Is Wal-Mart Taking Aim at the Dollar Stores?

If you had a dollar for every time an analyst speculated over what would happen if Wal-Mart   decided to target a certain market, then you would have enough money to buy a Family Dollar store outright instead of fretting over encroaching competition. The dollar stores do look like they could see Wal-Mart muscling in, so investors looking for another way to play the value segment of retail might consider Ross Stores or TJX Companies  instead.

Wal-Mart targets the dollar stores, or does it?
By now, most investors will be aware of Wal-Mart's recent announcement in which the company states that it intends to double its planned small-store expansion to 270-300 stores, from an initial target of 120-150. Essentially, this is seen as Wal-Mart taking direct aim at the dollar stores, especially given Wal-Mart's undoubted purchasing power and reach.

 

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Acuity Brands Lights Up The Markets

North America's leading lighting company, Acuity Brands (NYSE: AYI  ) , released its quarterly results recently, cheering the market with its positive outlook. The company offers good long-term growth prospects from both the increase in demand for LED lighting and a recovery in commercial and industrial construction. The market seems to have fully woken up to this story, however, and the company needs to deliver in order to justify the current evaluation. Is now the time to be chasing the stock?

An LED playThe growing acceptance of LED lighting is good for Acuity for two main reasons. First, it is seeing replacement demand coming from customers wanting to use LED lighting. Second, this type of lighting usually comes with control systems, so Acuity can generate add-on sales for the systems. Moreover, these demand sources don't rely on the economy or overall construction activity. In reality, it's more of an opportunity to grow sales (rather than margins), because its LED lighting solutions tend to have similar margins to conventional lighting.

Unfortunately, management didn't disclose the exact share of revenues coming from LEDs, but they outlined that it was at least above 21%. Consider that the last three quarters' numbers have been 13%, 15%, and 20%, respectively, which represents very good growth.

More than an LED playAcuity also offers earnings upside from an improving economy, and this time there are margin growth opportunities as well. Construction activity appears to be picking up, as seen in the Architectural Billings Index from the American Institute of Architects:

Source: American Institute of Architects.

The hope is that growing residential activity will ultimately translate into commercial and industrial construction. Increased housing construction implies the build-out of commercial buildings around the new communities. In addition, a resurgent housing market tends to grow household net worth, which in turn leads to increased consumer spending. Ultimately, this feeds into commercial and industrial construction investments in line with an improving economy.  

All of this positively affects Acuity in two ways. First, its strongest market has traditionally been the commercial and industrial sector, and any increase in activity will aid its top line. Second, new construction work is likely to create a higher margin mix than Acuity has now. For the second quarter in a row, Acuity saw its volumes rise 14%, though net sales increased by only 11% last quarter and 13% this time around. On the conference call, Acuity explained the discrepancy as being primarily due to changes in the channel mix, as well as the mix of products sold, and, to a lesser degree, lower pricing on like-kind LED luminaires.

Acuity's renovation work tends to be lower-margin activity, as does its sales through the home improvement stores like Home Depot and Lowe's. Clearly Acuity has a margin expansion opportunity provided that the new construction market improves next year.

Wal-Mart lights up the wayOne catalyst for growth could come from Wal-Mart (NYSE: WMT  ) , as it recently launched an LED light bulb selling for under $10. Analysts are mixed over the potential outcomes, with some seeing future margin pressure to come for Home Depot's LED bulbs (an important retailer for Acuity), and downward pressure on Cree's LED lighting margins. 

On the other hand, Wal-Mart's move is highly likely to spark wide-scale interest in LED lighting. This could turn out to be a net positive for the industry. Cree is also a large scale LED manufacturer, and an increase in end demand should help it to lower its prices. Meanwhile, Cree and Acuity could find it easier to convince customers to buy their lighting solutions if Wal-Mart's move creates mass awareness of the benefits of LEDs.

The bottom lineThere is a lot to like about Acuity, but at a price of $92.80 per share as I write, the company's stock is at 23 times its earnings forecast to August 2014, and around 20 times to August 2015. It looks priced for perfection, and any hiccup with short-term pricing due to Wal-Mart's move will hurt the stock. If you think the commercial construction market is going come back strongly next year, Acuity Brands stands to reap the benefits, but there are probably cheaper ways to play the idea.

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.

GameStop Set to Disappoint the Market in 2011?

GameStop $GME is a business that has been aggressively shorted over the last few years, but is it now becoming a contrarian play? Investors have been quick to sound the death knell for GameStop due to the ‘oncoming’ onslaught of online gaming sales, and according to Yahoo Finance the short percentage of the float was around 24% However, the recent results were superficially quite good and the stock rallied. Is it time to buy?

