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Retail beats but challenges remain

| August 24, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Retail results for the second quarter largely beat expectations, aided by a strong economy and bustling consumer traffic. Target CEO, Brian Cornell stated that the consumer environment is “perhaps the strongest” in his career.  The strong traffic growth at Target pushed same store sales growth to 6.5%, its best quarterly performance in 13 years.  They weren’t alone, as TJX Companies (TJX) delivered strong same store sales of 6% and noted that customer traffic across all divisions was the primary driver – their 16th consecutive quarter of traffic growth.  Home Depot (HD) posted 8.0% same store sales growth for the quarter, remarking that seasonal sales missed in 1Q were recovered in 2Q, while both tickets and transactions grew.  The better than expected performance led all of the aforementioned companies to increase full year guidance.  However, a few cautionary themes were echoed across the conference calls that could potentially impact margins should retailers have difficulty raising prices.

Transportation Costs Increasing  

Home Depot lowered its gross margin expansion guidance by a few basis points due to increasing transportation costs; a factor TJX also flagged as negatively impacting merchandise margins.  The two main components of the higher transportation costs are increased fuel prices and driver shortages. As digital sales increase, retailers must remain competitive with both bricks and mortar and online only peers with respect to shipping. In order to compete with Amazon, Home Depot is currently offering free two day delivery on thousands of online items with no membership payment required, while Target is offering free shipping on orders of $35 or more. 

Exhibit 1: National Average Gas Prices

Regular Mid-Grade
Current $2.831 $3.129
Month ago $2.843 $3.142
Year ago $2.337 $2.615

Source: AAA Gas Prices

Additional Omni-Channel Investments

Further investments in omni-channel are helping to offset increased transportation costs as most brick and mortar stores offer customers the ability to buy online and pick up in store. Retailers have made significant investments in technology that tracks store inventory levels more closely. This enables a retailer to utilize their store base to act more like mini-warehouses, thereby fulfilling online orders from stores closer to the delivery address. If multiple items are purchased from a retailer online, they may arrive in more than one package as the cost to ship multiple packages from stores can be cheaper than one package from a warehouse located hundreds of miles away.

Increased Tariffs

Most management teams are carefully monitoring the recent tariff announcements and understand the potential for the situation to escalate. Increased tariffs would mean that retailers either pass on the costs to the consumer or absorb some of the cost themselves. There are few remaining cost cutting levers for retailers to pull that can offset higher tariffs, leaving retailers to pass these costs off to the consumer or risk further margin deterioration. While the consumer appears to be in good standing, competition has led to more promotional activity which benefits the consumer.  Any major price increases on apparel and hardline goods could result in a pull back.

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