Holiday bargains will dent retail profits. Investors can get an edge
7 min read
Everyone loves a deal and consumers this holiday season can expect more savings in stores thanks to a glut of inventory at some of their favorite retailers. While the surplus merchandise is a boon for consumers, it does mean a potential hit to profitability for retailers — even if it encourages more shopping. It also makes for a complicated stock-picking environment for investors, at a time when retailers are in focus. In this challenging climate, analysts and investors say off-price retailers Ross Stores and TJX Cos., Ulta Beauty and dollar stores are among the best positioned and defensive names to ride out the season should consumers turn more cautious in the face of rising inflation. The bargain hunting for holiday shoppers started earlier than the usual Black Friday shenanigans as Amazon kicked off a two-day Prime Early Access Sale on Tuesday. This second sales event is a break from tradition for the e-commerce giant, which typically hosts its flagship Prime Day once a year. It will likely set the tone for retail’s busiest time of year. Rivals Target and Walmart aren’t waiting on the sidelines. Both have announced their own competing events as have Macy’s, Kohl’s and Bed Bath & Beyond as they race competitors to cut prices and clear out inventory. Last year, the picture couldn’t have been more different. Holiday shoppers continued to spend even as they found few deals at the stores . Consumers were eager to buy gifts and retailers had little incentive to mark items down as many were struggling to keep shelves stocked. The result was record high sales and strong profit margins. The supply constraints of last year are largely gone and the focus has shifted to mounting concerns that slowing consumer spending will leave shelves too full. For months, consumers have been battered by inflation, which has boosted the price of everything from food to travel, and the savings consumers built up during the pandemic is eroding. “What we saw was a supply chain crisis where companies couldn’t get enough items on the shelf, so they started ordering more,” said Randy Hare, director of research at Huntington National Bank. “All of a sudden, they started getting a surprise … the consumer shifted a little bit or slowed down.” The good news is that several consumer surveys are suggesting favorable spending trends. Stifel’s research found that consumers plan to spend 9% more this holiday season than in 2021, and roughly three-quarters of respondents to a PwC holiday poll indicated they plan to spend the same or more this holiday season. Stifel’s survey included a little over 300 respondents polled in mid-September while PwC surveyed 4,000 consumers in July. In this environment, products with quicker replenishment cycles like clothing for growing children may experience more demand this season, especially given that consumers over-purchased, stocking up on sales items in apparel and footwear, said Simeon Siegel, an analyst at BMO Capital Markets. A rush to fill shelves Many analysts have said the supply chain issues prevalent during the pandemic have eased as ports and borders reopened. But it also seems that patterns are still difficult to predict. In late September, Nike reported that inventory on its balance sheet had swelled 44% year over year — and was up 65% in the U.S. alone . But it noted that a large portion of its holiday merchandise was still in transit. Goldman Sachs retail analyst Kate McShane, speaking at an event in mid-September, said retailers attempted to pull forward some inventory to prevent the empty shelf disasters. To do this, management teams had to make decisions well in advance of the evolving macro picture. That strategy can be problematic, said Nicole DeHoratius, an adjunct professor of operations management at the University of Chicago’s Booth School of Business. Consumer habits are shifting erratically and trends are changing with the acceleration of the return to offices, which makes it difficult for retailers that are making purchasing decisions months in advance, she said. “We say that forecasts are always going to be wrong and that the winners are going to be those that have designed and built an agile supply chain,” she said. Savvy retailers like Target and Walmart have fallen victim to the changing buying patterns. Target warned in June of short-term hits to profit as it canceled orders and increased markdowns to get rid of unwanted and excess inventory. Walmart shared similar concerns in July when it slashed its financial forecast, noting that margins have taken a hit as it accelerates markdowns . Rather than marking down inventory, companies should hold on to it for the next year if their balance sheets can stand it, said Siegel. To be sure, this isn’t a solution for every retailer. In addition to funding, it requires access to warehouses and goods that won’t go out of fashion or spoil. “Companies that sold a lot of their goods to their consumers last year need to internalize that their customers don’t need those goods