Retailer Smoke Signals: Food Is Where the Action Is, But Do Not Forget Housing

Summary

• Home Depot (HD) and Target (TGT) reported weaker sales and confirmed consumers are not buying larger-ticket discretionary items. The primary reason is satiated demand and altered consumer preferences.
• Meanwhile, Walmart (WMT) is flying high on its strong discount grocery business.
• Target says it is shifting its merchandise to necessities, maintaining its full-year outlook in a show of confidence.
• HD warned of more weakness in consumer demand and cut its 2023 outlook – but seems not to be factoring in robust homebuilders and new home construction.

Market Implications

• We are cautiously neutral on equities, but see risks tilted to the downside due to sticky inflation. We are generally underweight retail.
• We expect Walmart and Target to face growing competition from dollar stores, making it difficult to outperform the retail sector and broader market.
• Barring a collapse in housing, we like Home Depot’s prospects in coming quarters.

Consumers Spending on Cheaper Food

Home Depot and Target both managed to report earnings beats but also slowing sales. Maybe no surprise there – people have been turning away from ‘stuff’ for nearly a year. Walmart, meanwhile, reported solid sales and earnings beats, largely because of its grocery business.

The difference in outlooks is striking. HD cut its 2023 outlook, saying it now expects comparable sales to drop 5%, from a previous forecast of flat. TGT affirmed its outlook even as it expects a weak Q2. WMT boosted its outlook and EPS from 6.05 to 6.20.

Major Retailers Are Doing Ok

Sales for major retailers compare favourably with recent retail sales data on a year-over-year basis, suggesting they are probably winning market share in a challenging environment (Table 1).

• TGT sales are up a modest 0.8%, but comparable categories (home furnishings/ apparel) are down 6.7% and 2.3%, respectively.
• HD sales are down 4.1%, roughly in line with building/garden supplies and home furnishings.
• WMT, with sales up 7.6%, is far ahead of food and apparel.

What to Make of This?

Notably, none of these companies mentioned concerns about recession risks. But they see consumer preferences changing, which presents other challenges. It is still early in the retail reporting cycle, but they seem to be gaining market share.

Both HD and TGT say consumers are buying fewer large-ticket and discretionary items. This appears to be largely because people do not need these items after bingeing on them during the stay-at-home pandemic period, although falling real incomes have been a factor too. If unemployment starts to rise, we will likely see households more actively cut back on discretionary items, but retailers are not positioning for that scenario.

The big jump in food prices over the past year has pushed people to switch to Walmart in search of lower prices. Some are doing so because of sticker shock; others out of economic necessity.

TGT says it is shifting its product mix more toward necessities and away from apparel and bigger-ticket discretionary items. This is probably why it has not cut its 2023 forecast. If (a big if) it succeeds, it could compete with WMT for market share.

HD Manages Expectations Downward

HD says sales were hit because of lumber price deflation and severe weather in California, warning that consumers are cutting back on discretionary items, such as grills, outdoor furnishings, and remodeling projects. We suspect HD is erring on the side of conservatism.

On lumber prices – lumber futures have traded in a narrow range since early January after declining throughout 2022. Notably, lumber is trading near pre-pandemic levels. Our guess is that lumber prices have returned to normal and will not ‘deflate’ much more.

In California, normally after weather disruptions there is a catchup period as people make those deferred purchases. In this case, we can reasonably expect that many people are buying more stuff to repair weather-damaged property.

Yet another factor is the strong earnings from homebuilders. They have reported increased demand for new homes because of low existing home inventory. That should feed into demand for construction supplies.

Our read is that HD is managing expectations downward based on softer consumer demand for big ticket items and is not factoring in California’s recovery or stronger housing activity. Barring a collapse in housing or the economy, HD may surprise on the upside later this year.

Are Retailers a Buy? We Like HD

We are cautiously neutral on equities mainly because we do not see a clear catalyst that could drive equities out of the range of recent months. But we see risks tilted to the downside because – contrary to equity market expectations – we expect inflation to remain sticky, eventually forcing the Federal Reserve to raise rates well above 5%.

There is also the risk of a sharp selloff if the debt ceiling is not resolved before the US Treasury must start prioritizing payments to avoid default on US government debt. But that will likely be temporary.

In this environment, we are generally underweight retail. We summarise our views on these three companies as follows:

• WMT is fully valued. Going forward a key risk is competition from other discount retailers, such as Dollar General and TGT. It may be difficult for WMT to outperform the retail sector and broader market.
• TGT is the cheapest company based on valuation, due to its inventory management problems last year. It could outperform if it can successfully shift its merchandise mix to necessities and convince consumers to shop there. It will also depend on how strong competition is from other discount grocers. TGT is attractive as a longer-term buy-and-hold as consumption patterns gradually return to normal, but it may have difficulty outperforming in coming quarters.
• HD may be underestimating the potential gains from a pickup in housing.

Of the three, HD appears to be the most interesting prospect for 2023.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

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(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)