Hop on the Bus, Gus

As the stock market declined last week, I was riding in a school bus filled with third graders. As we headed to a museum, I looked out the window and couldn’t help but appreciate how fortunate I was to be on a bus with laughing children instead of sitting in an office behind a Bloomberg. I knew if I was still managing a mutual fund, I’d be spending most of my days desperately searching for value in one of the most unattractive opportunity sets in the history of financial markets. Instead of forcing myself to find value where valued doesn’t exist — also known as manufacturing opportunity — I continue to believe my best option is to remain patient and watch the market cycle run its course from a safe distance.

As an absolute return investor eagerly waiting for free markets and investing (as I define it) to return, I was encouraged by last week’s fall in equity prices. However, the brief and shallow decline didn’t cause me to get overly excited about discovering value in the near-future. Until the current market cycle ends and valuations normalize, I expect opportunities will remain scarce. As such, I find little benefit in monitoring the daily movements in the markets and asset prices, even when they are falling. The decline that will eventually get me interested in allocating capital will most likely be considerably greater than Wednesday’s 1-2% hiccup (the past two cycle declines of 40-60% should suffice).

While I find the prices of most risk assets uninteresting, I continue to monitor the results and fundamentals of hundreds of publicly traded operating businesses. For my process and strategy to work, I need to be prepared to allocate capital at a moment’s notice. As seasoned investors know, the market cycle isn’t obligated to provide us with a formal notice or catalyst of its eventual demise. The abrupt ending of the internet stock bubble is a good example. When that cycle’s speculation bill arrived on March 10, 2000, it was unexpected, hefty, and due immediately. The decline was simply a result of an extremely overvalued market that stopped going up — that’s all it took.

Instead of watching investors buy the latest dip last week, I used my time to get caught up on consumer company earnings reports and conference calls. Earnings were mixed with some consumer companies reporting better than expected results, while others remained weak. Overall, in my opinion, the consumer environment has not changed meaningfully. For companies further removed from asset inflation, same-store sales comparisons remain in the low positive to negative single-digits — it’s stagnant. As I noted in a previous post, unless the consumer can rebound, I expect the recent bounce in aggregate earnings to lose steam later this year (easy comparisons with energy and industrial companies will begin to fade in Q3/Q4).

Below are some highlights of recent earnings reports and conference calls.

Wal-Mart (WMT) seemed to dazzle investors with its 1.4% same-store sales comparison and 1.5% increase in traffic (Wal-Mart U.S.). Management mentioned the delay in tax refunds was partially responsible for the slow start to the quarter and that sales trends improved throughout the quarter. Sales were also aided by the company’s investment in e-commerce. Specifically, Wal-Mart introduced free two-day shipping for purchases of $35 or more and began a pickup discount for products ordered online and picked up in the store. Wal-Mart also invested in lower prices. Despite these investments, gross margins were flat partially due to “savings from procuring merchandise”. While squeezing suppliers to help fund investments in e-commerce and lower prices seems to be working in the near-term, is it a sustainable strategy?

Target’s (TGT) comparable sales were also in the low single-digits, but negative with Q1’s comps declining -1.3%. The decline came from lower traffic (near 1% drop) and average ticket. Management called the environment volatile and does not believe conditions will change soon. Unlike Wal-Mart, Target was unable to avoid lower gross margins (down 40 bps) from its investment in e-commerce. Inventory was noticeably lower, down 5% from a year ago. Management believes competitor closings will continue to be disruptive and is planning for another low single-digit decline in comps in Q2.

After recently lowering earnings expectations, Foot Locker (FL) announced actual results last week. Operating results and guidance were less than expected, causing Foot Locker’s stock to decline -17%. Specifically, Foot Locker announced comparable sales declined -0.5%. Due to lower than expected April results, EPS of $1.36 was near the low-end of the company’s revised outlook. Management is now expecting low single-digit comparable sales and flat earnings in Q2.

