What’s in store for big-box retailers during inflation?

August 24 2022

Earnings from retail corporations, coupled with a federal report on July retail sales, made for an apt test to check the state of U.S. consumer spending. As it turns out, household consumption has been able to keep up the spirits amid uncertain times. Let’s delve deeper to see which way the wind is blowing.

Inflation eases out

The U.S. annual inflation eased more than expected, after reaching an over 40-year high of 9.1% in June, to 8.5% in July. However, inflation is still red hot, limiting consumers’ purchasing power. To further combat rising prices, it is anticipated that the Fed will raise interest rates by 50 basis points (or 0.5%) during its September meeting.

Exhibit 1: Year-On-Year US Inflation Rate

Source: U.S. Bureau of Labor Statistics, August 2022

Consumers are mindful but aren’t shying away from spending

According to a new federal report, overall spending in July increased by more than 10% compared to the same month last year. This suggests that the persistent record-high inflation hasn’t yet forced American consumers to stash aside their credit cards and cheque books completely. Consumer spending reached almost $683 billion in July, according to the U.S. Census Bureau’s advanced estimate of retail sales volumes for goods and food services. But retail sales were flat compared to June. While non-store retail sales rose 20.2% from the previous year, gas station sales increased by 39.9% in the same period. Additionally, overall sales increased 9.2% from May 2022 to July 2022 compared to the same time last year. However, it is impossible to determine whether the sales are up because more goods were bought or customers just paid more to cover rising prices, as the retail sales data is not adjusted for inflation.

Exhibit 2: Retail Sales Data (in %)

Source: U.S. Census Bureau, Bloomberg, August 2022

Though the consumers are still spending, they are spending differently than before. Due to soaring inflation, consumer behaviour has changed as they are spending less on high-margin discretionary merchandise and are focusing more on basic necessities. Over the course of July, gas prices significantly declined, making it easier for consumers to spend their money on other consumer products, including furniture, electronics, and appliances, as well as on building supplies and gardening tools. This pattern indicates that consumer spending might continue to be strong in the coming months, along with a still active labour market and solid overall wage growth.

Walmart’s upbeat quarterly results renew hopes for the U.S. economy

The largest retailer in the world, Walmart (WMT), reported better-than-expected results despite increasing inventory problems due to the adverse macroeconomic environment in the previous quarter. In addition to strong back-to-school sales, lower gas prices and increased spending by wealthy consumers looking for discounted deals pushed quarterly revenue 8.4% higher at Walmart. Moreover, its U.S. same- store sales climbed 6.5%, beating analysts’ expectations of 5.9% growth. Having triumphed in the physical retail space, Walmart also dominates the online grocery market with a 55% market share in June. Considered a bellwether for the retail sector, Walmart’s performance may provide the American economy with a renewed hope.

Exhibit 3: Walmart and Target’s Second Quarter Earnings Highlights

Source: Company Financials, CNBC, August 2022

Discretionary spending takes a hit at Target

Walmart’s biggest competitor, Target (TGT), was the worst hit due to changes in consumer behaviour post-pandemic. In the three months that concluded on July 30, the company’s net earnings plummeted by a whopping 90%, while its operating margin dropped to 1.2%. The Minnesota-based company, which sells more discretionary goods than Walmart, was compelled to aggressively price its surplus inventory in categories including motorcycles, patio furniture, and kitchen appliances in order to escape the inventory mess and stop further losses. Same-store sales for Target grew 2.6% in the second quarter but fell short of estimates of 2.8% growth.

Inventory glut poses a massive challenge for retailers

Supply shortages during the pandemic finally became post-pandemic oversupply. There was a high demand for retail products during the pandemic. Retail giants like Walmart and Target placed excessive orders because they misjudged consumer demand. Today, both businesses are sitting on stale inventory as they are struggling to sell their excess stock of goods. The overabundance of goods has ultimately put pressure on their profitability as they had to mark down products to get rid of some of that inventory.

On top of the inventory glut, many retailers are under tremendous margin pressure due to high inflation. They must decide how much of their rising labour and input expenses they can pass on to customers by raising the price of their products, which affects their profit margins. Consumers, especially in these hard times, often benefit from businesses’ margin anguish as they shop the discount racks in search of deals.

The road ahead for Walmart and Target

Walmart now anticipates a smaller profit decline than its earlier prediction. For the fiscal year 2023, Walmart sees its adjusted earnings per share to reduce by 9% to 11%. Earlier in July, the retail giant had forecast an 11% to 13% drop in its income on the fears of shifting consumer behaviour. For the third quarter, the top U.S. retailer expects 5% sales growth and U.S. comparable sales growth of 3%.

Despite the not-so-flattering earnings, there are numerous reasons to be upbeat about Target. As U.S. inflation slows, some of the pressure on discretionary spending should ease, which will be better for Target than Walmart since the former gets roughly 80% of its revenue from non-food items. Target also informed the investors that the back-to-school period had been successful, which is frequently an indicator of the fall and winter seasons’ business. The company also reiterated its operating margin forecast of around 6% for the second half of the year and low- to mid-single digit revenue growth for the whole year.

Exhibit 4: Stock Price Performance of Big-Box Retailers (in USD)

Source: Investing.com, Data as of August 22, 2022

Weak housing market powers a strong quarter for home improvement retailers

The slowdown in the U.S. housing market doesn’t seem to have had a significant impact on the spending on house improvements. Home Depot (HD) and Lowe’s (LOW) reported strong second-quarter sales from professionals such as contractors, plumbers and electricians. According to the retailers, these consumers have a sizable backlog of projects and a lot of unmet demand for home improvement.

Infact, it was a record quarter for Home Depot. The company reported its highest-ever quarterly sales, which were up 6.5% from last year. In comparison to the preceding year, net income for the quarter increased by 7.6% to $5.17 billion. Whereas, Lowe’s outperformed earnings estimates but missed on revenue expectations for the most recent quarter. The company’s earnings per share rose 9.8% year over year to $4.67, while revenue was practically unchanged, falling 0.34% to $27.48 billion. This is because the unit catering to professionals like remodelers, plumbers and handymen brings in more of Home Depot’s sales than for Lowe’s.

Exhibit 5: Home Depot and Lowe’s Second Quarter Earnings Highlights

Source: Company Financials, CNBC, August 2022

Since the pandemic’s peak, the companies attribute the ongoing strength to the state of the housing market as, according to them, people staying in their homes for a longer time may encourage renovations. The 30-year fixed mortgage’s average rate has nearly doubled since the beginning of the year, but housing starts have sharply decreased. “Oftentimes, what is bad for the home builder is not necessarily bad for the home improvement,” said Lowe’s CEO Marvin Ellison. Richard McPhail, CFO of Home Depot, added that the rise in home prices is “probably the strongest underpinning” of demand for home improvements.

Outlook for Home Depot and Lowe’s

However, both the home improvement giants, in terms of outlook, cited that a softening could be ahead. Lowe’s reiterated its full year outlook with the results. The company expects that earnings per share will likely be in the upper range of $13.10-$13.60 while sales will likely be in the lower end of $97 billion-$99 billion of revenue. On the other hand, Atlanta-based Home Depot, maintained its projection for total and comparable sales growth of roughly 3% for the year with an operating margin of about 15.4%.

Exhibit 6: Walmart Stock Price Performance History