This week’s research notes is a little earlier than usual in light of Thanksgiving. Wishing all our American readers a happy holiday!

📍 TLDR

• We take a look at the retail space ahead of Black Friday.

• AAP looks like it could be a short; JOAN looks like it should be a short.

• TCS shows high-risk promise; GPS can work on paper but needs a huge turnaround from Old Navy.

• WOOF is reminiscent of pre-pandemic retailers — which is not a good thing.

After two-plus years of intense market volatility, every investor has regrets. Every one of us has sold a winner too early, ridden a loser too long, or missed a massive opportunity.

For me personally, missing a broad short of U.S. retailers is one of my biggest mistakes. The potential for a sector reversal was obvious even a year ago. It seemed exceptionally unlikely that specialty apparel retailers had suddenly cured the problems which dogged the sector before the coronavirus pandemic arrived.

Indeed, in 2015-2018 I’d put on a number of (mostly) successful short trades in the space precisely because of those problems. But last year the stocks did look 'cheap’ amid explosive earnings growth, which raised timing concerns. By the time it was clear the market had caught on, the opportunity had (mostly) withered away.

It does look like there might be another, if smaller, opportunity on the short side ahead of the holiday season. Stocks across the sector have gained nicely after (and in some cases ahead of) fiscal Q3 earnings. The U.S. consumer, despite external pressures, continues to spend (for now). Expectations for Black Friday (the day after Thanksgiving) remain high.

But the short thesis in late 2022 is not terribly different from what it was twelve months earlier, or indeed six years earlier. The long-term pressures on US retailers are not going anywhere. The ‘omnichannel’ model of in-store and online sales pressures margins. Online competition hurts pricing power, in part because it’s so simple to shop on that basis. Amid the decline of the traditional US mall, scale matters more than ever, and there are too many players in the industry with too little scale. And given how thin operating margins are for many players in the space — often below 10% — there’s just no room for error.

Yet it still doesn’t seem quite that easy to put on shorts in the sector. Broad trends seem arrayed against the industry. But timing matters, particularly with holiday season looming and Q3 reports either in the books or on the way. Market sentiment has clearly returned toward pre-pandemic levels (at least in terms of multiples) which does run the risk of a weak report leading the stock higher simply because the quarter was “not as bad as feared.”

In this week’s Research Notes, a few days ahead of Black Friday, we’ll take a look at a few names in the retail space to get a sense of where the sector sits at the moment, and if there are opportunities out there — short or long.

Advance Auto Parts

Shorting auto parts retailers hasn’t exactly been a “widowmaker” trade but for the most part it hasn’t worked. The thesis here seems simple. At some point, the same pressures buffeting the rest of retail will come for Advance Auto Parts AAP 0.00, O’Reilly Automotive ORLY 0.00, and AutoZone AZO 0.00.

Amazon.com AMZN 0.00 is a bogeyman in this market (as it is in so many others) and worries about margin compression and decelerating sales growth have popped up on occasion. But for the most part, the industry just keeps growing and shareholders keep profiting.

Well, at least two-thirds of the industry does so:

source: YCharts. 10-year chart

Advance Auto Parts has not kept pace with rivals, and the divergence year-to-date has been particularly stark:

source: YCharts. year-to-date chart

Even after that performance, there seems to be a pretty solid case for going long AZO or ORLY (we’d pick AZO for its impressive buyback history and better valuation) and short AAP. Advance simply isn’t competing well: in the most recent quarter, its same-store sales gap relative to the two major peers was ~850 basis points.

Obviously, management is aware of the underperformance. But the plans to fix that problem, as detailed on the Q3 conference call last week, seem too thin. “Targeted inventory investment” and “surgical pricing actions” — both terms used repeatedly on the call — by definition can’t close that type of gap.

It’s tempting to at least consider a short of ORLY, which is trading at almost 23x 2023 EPS, while dynamics in the used car market suggest that recent tailwinds will moderate substantially. It’s probably tempting to some investors to take the bet that AAP, with a forward multiple less than half that of ORLY, can find some sort of turnaround here.

But one of the lessons in U.S. specialty retail before the pandemic was that pressing a short of a struggling retailer usually worked out. Momentum, once stalled out, was exceptionally difficult to regain.

The history of the auto parts space suggests that long ORLY or AZO, and short AAP, is an intriguing pairs trade. The history of retail more broadly suggests there might still be room to simply short AAP.

Gap Inc.

Despite my broader pessimism toward retail, I owned GPS for a couple of years before the pandemic. The thesis at the time was relatively simple: the Old Navy business supported the entirety of the company’s enterprise value, leaving the other three brands (Gap brand, Banana Republic, and athleisure play Athleta) available “for free”.

Despite the always-dangerous “for free” argument, that case was stronger than it might seem in retrospect. It’s worth remembering that Old Navy was one of the best retail businesses in recent history. The first store was opened in 1994. In fiscal 2018, 24 years after its debut, the brand generated nearly $8 billion in revenue.

To put that into context, there's little doubt that Lululemon Athletica LULU 0.00 is one of the best retail stories of the past few decades. That company was founded in 1998. 24 years after its debut, the brand is expected to generate...nearly $8 billion in revenue. Lululemon's products are better and higher-priced, yes, but from FY16 to FY18, Old Navy generated average Adjusted EBITDA margins of 18%.