right now no matter the discount,” he said. “But that’s not doom and gloom, because they’ll come back next year after they’ve burned through their scented candles.” Regardless of the discount, Siegel said most items — no matter how cheap they are — require a consumer motivation to make a purchase. Michael Kors’ owner Capri Holdings is one company that’s drawing a line. It is holding on to more of its core inventory and also raising prices. Finding value in retail For investors trying to navigate this climate, research from D.A. Davidson suggests that the retail stocks least tied to apparel and traditional consumer discretionary items perform best during the holiday season, analyst Michael Baker said. In a 2021 report, the firm found that both Best Buy and Dick’s Sporting Goods underperformed or fared weaker than the market in seven of the past 10 holiday seasons, with both companies historically reaping at least a third of their profits in the fourth quarter. Home Depot and Lowe’s were the best-performing retail stocks in most seasons since 2011, outperforming the market between Black Friday and the end of the year by 1.3% and 3.7% on average, respectively. So far this year, the S & P 500’s XRT index tracking the retail sector is down more than 35%. That said, the data suggests better times ahead given that November is the best month to own retail stocks on average — until Black Friday hits. “The XRT typically stays weak in January as retailers confess their Christmas numbers,” Baker wrote. “But once investors turn the page on Christmas risk, retail starts to do better, with February being one of the best months of the year to own retail stocks.” Home Depot and Lowe’s may fare even better given their insulation from the apparel industry’s markdown risk, Baker said in an interview with CNBC. Some analysts and investors agree that Lowe’s and Home Depot are among the best-insulated names to own during the holidays. Both companies indicated continued strength for home improvement even as a housing slowdown persists. Joe Feldman of Telsey Advisory Group said they should also expect gains from rebuilding efforts following the damage caused by Hurricane Ian. Beauty names like Ulta have performed particularly well compared with the broader market, with shares down 3% while the S & P 500 has plummeted 24.5%. By comparison, Best Buy’s stock has slumped 37.5% while Target and Walmart are off 32.7% and 8.4%, respectively. The resumption of in-person activities and tail winds from the pandemic’s focus on skin care and self-care position the makeup retailer to withstand a slowdown in consumer spending, said John Zolidis, president and founder of Quo Vadis Capital. Makeup also withstands pressure from inflation that could cut spending for lower-income consumers, while new brands and products fuel continued enthusiasm in the space, he said. While Zolidis does not currently hold any dollar store stocks, he does see value in the space. Consumers may rarely associate the sector with holiday gift stores, but they should benefit from consumers trading down, he said. Higher-income consumers are holding up relatively well despite the surge in inflation. However, Huntington’s Hare expects Ross and Marshall’s owner TJX to benefit from extra inventory sold to the retailer at a discount from many higher-end department stores. Both companies indicated during recent earnings calls they have seen increased inventories at their stores. At the same time, the surplus merchandise environment creates opportunities to work with newer vendors and brands. Shares of Ross and TJX are down about 25% and 16% year to date, respectively. “We buy so much of the inventory so close and relative to traditional retailers we don’t get stuck with this big liability of home product like many retailers would,” TJX’s President and CEO Ernie Herrman said during the company’s August call. Across the board, many flagship retail stores heavily focused on apparel and footwear like Kohl’s and Macy’s may struggle to lure customers intent on saving money on discretionary purchases. That puts names like Target and Walmart, offering groceries, makeup and other recession-proof products, in a better position this season, Zolidis said. Stifel’s recent holiday survey echoed that sentiment, with Walmart, Target and Costco among the top retailers where consumers intend to spend. Target’s emerging partnership with Ulta may also benefit the retailer, Zolidis said. He points to names heavily focused on electronics and home goods purchased by consumers during the pandemic as one of the weaker areas this holiday season. Data released Wednesday from Adobe suggests there’s already pressure on prices. Online prices fell 0.2% in September, according to the Adobe Digital Price Index. Within the index, electronics and computer prices were down sharply. “We’ve been seeing promotions uptick overall, we’ve seen gross margins come down and that’s because these companies are looking at this and saying ‘I have excess inventory, whenever that happens, I’m supposed to start promoting,'” BMO’s Siegel said.
