chinese automotive sector, and the U.S. building and construction sector. Here are the growth rates for automotive sales and production in China. 

Source: China Association of Automobile Manufacturers.

Production rates have been strong in the last few months, but production has outpaced sales throughout 2013. So is it time for a moderation in production growth?

Turning to the U.S. construction and building sector, the architectural building index has perked up in recent months. It will be interesting to see if Alcoa upgrades its expectations accordingly.

Source: American Institute of Architects.

The second key report on Tuesday will come from Yum! Brands (NYSE: YUM  ) . All eyes will be on its outlook for KFC same-store sales in China because it has lost a lot of ground thanks to fears over its chicken supply quality in China, and then an outbreak of avian flu in the spring.

Source: company presentations

The good news is there are some signs that the worst is over. First, on its last conference call, Yum! pointed out that its July same-store sales declined 13% versus a 26% decline in the second quarter. Furthermore, McCormick (a spice and seasonings company that is a major supplier to KFC) stated that its sales to quick-service restaurants in China were "better than we had expected." This is a good sign for Yum!'s earnings.

Wednesday

The attention shifts to the U.S. retail scene on Wednesday when big-box retailer Costco Wholesale (NASDAQ: COST  ) and discounter Family Dollar Stores  (NYSE: FDO  ) release earnings.

It's been a tricky year for U.S. retailers as consumers seem highly responsive to pricing and promotions. The pattern appears to be that retailers hike prices only to be met with a drop in volumes; then they are forced to take action to regain market share. Then the cycle is repeated.

However, Costco stands out because it has managed to generate sales growth, as well as margin expansion.

Source: company presentations.

The key things to look out for with Costco are its new membership signups and whether traffic and frequency (the rate that its customers return) remain in growth mode.

Turning to Family Dollar, its forecasts for the upcoming results are that same-store sales growth will come in at 2% and gross margins will be flat. The latter is somewhat of a victory because its margins have been under pressure due to its expansion in sales of lower-margin items such as tobacco and groceries.  

However, the key thing to look out for will be its core discretionary sales. At the last results, Family Dollar spoke of some stabilization in these sales. Discretionary sales at the dollar stores tend to be higher-margin items. Unfortunately, the dollar stores have struggled to deliver consistent discretionary sales growth in a difficult economy. Have they turned the corner?

Industrial-supply company Fastenal (NASDAQ: FAST  ) also reports Wednesday. The company has long been a good barometer for U.S. industrial conditions, and investors would do well to listen carefully to what it says.

The key thing to look out for with Fastenal will be how its plan to recruit 600-900 new in-store staff by year end is transgressing. The idea is that the new support staff should free up time for its managers to make more customer visits and help expand sales. Interestingly, Fastenal reported that its stores open for more than five years had sales growth of 0.6% in July, and then 4.7% in August. This implies that the plan is starting to work, and investors will want to see more improvements in September's numbers as well as some positive news on U.S. industrial conditions.

Walgreen Disappoints But is it a Buying Opportunity?

Investors in Walgreen (NYSE: WAG) have had a pretty good time of it over the last year with a near 50% gain as I write however, the recent results were somewhat disappointing. The market did what it does with an earnings miss and promptly marked the stock down. By now most interested parties will be aware of the situation so I decided to take a more in-depth look at what happened.

In summary, I think that this report contained some of the themes that have been repeatedly seen in the mass consumer market in recent years and this gives cause for optimism.

A tough mass consumer market?

Frankly the last few years have been difficult for the mass consumer market. It has been dogged with the levels of unemployment and sluggish spending that it wasn’t structured to deal with. As a consequence many of the old strategies aren’t working.  For example the challenges facing a company like Procter & Gamble (NYSE: PG) have been emblematic. It is known to have classic brands with which it can try and hold pricing (at the expense of volumes) during the downturn and then benefit from profit expansion when the upturn comes and volumes come back.

Unfortunately that upturn hasn’t happened yet –at least in the mass market- and the whole sector has been locked in a circular game of raising marketing and promotional activity, seeing volumes rise, then trying to take pricing, only to then see volumes and footfall decline as customers walk away to competitors. Then the cycle is repeated again with the company hoping that ‘next time round’ it’ll get lucky.