The problem is that Old Navy stopped being a wonderful business. Same-store sales (aka Comps) grew 3% in FY18, then declined 2% in FY19. FY21 showed a two-year increase of 12%, but in the context of the pandemic and government stimulus, that performance was not terribly impressive. Comps promptly plunged 19% in the first half of FY22 (against a +12% year-prior comparison). That’s even with promotional activity pressuring consolidated gross margin.

The hope before the pandemic was that Old Navy was simply struggling with execution, a problem that presumably could be fixed. And if Gap Inc. could get the brand back on track, there was value in Athleta (trailing twelve-month sales of $1.5 billion) as well, suggesting a path to $30-plus.

In theory, that path still exists. A revolving door at the management level — Old Navy’s president left in April after barely two years on the job; Gap Inc. chief executive officer Sonia Syngal, who had made her name at Old Navy, resigned in July — no doubt hasn’t helped the brand. The pandemic and significant supply chain interruptions have caused their own problems.

All that said, it’s been five years now since Old Navy looked like the powerhouse it once was. We don’t know what profit margins look like, but what clues we can gather from consolidated results suggest EBITDA margins are far below the 18% reported last decade. Athleta grew revenue just 6% in Q3. Management blamed “the shift in consumer preference from athleisure to occasion,” which presumably is news to Lululemon, which has guided for 20%-plus revenue growth in the same quarter.

With Gap’s enterprise value of ~$6 billion less than 1x Old Navy revenue, it’s perhaps tempting to bet on a turnaround here. But that bet seems logical only at a sharp discount, one that suggests downside is manageable if the business doesn’t improve. With GPS now up a surprising 67% since Sep. 30, and trading at 18x FY23 consensus EPS, it’s probably not a bet worth taking.

The Container Store

The Container Store TCS 0.00 has not been a good stock:

But there’s an argument that it’s actually been at least a decent business. Based on analyst estimates for FY22, revenue should grow over 90% (~5.6% annualized) since FY10 (TCS fiscal years end the following March). All of that growth is coming from store count, admittedly. But in the context of the space the performance is not that bad.

Adjusted EBITDA margins have stayed above 10% (with one exception, an ugly FY15). Margins should hold even with some normalization from 14-15% in FY20 and FY21. In fact, margins should be roughly flat over this 12-year period, which, again, in the context of the space is not that bad.

And year-to-date performance looks reasonably solid. Same-store sales are positive. Adjusted EBITDA has declined 20%, but the year-prior comparison is exceptionally difficult and the strong dollar is hurting third-party sales of the company’s Elfa shelving. Revenue should come in over $1 billion this year, and management insists on a pathway to the $2 billion level.

Even the products are useful and well-made (we have quite a bit in our home).

Yet TCS trades at a multiple befitting a much more challenged retailer — likely less than 4x this year’s EBITDA (barring a second-half collapse).

It’s exceptionally difficult to get bullish on a housing-related play at the moment. It does seem like there’s a good chance the bottom falls out on the business in calendar 2023. And so a cheap headline valuation is not enough.

But…TCS has been a buy in the $4s in the past. The company has a relatively passionate base of core customers. The move into closet installation has worked. An EV under $400 million seems reasonable in the context of pre-pandemic performance, when the company’s EBITDA mostly stayed in the $85 million to $95 million range. If the bottom falls out of the stock (and given leverage, in a broad market reversal that’s possible) there could be an opportunity here.

JOANN

On the other hand…how is the short interest for JOANN JOAN 0.00 just 6.8% of the float?

Here’s the profile. JOAN’s dividend yields 8.8%. The company has long-term debt of $1.1 billion, and a net leverage ratio of 5.5x EBITDA. It just posted an EBITDA loss in Q2. Gross margins on a GAAP basis were 46%, and 52% excluding freight; there’s room for that figure to come down.

In FY22, the two-year comps stack

The bull case perhaps is that supply chain pressures are hitting results, reducing margins and thus inflating net leverage. But against FY22 results (ending January), and even assuming some inventory help to free cash flow in the second half of this year, the business is still over 4x net leveraged.

This really looks like a 2016-2017 vintage bear case, in which pressing the short on a struggling retailer usually led to more gains. This may be a name we return to down the line.

Petco Health and Wellness

This is not a quantitative argument, admittedly, but WOOF sounds like an easy short in one very specific way.

After the second quarter report in late August, Petco cut its guidance for fiscal 2022 (ending January). WOOF stock fell 9% on the news, threatening an all-time low in the process.

Yet, listening to the Q2 conference call, everything was completely fine. The margin pressure driving the reduced profit guidance was coming from “transitory” pressures driven by inflation and macroeconomic issues.

This is precisely what seemingly every apparel retail CEO said on calls from, say, 2015 to 2019. The long-term plan was always intact; next year was always going to be better; this quarter was always just a matter of economic weakness or (more often than you might think) bad weather.

In retrospect, that call was a tell. WOOF is down 33% from that post-earnings close. That decline, and a 12x multiple to the midpoint of (current) adjusted EPS guidance for this year is probably enough to keep the short case from being too enticing just yet.

But investors considering Petco before the Q3 release should keep the sector’s history in mind. When a retailer — any retailer — says the problem is what’s going on outside its doors, the problem most often is what’s happening inside.

🙏 Happy Thanksgiving to all of our readers. We’re thankful for each and every one of you.

As of this writing, Vince Martin has no positions in any securities mentioned.

Stocks mentioned: AAP 0.00, AMZN 0.00, AZO 0.00, GPS 0.00, LULU 0.00, ORLY 0.00, TCS 0.00, WOOF 0.00

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