GameStop Earnings and Margins

A quick look at revenues over the years (year end to Feb)...

Sales ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	1,073.7	1,668.9	1860.2	1,756.5	1,720.0
New Video Game Software	2,012.5	2,800.7	3685	3,730.9	3,968.7
Used Video Game Software	1,316.0	1,586.7	2026.6	2,394.1	2,469.8
Other	916.7	1,037.7	1234.1	1,196.5	1,315.2
Total	5,318.9	7,094.0	8,805.9	9,078.0	9,473.7

...reveals that growth in the Used Video Game Software segment appears to be slowing. The importance of this can be demonstrated by a look at gross margins.

Gross Profit ($m)	2007	2008	2009	2010	2011
New Video Game Hardware	77	108.2	112.6	113.5	124.9
gross margin	7.2%	6.5%	6.1%	6.5%	7.3%
New Video Game Software	427.3	581.7	768.4	795	819.6
gross margin	21.2%	20.8%	20.9%	21.3%	20.7%
Used Video Game Software	651.9	772.6	974.5	1121.2	1140.6
gross margin	49.5%	48.7%	48.1%	46.8%	46.2%
Other	315.2	351.6	414.6	405	452.6
gross margin	34.4%	33.9%	33.6%	33.8%	34.4%
Total	1471.4	1814.1	2270.1	2434.7	2537.7

Over the years, the used game segment has made up the bulk of profits but growth appears to be slowing.  I think this is an understandable issue and I would like to explore the reasons why.

GameStop Structurally Challenged?

There are four main challenges to GameStop and I think all of them are significant.

1. Best Buy and Walmart are encroaching on their market share
2. Online merchants are grabbing market share from in-store sales
3. Software manufacturers are shifting to delivering the games online (avoiding piracy and protecting IP is a key driver here)
4. They are being forced into the 'long tail' of retail (superstores are selling the blockbuster titles) which is an area that is not their forte

The likes of Best Buy $BBY and Wal-mart $WMT, as indicated in an earlier article, are seeing some of their traditional markets erode to online competition. Therefore, they are seeking new ways to sell to their captive audience of shoppers. Naturally, selling new and used gaming software fits perfectly into the sales demographic of kids making trips to their outlets. This competition is significant for GameStop.

Similarly, online competitors like Amazon are continuing to grab competition from GameStop. The advent of smart phones that can read bar codes and immediately compare prices will pressure margins for ‘bricks and mortar’ retailers. GameStop will still be able to offer the ‘retail experience’ of kids checking out new releases but as the tables indicate hardware sales are low margin, and new software sales do not make up the bulk of GameStop’s profits.

However, the key challenge for GameStop will come from how the gaming companies deliver files. With the advent of 4G and other ‘fat bandwidth’ provision, it will become feasible for games to be sold online. This has great advantages to the gaming industry because they will be able to insure against piracy by selling gaming upgrades and licences to the original purchaser. This helps avoid the kind of piracy that is rife in this form of Intellectual Property. This will be a significant problem for GameStop and I think will hurt them sooner rather than later.

A Value Trap?

I think there is a value trap here. GameStop are talking about closing 200 stores and opening 200 others in an attempt to restructure the business, but I think the decline and structural challenges are already showing in the numbers. Let’s look at sequential numbers...

Gross Profit ($m)	Jan-10	May-10	Jul-10	Oct-10	Jan-11
New Video Game Hardware	40.9	21.2	25.9	21.7	56.2
gross margin	5.5%	6.1%	8.2%	7.9%	7.2%
New Video Game Software	322.2	174.5	141.7	182.4	321
gross margin	20.6%	20.0%	21.4%	21.7%	20.1%
Used Video Game Software	360.7	274.4	260	250.2	355.8
gross margin	46.4%	48.1%	46.0%	47.4%	44.2%
Other	150.3	100.7	89.2	92	170.7
gross margin	33.6%	34.7%	34.8%	35.9%	33.3%
Total	874.1	570.8	516.8	546.3	903.7

..and margins are clearly falling in the used games category. However sales are doing ok (on a like for like comparison)

The reason for this is that I suspect Sales for the used game segment will do well for a while due to the hardware upgrading cycle causing lots of new inventory to become available. Unfortunately, for GameStop this will be sold off a lower margin and is likely to get lower still, as games shift to being delivered online. All of which creates a value trap for GameStop, they could be reporting good sales growth but I would keep an eye on used game software margins. I think they are set to fall aggressively.