I remember last month being surprised that Foot Locker’s stock actually increased on the day it announced weaker than expected results. I discussed this in a recent post (link). I believe the stock’s positive response was due to management’s optimistic comments regarding an improving April (a things are bad, but they’re getting better preannouncement theme). While April’s results were strong, increasing in the high single-digits, they were lower than management’s expectation of a double-digit rebound. Hence, the sharp decline in its stock price.

Foot Locker’s guidance was also less than expected. The company is now forecasting flat earnings and low single-digit Q2 comps. Management mentioned they are now considering “Plan B” (reducing inventory and expenses) to achieve their earnings goals. Similar to several other consumer companies, management believes the delay in tax refunds was partially responsible for negative traffic and the slower than expected start of the year.

Although Dick’s Sporting Goods (DKS) earnings release was slightly better than Foot Locker’s, results and guidance were less than expected. Specifically, same-store sales were up 2.4%, while transactions increased 0.8% (1.6% driven by increase in ticket). Management noted, “Due to our slower sales in the first quarter as well as the potential for short-term headwinds from Gander Mountain’s liquidation sales and broadened distribution of product from a key vendor partner, we now expect consolidated same-store sales to increase between 1% and 3% for the year. This compares to our previous guidance of 2% to 3%.”

Interestingly, management did not blame the delay in tax refunds stating, “Yes, I know people have talked about tax refunds. I don’t really — I’m not sure that tax refunds had much of an impact.” Management also made some interesting comments as it relates to real estate saying, “With what we see with so many stores that are closing or purported to close or we expect will close, there’s going to be just a flood of real estate on the market. Our view is that we should not be opening a whole lot of stores right now because we’re going to pay a higher rent today than we would 2 or 3 years from now.” In effect, management plans to be patient and wait for better opportunities – respect.

One of my favorite retailers (for shopping, not investing) is Stein Mart (SMRT). Stein Mart reported comparable sales for the first quarter declined -7.6%. Management noted, “We continue to experience traffic weakness that we have not seen since the 2008/2009 recession.” Management also commented that it is observing a dramatic change in consumer shopping behavior. As a result of the difficult operating environment, Stein Mart is conserving cash and cut its dividend. Similar to Dick’s, Stein Mart does not believe “tax returns had any impact on our particular customer base.”

Home Depot (HD) continues to report strong operating results with same-store comps increasing 5.5%. However, transactions only grew 1.5% with average ticket increasing 3.9%. Inflation in lumber, building materials, and copper positively impacted ticket growth by 0.75%. Furthermore, comps continue to benefit from big-ticket sales with transactions over $900 up 15.8% (20% of sales are classified as big-ticket).

Dependence on large ticket sales works both ways, depending on where we are in the cycle. Currently, with home prices rising, the cycle is clearly up. Management noted home prices increased 5% year-over-year and they see continued growth in residential investment. Management also stated, “There are 76 million owned households in the United States. And of those, there are only 3.2 million that have negative equity in their home. And you go back to 2011, 11 million of those households had negative equity in their home. So the amount shows that since 2011, homeowners have enjoyed a 113% increase in wealth, if you will, coming from home price appreciation. So on average, $50,000 per household. So you can imagine, at some point, to Ted’s point, they’ll take that down out and do a bigger millwork or a total remodel job.”

Kohl’s (KSS) had another weak quarter with comparable sales declining -2.7%. Kohl’s continues to pursue the strategy of lowering inventories with inventory units per store declining -5%.

Ralph Lauren (RL) is taking Kohl’s strategy of lowering inventory a step further. In its effort to align inventory with demand, inventory declined 30% versus last year! Results were weak, with North America revenue declining -21%. The company’s decision to reduce inventory is expected to improve full-price selling, or reduce discounting. It’s an interesting and drastic strategy. I look forward to watching it play out. At the very least, with such sharp declines in inventory and sales (big bath), one can reasonably assume the sharp double-digit declines will eventually stabilize. At what level and at what margins is the unknowable, in my opinion, making any valuation with a high degree of confidence difficult. It will be an interesting case study in discovering the appropriate response to a rapidly changing retail environment and sluggish end demand.