The Long and Short
Managing retail inflation gets harder
Meredith Contente | May 20, 2022
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.
As results from the first quarter roll in for retailers, the mixed bag of earnings has one common theme: inflation. All retailers currently face high inflation, but some have been more aggressive with price increases. That is both helping the top line and keeping margin deterioration at bay. While the first quarter typically is the weakest for most retailers, cuts to full year guidance are hitting stocks hard and pushing out already wide credit spreads. Most retailers’ results suggest the consumer is not yet slowing down. The second half of the year is expected to be weaker given the strong comps, continued supply chain issues and soaring energy costs.
Exhibit 1. Retail Earnings Comparison
The Home Depot (HD – A2/A/A)
HD witnessed a strong start to the year as both revenues and EPS beat consensus estimates. In fact, the company witnessed its highest first quarter sales in its history. Management noted that the growth was impressive as comps were difficult give then historic growth witnessed in the year ago period, coupled with a slower start to the spring season this year given the unseasonably cold weather. Sales in the quarter grew 3.8%, or 2.2% on a comparable basis, while EPS of $4.09 was up 6% year-over-year. HD’s operating margin in the quarter was 15.2%, a slight contraction of 20 bp, highlighting management’s ability to navigate the dynamic environment of raising prices and managing costs in the face of high inflation and a tight labor market. Management noted that while they do not know how the current pace of inflation will impact consumer behavior moving forward, they are closely monitoring elasticities and consumer trends and are encouraged by the underlying strength of the consumer. HD noted that inflation is running higher than they were anticipating as they were expecting inflation to add about 5% growth in the average customer ticket but was much higher at 11.4% (Exhibit 2). Management expects it to continue to run at this low double-digit rate for the remainder of the year.
Exhibit 2. HD Selected Sales Data
With respect to guidance, HD now expects total sales growth and comparable sales growth to be up roughly 3.0% for the year, versus previous expectations to be slightly positive. Comps are expected to be stronger in the first half of the year versus the second half. The operating margin is now being guided to 15.4%, which is up from the 15.2% previously anticipated. EPS which was forecasted to be up in the low-single-digit range is now expected to be up in the mid-single digit range. We estimate that HD ended the quarter with lease-adjusted leverage of 1.8x which is flat from year-end and below their long-term leverage target of 2.0x.
Lowe’s Companies (LOW – Baa1/BBB+)
LOW’s top line met a different fate than its peer HD as the company posted a sales decline of 3.1% in the quarter. On a comparable basis, sales were down 4.0% year-over-year. LOW noted that sales were in line with expectations, except for the outdoor seasonal category, which was negatively impacted by an unseasonably cold April. LOW has a higher percentage of DIY customers versus HD which is why they were impacted more negatively by the cooler temperatures. May has been off to a strong start for LOW as warmer spring temperatures have finally arrived. EPS for the quarter of $3.51 came in $0.27 higher than expectations. Management chalked up the EPS performance to over 65 bp of operating margin improvement (to 14%), which was fueled by the company’s Perpetual Productivity Improvement (PPI) initiatives.
All guidance was reaffirmed for the year including total sales in the $97 to $99 billion range and comparable sales in the negative 1% to positive 1% range. LOW expects the gross margin to be up slightly for the year from the 33.3% posted in fiscal 2021. The operating margin is forecasted to be in the 12.8%-13.0% range, which is up from 12.6% posted last year. Furthermore, EPS is expected to be in the $13.10-$13.60 range, which represents growth of at least a dollar from the $12.04 posted in fiscal 2021. LOW continues to target adjusted leverage of 2.75x and remains comfortably below at 2.24x. LOW has a very manageable debt maturity profile with basically nothing maturing this year and approximately $500 million maturing in both 2023 and 2024 (Exhibit 3).
