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Tariffs take center stage in retail earnings

| May 17, 2019

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 earnings kicked off this week with both Macy’s Inc. (M) and Walmart Inc. (WMT) reporting fiscal 1Q results.  Despite M beating same store sales (SSS) guidance and WMT meeting street SSS expectations, results were overshadowed by the tariff headlines. Given that the tariff situation remains fluid, both management teams took time on their respective earnings calls to discuss what tariffs mean for the consumer and guidance. The overall theme seems to be that retailers can only absorb so much additional cost before having to pass these on to the consumer.

Additional tariffs not included in Macy’s guidance

M is viewing the current tariff situation from a tiered approach.  According to M, the three tiers of tariffs that were enacted in 2018 had no meaningful impact on the company’s business and have been factored into current guidance.  With the increase on the third tier last week from 10% to 25%, M noted that it will have a small impact on the company’s furniture business.  While M does not break down the percentage of sales from its furniture business, we note that the Home/Other category represented 16.4% of total fiscal 2018 sales.  Management assured investors that they have strategies that can mitigate the impact to the furniture business and should not affect current guidance.

The real impact would come from what management believes to be the fourth tier, or tariffs affecting approximately $300+ billion of Chinese imports.  The fourth tier would affect most of the apparel and accessory categories, including both private label and national brands. Management noted that they would be hard pressed to find a way where those tariffs would not affect the customer. Furthermore, any type of impact from the fourth tier has not been included in current guidance.  Management has been working to move production of its private brands, which represent 20% of sales, out of China. M is more concerned about negotiations with its branded partners and sharing potential costs.

Increased tariffs lead to increased pricing for Walmart

Given WMT’s scale, the company may have more negotiating room with suppliers to share in costs.  However management was quick to note that higher tariffs will lead to higher prices.  At the moment, they noted that the impact on the consumer has been modest given that they have been balanced with respect to pricing.  Pricing remains category specific as WMT has passed on higher costs in some areas, while reducing costs in areas where they have experienced deflation. Additionally, the company continues to pull through inventory in an effort to limit the impact in a “worst case scenario” should tariffs be imposed on all Chinese imports.  Management was quick to relay to the investment community that the pulled through inventory is all high quality, which should help lessen any margin impact associated with clearing merchandise.  The grocery business, which creates consistent traffic for WMT, should not really be affected by tariffs as the majority of products are sourced from the United States.

More earnings and tariff talk to come

With the bulk of the retailers to report next week, expect further discussion of tariffs to dominate earnings calls. Most management teams will want to try to mitigate the impact of higher tariffs within reason. Realistically, should further tariffs be imposed, prices should largely be passed on to the consumer. Mass merchants, such as WMT and TGT, should fare a little better given their scale and their ability to negotiate with suppliers to split costs. However, department stores and specialty retailers have less leverage to negotiate. Furthermore, their ability to absorb costs have lessened, as margins have declined over the past few years with competition from online retailers coupled with significant investments in omnichannel.

Relative value

Additionally in M’s release, the company noted that they extended their $1.5 billion revolver to mature on 5/9/24.  We had long felt that the company would look to extend the line to a true 5-year given the improved operating performance and stronger credit metrics.  M 2.875% 2023 bonds now mature ahead of the bank line, which we view as a catalyst for spread tightening in the particular issue. The M 2.875% 2023 bonds currently trade roughly 80 bp (g-spread) behind M 3.45% 2021 notes.  Currently the BBB discretionary 2y/4y curve is worth roughly 17 bp.

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