Retail stocks are one of the most interesting sectors in the market right now. And they've certainly been among the most volatile, particularly over the past year.
Indeed, between July 2015 and November 2017, the SPDR S&P Retail (ETF) (NYSEARCA: XRT ) lost about 25% of its value. Even that performance understates the carnage in the sector, particularly for mall-based retailers. XRT owns e-commerce stocks that have benefited from the " death of the mall " narrative, most notably Amazon.com, Inc. (NASDAQ: AMZN ).
The sentiment toward the space has reversed notably. XRT has gained almost 30% since November, recouping almost all of its losses. And a number of mall-heavy retailers - the stocks most impacted by the decline - have gained nicely.
At least 21 different retailers have more than doubled from their 52-week lows, among them big mall names like Abercrombie & Fitch Co. (NYSE: ANF ), American Eagle Outfitters (NYSE: AEO ) and Ascena Retail Group Inc (NASDAQ: ASNA ).
Clearly, investors are starting to believe the reports of the demise of brick-and-mortar retail have been overstated. Is that really the case?
The Case Against Retail Stocks
I'll admit to being surprised by the recent rally. I've been bearish toward retailers - particularly those with heavy mall exposure - for some time. The bear case has been relatively simple, and it extends beyond simply the threat from Amazon.
First, traffic is declining. Hard data isn't easy to find, but this report suggests a 5-6% annual decline for large mall owners like Simon Property Group Inc (NYSE: SPG ) and GGP Inc (NYSE: GGP ). That squares with commentary from a number of retailers who have cited "mid-single-digit" declines.
It's exceedingly difficult to drive any sort of same-store sales growth when traffic is falling 5% a year. And that's doubly true because of the second concern: pricing. Online shopping not only provides competition; it makes pricing purely transparent.
Add to that the fact that mall retailers have fought for a larger share of declining traffic by increasing promotional activity, and there's been (generally) a significant amount of pressure on merchandise margin in the industry (both in malls and out).
Third, operating expenses are rising. Labor costs are climbing as even low-wage employers like McDonald's Corporation (NYSE: MCD ) and Walmart Inc (NYSE: WMT ) raise pay . Input costs (notably freight) are starting to rise as well.
Generally speaking, a retailer needs ~3% same-store sales growth simply to keep pace with inflation. Few retailers - in the mall or out - are hitting that number right now.
Slowing sales growth (if not declines) and dropping margins are a toxic combination. Given that most retailers have operating margins in the single digits, even a point or two can have a big impact. And so the long, steep decline in so many retail stocks over the past few years made some sense. It wasn't just an Amazon problem.
Why the Sector Has Rebounded
But again, sentiment clearly has changed over the past seven months. And there have been a number of factors.
First, tax reform was a huge help to the sector. With most retailers primarily U.S. based, tax rates in many cases moved from the high 30s to the low 20s. That alone suggests as much as a 25% boost to earnings and a corresponding increase in the future value of those earnings.
Secondly, retailers are adapting. Many were slow to get into "omnichannel" retailing, but leaders like AEO and Childrens Place Inc (NASDAQ: PLCE ) are driving over one-quarter of their sales online. The ability to meet customers where they want to shop can turn what looks like a liability into a competitive advantage.
And, third, it appears that investors are anticipating that retailers will be able to reduce their rents. While retail stocks have soared, their landlords have struggled. SPG is down 5% this year. GGP, Taubman Centers, Inc. (NYSE: TCO ) and Macerich Co (NYSE: MAC ) are down double digits. Those are the strongest mall REITs, with the highest proportion of "Class A" properties.
As a result, investors appear to argue that most retailers, particularly smaller operators, will be able to muddle through. And they're now pricing those stocks for roughly flat cash flow instead of for declines, as was the case for most of 2017.
Is the Rally for Real?
While I understand some of the gains - particularly relative to tax reform - I haven't given up my skepticism toward the industry. I still don't see margin pressure abating. Same-store sales for the most part remain in the low single digits - positive, but not enough to drive any growth. And there are two negative factors that may have been forgotten in the recent gains.
First, all things equal, retail stocks should be getting a compressed earnings multiple. This is a cyclical space, and we're now in year 10 of a pretty much uninterrupted economic expansion.
Pre-tax earnings growth remains muted - at best - at a time when unemployment is low and consumer confidence is high. What happens to these retailers, including department stores like Macy's Inc (NYSE: M ) and Kohl's Corporation (NYSE: KSS ), when the economy inevitably slows down?
And, secondly, I still see margin pressure as a long-term problem. Labor pressure isn't going away. The move to omnichannel retailing is necessary, but it's also expensive. Adding distribution capabilities for e-commerce isn't cheap. Free shipping and other bells and whistles pressure margins.
I'm far from convinced that brick-and-mortar retailers are going to see earnings grow for the foreseeable future, even if, as a group, they can grind out some level of positive same-store sales growth. Rent relief can help, but it only delays what appears to be the inevitable.
From here, the sentiment toward the sector has shifted too far. There is some better news, and it's likely that late 2017 lows in many cases were too low. But retail stocks aren't out of the woods by any means, and expecting earnings growth across the board is too optimistic.
There was a lot of money to be made shorting the sector in 2015-2016, and it sure looks like there will be an opportunity to do so again very soon.
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As of this writing, Vince Martin has no positions in any securities mentioned.
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