It turns out that the way to play this type of market has been to buy companies with good brands who are under-performing but about to make these changes. Procter & Gamble has been a good example of this. It has had to fight hard to stabilize its core North American market, but its emerging market performance hasn't been great recently. No matter, the market has rewarded it for sorting out its pricing strategy.

Procter & Gamble's 25% stock price rise over the last year is a testimony to what can be achieved when companies start to leverage the underlying strength of their brands. For example it recently stated that two thirds of its business in the U.S. (defined by sales) had held or increased sales in the last quarter. This compares very favorably with a figure of only 15% for the June quarter last year.

And Walgreen another?

All of which leads me into Walgreen’s Q3 report. Earnings missed estimates and the disappointment is centered on comparable same store sales only being up .4% and comparable store traffic down 3.9%. It appears to be a familiar story of Walgreen cutting back on promotions and discounts only to see customers walk away to competitors like CVS Caremark (NYSE: CVS) or even a big box retailer like Costco Wholesale (NASDAQ: COST).

With regards to Costco its performance in the last quarter, as discussed here, stands in contrast to much of the sector. Costco’s traffic remained stable, but its frequency  was up 4-5%. In other words its customers are making more trips, on average, to the store in the quarter.  This is a good indication that it is doing a good job engendering customer loyalty and understanding the purchasing needs of its members. This is easier said than done, especially in a quarter categorized by issues such as unseasonable weather, delayed tax refunds, rising gasoline prices, the sequester and payroll tax increases. Costco may have done well thanks to its gasoline sales driving customers as well as its relentless focus on pricing.

Unfortunately Walgreen did not fare so well and frankly this wasn’t the time to cutback on pricing and promotions. With that said Walgreen has recognized the problem and a renewed focus on promotions and pricing was initiated in mid May. Essentially it is trying to drive traffic and same store sales growth. This is likely to impact margins, but Walgreen is quite candid that it is more focused on gross profit than margins. Which means that it is willing to discount and promote (which reduces margins) in order to drive revenue and profit growth.

Elsewhere its script comparables were up 7.1% in a market where physician visits were reported to be down 2.7% in May. Therefore I don’t think it’s fair to conclude that the weak sales are a consequence of ongoing weakness due to the Express Scripts debacle. Walgreen is winning customers back.

CVS reported results at the start of May and its front store business comparables were only up 1.4% with front store traffic ‘down slightly’ although it claimed to have gained market share. CVS claimed its market share compared to other drug retailers was up 1.2% and 0.1% against multi-outlet retailers. The former number suggests CVS has taken market share from Walgreen.

As ever, investors will focus on the CVS vs. Walgreen debate but frankly I see no reason why you can't hold both! If you like the long term trends of increasing generics sales (which tend to slow revenue growth but increase margins), expanding private label sales (higher margin) and the demand pull from an aging demographic than both are set to grow over the long term. These trends have resulted in substantive increases in free cash flow for these businesses over the last few years.

WAG Free Cash Flow TTM data by YCharts

And despite good stock price performance, both companies look like good values.

WAG Price to Cash Flow TTM data by YCharts

The bottom line

In conclusion, I think there are reasons to be positive. Its retail traffic and sales problems appear to be issues related to pushing its balanced rewards card and losing focus of promotions and discounts. The good news is that recent history suggests that these issues can be rectified in due course within the retail sector. If customers aren’t ‘loyal’ to Walgreen then they are not likely to be loyal to CVS, Wal-Mart, Costco or whoever.  Moreover the balanced reward card gives Walgreen more data with which it can better manage its sales initiatives. It can also use reward cards to drive promotions and pricing.

Long-term growth looks assured and history suggests that customers are price sensitive. In other words when Walgreen makes the necessary pricing and promotional adjustments it should see traffic and front store sales growth come back. The valuation remains attractive and I think it's a decent opportunity to pick some up. 

