Welcome all new subscribers to Alpha Letter. Every week I write about interesting investment opportunities in public markets. I like stocks off the beaten path. Tiny, tiny companies that no one else is talking about. Valuations so depressed that any good news will re-rate a company higher. Alpha Letter is for investors who want unique research that won’t find anywhere else.
Today’s piece will be about my history in the retail industry and what I think will happen to the industry in 2023. The retail industry has a lot of high beta names so the stocks trade wildly. An investor with a good head on their shoulders can take advantage of these volatile movements and capitalize on Mr. Market’s mood swings.
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The Retail Industry for 2023
I spent the past few days thinking about the retail industry. It has been an area of my interest for the past few years. It started during the dark days of COVID. Retail names were beaten to a pulp. Everyone in the US was forced to stay home. You couldn’t run a physical business. The only companies open for business were the tech players or someone with an online platform. Amazon, Walmart, Zoom and a number of other names dominated the small American business landscape. Everyone else burned cash as fixed costs stayed fixed and revenues went to zero for a few months.
During this period valuations crumbled. Even when stores were allowed to reopen there were capacity restrictions. Then the rioters came and looted merchandise. As time passed investors predicted that the “new normal” would forever change the physical brick and mortar business model. Anyone company with a thriving online presence saw their valuation soar. Multiples increased for these tech savvy companies. Large bonuses were handed out at year-end to the executives running these thriving online platforms.
The lack of revenues and forever changed landscaped forced management teams to rapidly cut costs. This environment allowed these management teams to go to landlords for the first time in history and renegotiate lease costs and structures on a large scale. Landlords gave in. There were rent concessions. Lease structures that were changed from a widely fixed expense to a more variable expense. Managers who were able to structure their leases as a percentage of revenues created significant shareholder value and de-risked their entire corporate platform. Other costs were rapidly taken out too. From employee costs on the COGS line, to wide corporate restructurings that slashed SG&A.
I was a buyer around this time. Costs were cut and valuations were still at incredible lows. There appeared to be pent-up demand for everything. People needed new clothes because they gained the “COVID 15” in their gut. Shoes were blown out. Individuals were tired of wearing pajamas and loungewear. They wanted to feel good about themselves. Go to parties and look great. Then stimulus checks were printed and there was a large rush of individuals buying everything they couldn’t in months.
Retail names re-rated. Names that were stimulus beneficiaries overshot on valuations as revenues exploded and operating margins expanded. Analysts began to pencil in these higher growth rates for years to come. Valuation multiples increased as costs came down and margins went out. When things are good on Wall Street analysts tend to extrapolate these results for years to come – even if it clearly a one-time event. It happens on the upside and the downside. When Mr. Market is a pessimistic, he oversells securities too far. When Mr. Market is an optimistic, he over values securities to far. An analysts job is to determine where free cash flows will be and what part of the cycle Mr. Market is valuing companies at.
Things were so good in 2021 that everything was selling out. Inventories were light. In the retail industry when inventories are light margins are high. Because if you have more demand than supply you raise price. But as the flood gates to demand opened up, things started to break. The cost of a shipping container skyrocketed. Things were clogged up at the port. It was incredibly challenging to get labor to unload the containers and then ship them via truck to the store. Merchants began to order inventory several quarters ahead to make sure they can get the inventory they needed for each season of 2022. A disaster began.
The consumer started to feel the effects of inflation. Oil and gas hit record highs not seen in years. Every commodity took off. As prices went up consumers slowed spending. The confidence the consumer had in the economy declined. Then all this inventory came in at the same time. At the same time the consumer was slowing down their purchases. Retailers were forced to do wide promotions. Promotions impacted merchandise margins. The highly profitable year of 2021 did not continue into 2022. 2022 was described as retailers using all their cash to buy inventories and then selling it for a discount to the consumer. Cash was burned. A lot of it.
