Retailers are trying to get back to black…literally

Tue Nov 5, 2013

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Recent trends among apparel retailers have been a complete bust.

By Ward Davis and Brian Agnew

In July 1980, six months following the unexpected death of lead singer, Bon Scott, AC/DC released their seventh album, Back in Black. The Australian hard rock band nearly disbanded after Scott’s death, but rallied around new lead singer, Brian Johnson, to produce what would become the best-selling hard rock album of all-time. The album’s all-black cover was a "sign of mourning" for Scott, according to lead guitarist, Angus Young. Back in Black contains many of AC/DC’s biggest hits, including "Hells Bells," "You Shook Me All Night Long" and the album’s title track. These classic tunes helped immortalize the band which was inducted into the Rock and Roll Hall of Fame in 2003.

Far from top-selling and immortal, recent trends among apparel retailers have been a complete bust. The back-to-school shopping season was among the worst we’ve witnessed in our twenty years in the business. Countless companies across the specialty apparel and department store sectors announced utterly dismal sales results and downward revisions to earnings. Teen retailers Abercrombie, American Eagle, Aeropostale, and Rue 21 were particularly hard hit by traffic declines and announced substantial downward revisions to EPS guidance. Problems at Rue 21 nearly derailed a private equity takeout bid announced in May (that probably should have been derailed). However, the sudden sales falloff wasn’t just contained to the teen players. Department store companies Kohl’s, Target and Nordstrom had to lower their respective sales forecasts as well. Seemingly every day, another retail company with exposure to apparel lowered guidance.

The alarming decline in apparel demand has triggered a sudden shift in fashion. Following several fruitful seasons of inundating shoppers with bounties of color, retailers have met the shocking sales decline with a return to ultra-conservative, classic black. Windows once bursting with mimosa, honeysuckle and tangerine tango have been scrapped in favor of grays, whites and predominantly black tones. Suddenly, no longer willing to take fashion risk, retailers are just trying to control the damage, but in so doing, are boring the shopper to tears.

Uptown on Madison Ave & Downtown in SoHo – All Retail Windows Look the Same

The reappearance of basic black, however, does not mean a return to high profits for retail. Rather, "back in black" may be a sign of mourning for the industry as we approach the critical holiday shopping period. The boring sameness may actually be contributing to further declines in customer transactions, and the problem appears to be spreading. The depth of this particular downturn has yet to be reached: recent top performers have also seen slowing revenue trends.

In addition to sales weakness, retail inventories appeared elevated exiting the second quarter.

Given further deterioration in traffic trends, gross margin compression is likely in the second half of this fiscal year. Factoring in the short shopping window for the holidays this year (one less week between Thanksgiving and Christmas), retailers with exposure to apparel could be in trouble and experience downward earnings revisions. Brian Johnson’s raspy lead vocal on the rock ballad, "Hell’s Bells," may be more appropriate background music over Bing Crosby’s "Jingle Bells" while walking the malls this holiday season.

The slowdown in discretionary spending has not been contained solely to mall-based apparel retail. Higher taxes, the sequester, and anemic job and wage growth have all seemed to take a bite out of consumer spending. Despite all these concerns, consumer discretionary stocks have continued their ascent. We have noticed an ever widening spread among the winners and losers in our universe.

• September sales trends for casual dining restaurants weakened further from August and July’s lousy showing with same stores sales down 1.8% according to Knapp Track (a restaurant consultant). These weak results came against easier year-over-year compares in September and represented the second worst two-year results of the year.
• Hertz lowered revenue guidance for the balance of the year citing, among other things, a slowdown in bookings by leisure customers.
• The SAAR for autos slowed from 16M units in August to 15.2M in September, below expectations calling for 15.7M.
• Stanley Works lowered revenue and earnings guidance for the balance of the year citing revenue weakness in its corporate security and industrial sectors.
• Petsmart lowered their same store sales guidance due to slowing trends.

The fiscal impasse in the US had little impact on equity prices. Contrary to prior budget-related crises, stocks have continued to surge with only a small handful of intraday corrections to temporarily scare markets. The constant bombardment by the press may be diverting investor attention from some of the slowing we are seeing at the front-end of the economy. In fact, companies now have a built-in excuse to lower guidance for the remainder of the year, and this may be emboldening investors and scaring short sellers. The economic softness we are seeing may also explain why the Fed reversed course last month and postponed their planned monetary stimulus tapering. The renewed dovish tone is allowing for steep expansion of stock multiples, inflated even more given the rash of downward earnings guidance across much of the sector. Unless company managements come out and officially lower their revenue and/or earnings targets, stocks are likely to keep climbing on the hopes that ongoing monetary stimulus will eventually lead to tangible growth. Absent a material improvement in jobs and wages, we have a hard time seeing a "hockey stick" economic recovery on the horizon from our consumer-focused vantage. P/E multiple expansion under these circumstances cannot continue forever.

In spite of the growing number of negative, bottoms up data points, we continue to find pockets of strength within the global consumer sector and an abundance of undervalued equities. We remain bullish on the lodging sector where we see a continued benefit to revenue per available room from the anemic level of overall room growth and where we see tremendous appetite among private equity to buy lodging assets. Fortunately, we have remained bullish on global gaming stocks, especially those that generate the majority of earnings in Macau, China where the overall market is growing in excess of 15%. In addition, we continue to believe that the video game hardware console transition will drive the industry to overall growth. We are optimistic that the conclusion of the issues in Washington (for now) could lead to a more rational environment for finding great opportunities on both sides of the portfolio.

Ward Davis and Brian Agnew are the portfolio managers of Caerus Global Investors, a $200 million global long/short equity hedge fund in New York. This column was adapted from a recent letter to investors.

ISSN: 2151-1845 / CDC10004H

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