2011 Retail Analyst Predictions, Part 5: Charles Grom, JPMorgan Chase

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Charles Grom, JPMorgan Chase analyst, discusses how increasing gas and commodities are affecting retail.

Increasing gas prices to cause pullback in consumer spending

Same store sales rose 4.2% in February, according to the International Council of Shopping Centers (ICSC). Consumer confidence recently hit a three-year high and the Bureau of Economic Analysis reported that spending on goods last quarter surpassed 2008 levels, stated CNN Money.

But retail analysts have begun to sound warnings about the danger that high gas prices pose for the sector. In the same report that announced the rise in February sales, the ICSC added that the rising cost of crude was “the big worry” facing consumers and the economy.

“All told, with gasoline prices expected to be up almost 6% in 2011, there is likely to be some pullback in retail sales and consumer spending as a result,” wrote J.P Morgan’s Charles Grom in a recent note.

It’s easy to see why rising gas prices have alarmed investors. When people pay more for fuel, they’re less likely to drive to stores. Once they’re there, they have less money to spend, said CNN. Every $1 increase in the price of a gallon of gas lowers consumer spending by $100 billion, stated the CNN article. If gas prices were to stay at $3.47 through the rest of 2011, resulting in a yearlong average of $3.41 — a $0.67 increase from 2010 — consumer spending would decline by $67 billion.

Meanwhile, the companies that were worst off when gas prices were high were value-oriented chains — Family Dollar, Dollar Tree, and 99 Cents Only. Because those companies’ customers tend to be less well off, they spend a larger proportion of their overall budget on gas. As a result, when gas costs go up, their purchasing power goes down.

CNN explained that however, if gas prices stay high for long enough, even if their usual customers spend less, more consumers will move to shopping at value chains for that time.

Grom thinks Wal-Mart’s U.S. same-store sales deterioration could be a lasting trend

In an interview with CNBC’s Fast Money, Grom discusses why he chose to downgrade his target on Wal-Mart from $59 to $54.

3 Reasons Wal-Mart is struggling:
1. Same store sales deterioration in the US
2. Heightened competition from the niche grocers and dollar stores
3. Lack of free cash flow due to international expansions.

How can Wal-Mart turn itself around?
If you look back over the past couple of years, Wal-Mart has gone from guardrail to guardrail trying to fix its traffic issues, stated Grom. A few years back they tried to go upscale and be like Target, last year they went aggressive on price, and over the balance of the second half of last year they tried to unwind some of those mistakes. “What we’ve been able to tell from some of the Nielsen data and store checks we’ve done is that their traffic simply remains elusive,” said Grom.

JPMorgan Chase is concerned for Wal-Mart’s U.S. performance in 2011. “We’ve become increasingly concerned that the company’s recent same-store-sales deterioration in the U.S. could be a secular problem that could last multiple years — not just a few quarters,” Grom wrote in a research note. Despite good outlook for international expansion, Wal-Mart’s U.S. base is suffering. Since nearly 80% of Wal-Mart’s business comes from the U.S., they will seriously need to focus some of their spending on traffic-driving initiatives. “We’ve been big advocates of trying to fix the mothership before trying to expand internationally,” Grom told CNBC. “They need to figure out how to compete more effectively against the dollar stores, against the niche grocers, and against some of their traditional supermarket peers like a Kroger.”

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Costco Wholesale is hesitant to pass on cost increases to members

In a March 3rd earnings call with Costco, Grom noted that their fresh foods margins have been down. Richard A. Galanti, Executive Vice President and CFO, agrees with Grom’s assumption that it is because they haven’t been willing to pass on the price increases to customers. Looking ahead, if price increases continue to rise, Galanti states that they typically will wait several weeks or a few months before raising prices by $0.30 or $0.50 for example, to get back to their regular margin. “That’s not a competitive issue other than we want to protect the prices for the members who are buying these items,” stated Galanti. “We feel that overall margins have been quite good. We really don’t see any major competitive issues in our fresh foods.”

Grom also noted that Costco said gas pricing had hurt them in the second quarter. Galanti explained that gas is still a profitable business, but a very low margin business. “A business as I mentioned before requires some (stomach lining) occasionally but, nonetheless, we are getting good frequency,” stated Galanti. “But certainly when prices spike for a week or two here you see some relatively flat numbers, whether it’s plus a little bit of profit or minus a little bit of loss, it’s not a real big issue.”