Exhibit 3. LOW Debt Maturity Profile
Walmart Inc. (WMT – Aa2/AA)
WMT’s reduction to full year income guidance sparked a massive sell off in the equity but spreads have held in relatively well as they were only a few basis points wider across the curve post earnings. While the company delivered solid topline growth of 2.6% (ex fx) for the quarter and 3.0% on a comparable basis, both the gross and operating margin witnessed some deterioration. The gross margin contracted roughly 90 bp year-over-year (to 24.5%) due to elevated supply chain costs and product mix, while the operating margin witnessed a 45 bp decline (to 3.8%), primarily due to wage costs in the U.S. as the company increased its hourly wage last year. Gross margin pressure is expected to continue in 2Q, but WMT expected to achieve some improvement on a sequential basis. Furthermore, management took some actions late in the quarter to offset the soaring costs which include reduced staff levels and price increases to help manage pricing gaps.
Full year sales are expected to increase 4% (ex fx), which is up from 3% previously forecasted (Exhibit 4). The reduction to operating income and EPS is what spooked the equity market and caused the sell-off. WMT had previously expected operating income to be up 3% this year, but now expects operating income to decline roughly 1%. EPS is also expected to be down 1%, after previously guiding to mid-single digit growth. While WMT is assuming the consumer to remain relatively stable for the year, it does not expect supply chain disruptions or the pace of inflation to abate anytime soon.
Exhibit 4. WMT Updated Full Year Guidance
Target Corp. (TGT – A2 (p)/A/A)
Like its peer WMT, TGT also witnessed solid top line growth with comparable sales up 3.3%, which reflected 3.9% traffic growth. We note that this marks TGT’s 20th consecutive quarter of sales growth. Management noted that sales growth was led by frequently purchased categories including Food & Beverage, Beauty and Household Essentials. However, it was the operating margin decline of 450 bp year-over-year (to 5.3%), that had equity investors hitting the sell button as inflationary pressures were not necessarily passed through to the consumer. TGT’s efforts to reduce excess inventory in discretionary categories via increased promotions, coupled with higher freight and transportation costs greatly impacted margins. Management noted on the earnings call that they try to maintain prices wherever possible as it tends to be the last lever to be pulled, but given the pace of inflation, they have had to raise prices across a broad set of items in multiple categories, which should help improve profitability as the year progresses.
Exhibit 5. TGT Margin Analysis
While TGT reaffirmed its low-to-mid single digit revenue growth guidance for the full year, it now expects the operating margin to be in a range of roughly 6%. This is below original guidance of at least 8%. Excess discretionary inventory is expected to be worked through by the second half of the year, which will help to improve profit performance. Global supply chain issues are expected to persist until 2023 at the earliest. However, management assured investors that its 1Q performance has not changed its long-term expectations of delivering an operating margin of 8% or higher. Additionally, the company has significant financial flexibility to weather the inflationary environment as leverage is 1.6x and well within the range for the existing ratings (roughly 2.0x).
TJX Companies (TJX – A2/A)
TJX’s net sales in the quarter were up 13% year-over-year. Comparable store sales were flat versus the strong 17% comparable sales growth witnessed in the year-ago period. The adjusted pretax margin was 9.4%, up 220 bp year-over-year, as COVID related expenses declined, and pricing initiatives helped to offset inflation. Freight costs continue to impact profitability by over two percentage points. EPS of $0.68 not only beat street estimates but came in above management’s forecasted range of $0.58-$0.61. TJX recorded an impairment charge of $217.6mm in the quarter to write down its minority interest in Familia (an off-price retailer that operates in Russia). The impairment charge represents the company’s investment in its entirety and was excluded from the aforementioned margin rate.
Sales trends in in 2Q are off to a good start but are off from the strong comp pace of 21% witnessed last year. That said, 2Q comparable sales will be down in the 1%-3% range. For the full year, comparable sales are being guided to be up in the 1%-2% range, which is down from the 3%-4% originally forecasted. Management noted that the new full year comparable sales outlook implies a 4%-5% comparable sales increase in the second half of the year. The adjusted pretax margin is expected to be in the 9.6%-9.8% range, which is flat to 20 bp higher than the margin posted last year and translates to a double-digit pretax margin in the back half of the year. We note that the impairment of the Familia investment impacted the margin by 40 bp and is being excluded the guidance range.
Exhibit 6. TJX Pretax Margin Guidance