Bankruptcy: a word that no investor ever wants to see. It’s amazing how often it comes up in retail, though, with large chain stores running out of money and closing up shop, hoping that a buyer will swoop in to get them out of the leases and take whatever stock they can.
More often than not, the backstory to a retail failure is one of an overindebted balance sheet, with long-term debt climbing as working capital ratios deteriorate. Ernest Hemingway’s “gradually and then suddenly” quip about bankruptcy is highly applicable to retailers.
It may also be true that retail failures simply get more attention in the headlines than other sectors do, as investors (and the public) are familiar with the store names. The media focus on selling clicks, so familiarity bias is their friend. Whether bankruptcies are more common in retail than in other sectors or not, there’s no denying that retail is a sector that can dish up high-profile failures alongside great successes, so investors need to be cautious.
To make it even trickier, size is a poor predictor of failure. A small retail chain run to a high standard can achieve great economic returns. Conversely, large chains can and do fail.
A retail chain is little more than a collection of little businesses, so poor performance in each store scales up to a really large problem. Large chains also appeal to banks, which see them as more financially resilient and able to provide security on larger loans, so you’re more likely to find an ugly balance sheet in larger chains than smaller, lean operations.
The latest example of a retail failure in the US is Big Lots, which focuses on selling furniture and homeware to lower- and middle-income consumers. This is the part of the US consumer market that has taken the biggest strain, thanks to stubbornly high interest rates and the impact of inflation. The “American dream” is definitely not something that exists in every city in that country.
A small retail chain run to a high standard can achieve great economic returns. Conversely, large chains can and do fail
Perhaps unsurprisingly, a private equity firm is going to buy Big Lots out of bankruptcy. In these types of deals, it’s usually the case that the investor takes over only the better-performing part of the store footprint, leaving the rest to perish. Where leases won’t be retained, they are sold to competitors looking for space for their own stores. We saw this recently with Dollar Tree buying the leases of many 99 Cents Only stores, with that retailer having filed for bankruptcy in April.
Another feature of the Big Lots deal that is common in retail failures is that the existing lenders are staring down the barrel of huge losses, so they have decided to throw good money after bad and put in more support under new ownership, hoping that things will improve. What’s that saying again? Aah, yes — a rolling loan gathers no loss.
With that cautionary tale about the retail sector out of the way, it will hopefully make more sense that we are seeing exceptional volatility in the sector in current conditions. A couple of years ago it was the Big Tech names in the US that were dishing up outrageous moves of 20% or more in a day. It seems like that baton has been passed to Big Retail, with stock prices being tossed like a salad as guidance is updated when earnings are released and the market digests a potentially different future from what was expected.
When things are a little crazy out there, we find ourselves in that loveliest of lovely things: a stock picker’s market.
Heroes and zeroes
The best place to play this year has been in the more defensive names, though you still needed to be careful which ones you select. Before we dig into the performance differentials, it’s worth understanding why general retailers are seen as defensive and what that really means.
The defensiveness is found on the revenue line rather than the net profit line, which means that names like Walmart aren’t immune to volatility in profits. It’s true that people will always need groceries and basics and will therefore provide Walmart with plenty of feet through the door. It’s not true that they will need TVs, exercise equipment and all the other discretionary items that help Walmart make the real margins.
At an operating margin of between 4% and 4.5% and a net income margin of between 2% and 2.5%, a modest 50 basis point swing on Walmart’s gross profit margin of 24.5% can have a substantial effect on net profits. A change in product mix can quite easily cause a swing of that magnitude. While Walmart is indeed more defensive than cyclical retailers such as clothing stores, be careful about what defensive actually means. It’s a relative measure rather than an absolute promise.
Moving on to performance in the sector, Costco is up 38% this year and Walmart has done even better, with a 46% return. These retail giants have been able to take advantage of their market positioning and sheer scale, with the ability to execute price decreases in many categories and drive volumes accordingly.
Notably, that return has not been driven by earnings growth at anywhere near the same level. The market has piled into these names in search of safety and has driven the earnings multiples to unsustainable levels. Buying Walmart on a p:e of 40 seems unlikely to end well.