For more insight on how to be innovative with your grocery business, check out our Grocery Innovation Report »

Target expects substantial growth with entrance into Canadian market

In a February 24th earnings call, Target stated that they expect to invest about $2.5 billion, plus or minus $200 million, in capital in the U.S. Retail segment in 2011, up modestly from the $2.1 billion they invested in 2010. This increase is driven in part by a larger remodel program and in part by modestly higher investment in future new stores as well. In their Credit Card segment, they expect receivables will continue to decline, although the pace of decline should begin to moderate as the year progresses.

With their movement into the Canadian market, they expect those stores to help the company exceed $100 billion in sales in the next 6 to 7 years, increasing earnings per share by 10-12% annually in the next few years, and even stronger after that.

Grom stated that in the fourth quarter, Target’s gross profit margins were down about 40 basis points, and it sounds like that’s mostly from their PFresh grocery and 5% Rewards credit card initiatives. In response to a question Grom asked about whether or not that is a good proxy for 2011 when looking at Target’s gross profit line, Douglas Scovanner, Chief Financial Officer, Chief Accounting Officer and Executive Vice President, clarified that the combination of the impact of PFresh and the 5% Rewards program adds up to more than the gross margin rate decline. So net all other factors, they are slightly positive, and therefore, as an outlook, particularly as these strategies build to more importance in 2011, the combination of the two will be larger, not smaller than 40 basis points.

When it comes to consumer outlook, Target explained that, following a pullback in the second and third quarters, consumer optimism is once again increasing and close to where it was in the first quarter of 2010. Even so, guests are telling us that they are still risk-averse. They’re concerned about losing their jobs and focused on controlling household budgets, leading to increased coupon use and a focus on promotions. For everyday purchases, guests often choose the good items rather than the better or best items within categories. In turn, they use those everyday savings as justification to occasionally splurge on the best items in categories most important to them. This has created softness on better items in some categories, making it more important than ever for us to help our guests understand features, quality, and value at every price point.

Quantum Retail’s CEO, Vicki Raport, recently spoke at the Target Analytics Forum on the future of business intelligence. Watch the video here»

Macy’s sees 2011 as another positive year

In a February 22nd earnings call, Macy’s stated that their 2010 4.6% annual comp store increase was their best performance in at least 15 years and it compared favorably to their key competitors. At this time last year, they expected comp store sales growth of 1% to 2% for 2010 and they obviously far exceeded that. “That delta is important and enabled us to produce higher-than-expected earnings and cash flow,” said Karen Hoguet, Chief Financial Officer and Executive Vice President.

Looking at 2011, Grom noted that on the gross profit margin line, it sounds like Macy’s expects their first quarter to be down. Hoguet confirmed that it could be down by more than the fourth quarter was, primarily due to non-merchandising margin issues, but she does think it will come back as they go through the year. She also expects a 3% comparable store sales increase for 2011 and does not see a huge deviation from quarter-to-quarter.

Grom stated that when they met in the past, she had spoken to year three of the My Macy’s program as an inflection year. Hoguet responded that she thinks the progress will continue. She stated that when looking at the top districts or the top regions for 2010, it’s many of the My Macy’s pilot districts and particularly the Upper Midwest, Chicago, Minneapolis and Detroit, one of their best performing regions on a comp percent versus the prior year. In fact, they had an increase over a two-year basis, which was not true for the company in total.

When it comes to commodity price increases, Hoguet said that it is a challenge Macy’s is taking very seriously. “As a better-fashion retailer, we are less reliant on opening-price-point basics and have the ability to add quality features and fashion details that command a higher price point,” she continued. “Average unit retails in these categories will increase, but into a lane in which we have successfully played prior to the recent recession.”

She asserted that a significant portion of Macy’s businesses are in categories that are not impacted by the escalation in raw material prices. Hoguet said Macy’s has established a pricing team to provide more analysis on pricing decisions. The retailer is also monitoring consumer reaction to price increases on spring merchandise. In addition, it is editing peripheral assortments to improve costs and working to maintain its value position relative to competitors when passing along price increases.

One way retailers can adapt to rising commodity costs is by editing their assortments and having the right amount of stock levels. Check out our Guide to Creating a SKU Rationalization strategy that works»

Look out for next weeks’ post with insight from Matthew Fassler, of Goldman Sachs.

Sign up to receive updates throughout this series.

SOURCES: CNN, Business Insider, CNBC, MSN, Seeking Alpha

Download a PDF of the full series HERE»

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