Why Costco is Outperforming

The retail sector usually makes sense,or at least we can delude ourselves that we can make sense of it all. There are obvious macroeconomic trends filtering through into the results of the companies in the sector. From the dollar stores to the high end, through the specialty stores and the online based companies, there are discernible patterns we can use to gauge future performance. And then there is Costco Wholesale (NASDAQ: COST).

Costco executes

I last looked at Costco in an article linked here and highlighted how well the company was doing but also inquired as to where the value was in the stock price.  The answer to my question was that it lies within its ongoing execution and ability to service its customers with the goods they want. As investors, we are more interested in its stock price potential rather than its company performance per se, but in this case I think the stock’s evaluation of 24x trailing earnings is at a level where the two things are correlated.

This chart helps to outline how well the company has been doing over the last year:

Clearly gross margins have been expanding over the last five quarters (note that the yearly comparisons are starting to get tougher too) while comparable sales growth remains good too. Overall revenue growth remains in the high single digits, and the company’s expansion program (particularly internationally) remains on track. Indeed, Costco expects to finish the year with 28 new openings as opposed to 16 last year. Of the nine more expected for 2013, three are planned for the U.S. and the other six are international.

What is Costco doing right?

And, more pertinently, can it continue to do these things right? I have a five main points to discuss from its recent Q3 results.

Firstly, Costco’s traffic remains strong and it reported year to date frequency up 4-5%. Costco cited the draw of its gas sales (30% of people buying gas go on to shop at Costco), fresh food (which has seen increased demand as the slow economy has reduced the demand for eating out), and the ‘wow’ factor of many of its items.

Second, I think the psychological effect of inducing people to shop at Costco after they have paid a membership fee is a sound one based on many of the principles inherent in work on behavioral studies. I think a membership fee is looked at as a sunk cost, but since people will ‘pay’ more to avoid a ‘loss’ they will shop at Costco in order to do this. Of course if that cost increases (and Costco has hiked membership fees in recent years) than the feeling of 'loss' will increase and customers may be induced to shop more at Costco.

Third, membership fee increases have not encouraged churn. In fact business renewal rates started and finished the quarter at an impressive 93.9%. New membership signups increased 19% with particular strength in Asia. Membership fee income increased 12% to $531 million.

Fourth, Costco continues to generate growth where others can’t. In particular I was struck by the strength within hard lines where it recorded strong growth in lawn and garden and consumer electronics.

And lastly, Costco continues to reduce its stock keeping units (SKUs) in order to optimize inventory turns and profitability.

Costco is, of course, not alone in many of these activities but it compares very well across the sector because it does all of them well. For example Lowe’s Companies (NYSE: LOW) has an ongoing plan to reset its product lineups in order to reduce SKUs and ‘normalize inventory.’ While this may appear routine stuff, Costco has been doing it well for years while Lowe’s has had to adjust because it wasn’t doing it well. With that said, Lowe’s actually has some upside potential from successful execution of this plan.

Moreover, Lowe’s (and Home Depot for that matter) both reported that outdoor and garden items were a bit soft in the last quarter thanks to the late spring. In comparison Costco cited these categories as being strong.

Whither Wal-Mart?

Costco isn’t alone in its membership fee model as BJ Wholesale and Wal-Mart’s (NYSE: WMT) Sam’s Club also take membership. Wal-Mart is following Costco by increasing its membership fee but its execution is nowhere near Costco. For example its comparable sales growth (ex fuel) was only up .2% in the last quarter with traffic up 1.3% compared to Costco’s 4.5%. In addition its ticket value was down 1.1% while Costco’s was flat.

So while the economic environment is difficult and Wal-Mart on the whole has been a bit disappointing (a net sales increase of only 1.8% in the last quarter), Costco has outperformed, particularly against Sam’s Club.

The bottom line

In conclusion, while something like Wal-Mart is largely a play on the economic environment, Costco has demonstrated that its superior performance can justify an evaluation premium over Wal-Mart. The problem is that it will be pressured to continue this execution in order to be rewarded by the market. Any slip-up and/or step-up in competition from Target or Wal-Mart and its current PE of 24x will start to get hard to justify.

How Much Longer Can Whole Foods Keep Growing?