We are now in the early days of 2023 and the narrative is just starting to get developed. As an analyst and investor in these names I would like to spend some time today thinking about what could happen in 2023 for the retail industry. Predicting macro events is incredibly hard and I will likely be wrong. But it is a good exercise to go over for an industry you are interested in. A learning experience that lets you think about drivers of cash flow.
Here are a few themes to think about going into 2023:
A global recession
Pricing and promotions
A Global Recession: The big question in everyone’s mind is the risk of a global recession and what it could look like for the entire industry. From my discussion with management teams, they are cautious going into 2023. Cash will be hoarded on the balance sheet, and it is unlikely we will see aggressive repurchase programs or special dividends. If there will be store openings or repurposes they will likely happen in the back half. By mid-2023 this narrative of a recession might flip if we don’t go into a downturn and then I would expect capital allocation among retailers to switch. For the first half of 2023, I wouldn’t expect anything aggressive from the industry as a whole regarding returning capital.
Inventories: In 2022, retailers pulled inventories forward and working capital was a huge drag on balance sheets. Cash was depleted and converted into inventories. As the year progressed, the promotional environment increased and gross margins were impacted as retailers across the board sold items at a discount in order to move through their large inventory positions. Going into 2023, inventories are much leaner, and cash is starting to come back on the balance sheet (I’d argue we will see a large cash inflow in Q4 from cash from operations). With the supply chain issue largely resolved, I would expect working capital to return to its normal cycle. Cash flow should be generated all else being equal.
Shipping Rates: have collapsed back to normal levels and will provide a large tailwind for retail companies. This will flow through costs of goods sold which will increase gross margins in 2023. There likely won’t be an immediate effect seen across the industry as retailers tend to lock in shipping containers on a 12-month contract basis. My sense is that by mid-2023 most retailers will be lapping higher prices and locking in new lower prices, which we should see the effect on the income statement that eventually will flow through the cash flow statement.
Raw materials: will also be another tailwind into 2023. Cotton prices have fallen dramatically along with commodities across the board. Like shipping costs, most retailers lock in cotton prices over a multi-quarter period so it will take a few quarters to lap higher raw material prices. Eventually lower prices will get locked in, which will directly impact, and lower cost of goods sold.
Pricing and promotions: From my discussions with management teams, Q4 2022 is the quarter to liquidate inventories. Retailers want to start 2023 in a lean position. Nobody wants a bloated balance sheet. It is easy to get merchandise compared to 2022 so retailers will not be buying merchandise two quarters ahead. Air freight will essentially be eliminated. The lean inventory position going into 2023 will allow retailers to increase pricing, or hold it steady. This should drive gross margins higher. On the flipside, if we head into a global recession, promotions will likely continue as consumers will be spending less.
All these predictions are predicated on a global recession. Should a large global recession and downturn occur in 2023 the entire space will be challenged. Unemployment will skyrocket. The consumer will pullback on spending. Pricing will come down across multiple industries as demand for goods and services plummets. The Federal Reserve will get what they want and inflation will falter.
The dynamics in 2023 will be exciting, thrilling and nerve wrecking. There is never a dull market as an active investor on Wall Street. Every year the market throws something at you that you couldn’t have predicted. A global pandemic. War in Europe. China tariffs. You name it. The market is a challenging beast and actively investing in common stocks may be one of the most humbling and gratifying experiences an individual can concern themselves with.
There is one thing I have learned about the retail industry over the past few years that should be noted before I close out for the day. The institutions trading retail names are almost the perfect counterparty you would want to have as a value investor. Use their short-term mindset to take advantage of companies when valuations get the bucket and sell them the equity back when valuations trade above fair values. There are wild swings in retail names on a quarterly basis, so having financial models built out and understanding the long-term economics on how cash is generated will pay dividends down the road. So as Mr. Market has his wild mood swings, I plan to take advantage of good value when I see it.
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Interesting read - to what extent do you think the skew of buying opportunities in this sector lies in the US, versus other markets (e.g ourselves here in the UK), given the asymmetric impact of factors you mention (like shipping costs)?