And yet, the valuation gaps just stubbornly refuse to close. Target competes directly with both those companies and especially with Walmart, yet the share price is up just 5% this year and it trades on a p:e of 15. There’s no doubt that Walmart is a superior business, and the earnings outlook supports this view, but is a 40 times vs 15 times traded multiple gap reasonable?
Yes, retailers that are priced for perfection aren’t about to go bankrupt and lose all your money. Still, they can easily suffer substantial drawdowns in value if growth falters or if investors rotate from defensive to cyclical stocks (a plausible strategy when rates start being cut), so be careful about buying things at multiples that are way above historical averages. Walmart’s 10-year average p:e is 27. If the current multiple reverts to that average, it’s a drawdown of nearly 33%. Moves of that size are extremely rare, but Walmart has dished up 20% corrections before. At these levels, IM won’t be a buyer.
If you think the defensive retailers have dished up volatility, just wait for the cyclicals
IM is also not a buyer at Target, where the company seems to be in strategic no-man’s land. On the one hand, it is trying to appeal as a value-focused retailer, which sounds like Walmart. On the other, it offers an assortment that positions it as being more upmarket than Walmart and certainly Costco, which is then at odds with the value focus. Target has been left for dead by competitors, with a 10-year share price compound annual growth rate (CAGR) of 9.6% vs 11.8% at Walmart and a whopping 21.5% at sector darling Costco. Cheap isn’t always cheerful and Target could be a value trap more than an opportunity.
What about the cyclical retailers?
If you think the defensive retailers have dished up volatility, just wait for the cyclicals.
Market darling Lululemon has soured, with the share price down 50% this year! When a growth story breaks, it breaks severely. When the selling is this aggressive, it’s best to wait for a clear sign that the worst is over before putting in more money and dropping the average in-price. With a five-year CAGR of 4.9% and a trailing p:e of 19, it’s not impossible that there could be more selling pressure before the worst is behind the group.
Lululemon is an extreme example but certainly not the only one. Unlike Lululemon, Foot Locker relies on the resale of other brands rather than its own high-end brand. Also unlike Lululemon, Foot Locker has been anything but a market darling, so it didn’t have the problem of trading at a high multiple.
Stops and starts have been the order of the day for Foot Locker, and those who timed the upswings have done well, yet the trend has been unmistakably bearish for years. Still, the year-to-date performance of -19% is better than Nike’s -27%, with that company having caused many headaches for Foot Locker by pulling back on supply and forcing Foot Locker to fill its shelves with competing brands. Nike is another very good example of a cyclical stock at a heavy growth multiple, with the results clear to see.
Moving on from clothing, there has also been trouble in the makeup aisle. Ulta Beauty has seen a 22% decline in its share price this year, despite operating a lucrative model that achieves gross margin of about 42.5% and a net income margin above 10.5%. Shareholders are getting four times more benefit per dollar of sales at Ulta Beauty than at Walmart, yet Ulta now trades on a p:e of 15 vs 40 at Walmart.
The reason? Extensive competition has eroded Ulta’s growth story. Its lucrative model is no secret, and many other players want a piece of that action. The disrupter is now the disrupted, with Ulta having to scramble to respond to the competitive threats. Being more competitive on price doesn’t seem to be working, as volumes aren’t responding to promotions.
That’s a problem that is hard to solve when consumers are still dealing with high interest rates that are forcing them to make affordability their major reason for choosing a product or retailer.
Time to rotate?
The cyclical retailers have had a difficult time, while the defensives have been basking in the sun. With the best defensive names now trading at growth multiples and the best cyclical names trading at multiples well below longer-term averages, a cut in rates could trigger a rotation out of defensives and into cyclicals.
Like all great cyclical stories, those stocks will start running before management gives guidance that reflects the benefit of improved conditions for consumers.
Though caution is certainly warranted, a careful positioning within the US retail sector to take this into account could be lucrative. It seems unlikely that the outperformance of defensives vs cyclicals can carry on much longer.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.