Whole Foods Market (NASDAQ: WFM) is one of the stocks that is going to give emotional investors sleepless nights. On the one hand it’s starting to look expensive in relation to its growth prospects, particularly with competitors making plans to encroach on its market area. On the other, its growth prospects are starting to make it look cheap on a long term basis. I happen to like both sides of the argument, hence the uncertainty. I don’t buy stocks that I am uncertain of, but I’m sure others will have more concrete views.

I wanted to articulate some of the salient points so investors could make their own minds up.

A Smaller Piece of a Bigger Pie?

The sub-heading is why the proposition is so tricky at Whole Foods. More often than not, any analysis of a company usually involves trying to find its value proposition within a particular point of a cycle that most companies go through.  I’ll try to elucidate. The cycle typically runs a bit like this: high growth nascent industry phase, growth phase as company matures, GDP (plus a bit more) growth phase as maturity sets in and competitors enter, GDP (or less) growth phase as the company matures.

Of course this type of conceptual thinking is usually expressed rationally in a discounted cash flow analysis and the question is always “am I paying the right price for the stock?” The best answer usually lies within a better understanding of where the company is in the cycle. So what does it all mean for Whole Foods?

Well, usually a company is involved in fighting for a bigger piece of a relatively smaller pie in the future. Competitors enter and it gets that much harder to retain or grow market share. However, with Whole Foods I think that its end markets will accelerate in the future so that we will be in an elongated position within the second growth phase of the cycle.  The pie will get bigger and Whole Foods can still generate growth even with a smaller piece.

A quick look at some of the key metrics suggests that quarterly gross margin comparisons are still favorable while same store comparables remain in the 8%+ range.

So far so good, and there are no real signs of slowing growth in the metrics yet.

Bigger Pie

Long term, the trend towards organic, ‘healthy’ or non-GM foods looks assured. I use inverted commas because I’m not someone who views GM foods as being unhealthy, but I am a cynic when it comes to the unfailing ability of the media and celebrities to discuss important subject matters that they know nothing about. Scare stories involving health issues are particularly prevalent and few more so than GM foods.

Another favorable trend will be that of increasing discretionary spending by wealthier career women. I wouldn’t underestimate this trend. Indeed, in the recent conference call Whole Foods outlined that 20% of its customers do about 75-80% of its business. This is a kind of devotion only usually inspired by Scientology or other cults. In addition marketing data suggested that they gained 22% in new customers in the quarter.

In a sense, this is why Wal-Mart (NYSE: WMT) and Costco (NASDAQ: COST) don’t appear to be making inroads yet, despite their expansion into the food category. Shoppers like the Whole Foods retail experience and the feeling of ‘being healthy’ by eating there. They don’t get this at Wal-Mart or Costco, even if the food is exactly the same. Moreover, if Wal-Mart and Costco are expanding their food operations, it will squeeze the traditional mass market grocers who will then try and find other areas of growth, and this could mean trouble for Whole Foods.

A Smaller Piece

With that said, I’m simply not ready to cast aside everything I’ve ever learned about market forces. The big box retailers may not offer the same retail experience to a typical Whole Foods customer, but traditional grocers like Kroger (NYSE: KR) and Safeway (NYSE: SWY) have a footfall of customers who probably also shop at Whole Foods.

Kroger in particular has management that has demonstrated that it is willing to go to every length to wring every sale it possibly can out of its customers. At some point, the sheer weight of footfall will start to tell, and they will both start to grab meaningful market share.

Moreover, while the devoted will still stay, the newly acquired customers may prove fickle amidst the temptation of every food retailer chasing the ‘health’ angle.

Where Next for Whole Foods?

If you strip out the amount spent on new stores the FCF/EV yield is 4.5%, which is a surprisingly high number for such a highly fancied stock. However, I think it does imply that Whole Foods needs to hit its earnings targets over the next few years.

There is little margin for error here, and any slowdown in comparable same store sales growth and this stock will get hit hard. If so, the stock will be worth a look because its end markets look good. However, I would rather buy it when the market is pricing it as I see it, rather than as a bigger piece of a bigger pie.