Thursday, January 03, 2008
USA Retail's Perfect Storm
There was a time but a few years ago when the US consumer was, as the saying goes, "flush" - largely a result of rising home values, themselves a result of nearZIRP in Ameica and Japan, yet still with a strong dollar, unfathomably cheap energy & commodity prices (in both USD and non-dollar terms), and lots and lots of cheap stuff flowing in from China. Wealth was further buoyed by deflationary effect of all manner of factories exiting the US in favor of Chinese elve-dom - some of which was passed on to the consumer. This was wondrous unless of course you were a worker at one of the factories now-shuttered, in which case there was no reason to worry for there was a job for you building houses, selling kitchens, brokering real-estate, or greeting at Walmart, Target, Beebe, Chico's, or if you were the granola-chomping kind of slacker, Whole-Foods Market.
These times were bountiful for retailers as well. Demand was increasing, wage-bills were in check due to munificent forces of globalisation, corporate taxes were cut, sourcing from China meant COGS were actually falling or at worst stable, distribution costs too were stable, low energy costs meant one could be wasteful-beyond-thought without it ticking the bottom line, yet miraculously, as if in a Disney fairy-tale, consumers
seemed to have more-than sufficient disposable income. And if the consumer balked for a moment, a rising stock-market or another round of refi would refresh the well with what felt like an inexhaustible supply of freshly conjured money. Some called it Goldilocks. Some termed it a virtuous circle. But, perhaps most importantly to observers, the basis for this prosperity was NOT the rewards derived from the sustainable production of goods and services, but the rather somewhat fictional and almost-certainly unsustainable production of promises.
Many a skeptical investment manager - particularly those of foreign persuasion - were handily spanked in 2004 and 2005, and again in 2006 for doubting the sustainability of this entente cordial between lenders and borrowers. Growth, it seemed had no limits, and very soon (so the story went) ordinary Chinese would be adorning themselves with URBN & BEBE designs, shopping at WFMI, or laughably eating at PNRA, CAKE, or PFCB (a horrendous upscale Chinese eatery mushrooming across America). The second half of 2007 however, saw the market wake up to the reality of what these things might be worth in the event the circle was less virtuous in the future than in the past. What might happen to sales and profits IF sourcing COGS rose as a result of a weak dollar and inflation, distribution and energy costs vaulted, wages and benefits ticked higher despite wage-depressing impacts of globalisation, real estate prices and stock prices FELL as energy and food costs ROSE leaving the average consumer squeezed BOTH on both their income statements AND balance sheets?? Ohhh it wouldn't be a pretty picture at all. No it would not. Only food retailers (and not the WFMI Whole-Paycheck Market tail of the market) would be spared and maybe even prosper, or not be subject to the wealth destruction preying upon discretionary purchases.
How would American's respond? First, by denial. The clouds may be dark, and the air pregnant with moisture, but it will pass. Then by cosmetically rearranging purchases. But as the storm unfolds, they will understand what it means to be hit from ALL sides. Higher unemployment, higher basic costs for food & energy, higher import prices for goods, diminishing wealth efects and a renewed effort to save which will feed back into lower consumption, and then, perhaps only then will lower prices will follow.
Retail and restaurant indicies have been crushed in the second half of the year, with only a few being spared, but they are still factoring in some growth, and perhaps are not factoring yet further margin erosion from - in the case of restaurants - higher input costs and lower demand, and in the case of retail, higher distribution and sourcing costs coupled with diminishing demand. Dark days are ahead as investors (and management) discover that retail is, in fact cyclical, with enormous macro-economic sensitivity. There was, perhaps a reason why retail historically traded upon single-digit ratings, for over the course of the cycle, this perhaps equated to an average equity risk-premium in-line with the rest of the market.