The media has also been quick to leap on the first absolute decline in retail and food service sales (2008 vs. 2007) in post war history.
The retail sector is the second largest component of GDP in the US (after information technology) and accounts for more than 1/3 of total US GDP.
Pundits have now officially capitulated. If we are to believe such talk, capitalism and the free world have clearly come to an end. The level of bearishness in the media has, to my way of thinking, reached manic proportions. Investors and analysts alike are now embracing negative events.
As investors, we should all pay attention to some sage advice that our parents tried to instil in us, as children:
“Just because your friends are all jumping off a bridge does not mean that you should do it too”.
An awareness of how retail sales are tabulated, and their impact upon GDP estimates, goes a long way towards understanding how the 2nd largest component of US economy was reported as going from “so good” to “so bad”, in just 24 short months.
The devil is in the GASOLINE sales figures.
Retail gasoline sales are included in the category and accounted for more than 10.8% of total retail spending in 2008. Accordingly, the price of gas inevitably gets bundled up into estimates of GDP growth or contraction.
For the years 2001-2008, it has been oft reported that consumer spending has grown by an average of 4% per annum.
However, a careful look at the components within the total, reveal a somewhat different story.
- Retail expenditures (ex gasoline) have grown by an average of 3.4% annually from 2001-2008.
- Expenditures on gasoline were up by 11.7% per annum from 2001-2008.
Price changes in gasoline are essentially MEANINGLESS to GDP, as retail gasoline is essentially sold under a “cost plus” system of distribution.
Refiners make the lion’s share of profit on gasoline. Most refiners sell gasoline through their distribution networks with an emphasis on volume, not profit. What little profit is earned generally comes from convenience store sales.
Retail gasoline revenues are also UNIMPORTANT to the overall economic picture, insofar as profit margins go.
No other business in the retail sector operates with such low profit margins, as does a gasoline retailer. One station operator estimates that he earns more selling one can of Coke, than he makes on 10 gallons of gasoline.
When we factor out gasoline price changes, it turns out that the retail sector has been hard pressed to post positive comps for almost 3 years.
Gasoline revenues, as a percentage of total retail sales in the US, grew from 9.65% to more than 10.8% in the past 24 months.
Ex-gas, US retail spending has grown by a total of just 2.3% since 2006. That's total...not annualized. This level of sales growth was wholly inadequate to maintain retail profits, after adjusting for inflationary pressures.
US retail and food service sales, including gasoline.
2001: $3.38 trillion.
2002: $3.50 trillion.
2003: $3.61 trillion.
2004: $3.83 trillion.
2005: $4.08 trillion.
2006: $4.31 trillion.
2007: $4.49 trillion.
2008: $4.47 trillion.
US gasoline sales.
2001: $251 billion.
2002: $250 billion.
2003: $274 billion.
2004: $319 billion.
2005: $373 billion.
2006: $416 billion.
2007: $445 billion.
2008: $486 billion.
US retail and food service sales, ex gasoline.
2001: $3.13 trillion.
2002: $3.25 trillion.
2003: $3.34 trillion.
2004: $3.51 trillion.
2005: $3.71 trillion,
2006: $3.89 trillion.
2007: $4.05 trillion.
2008: $3.98 trillion.
I won’t be unduly alarmed when the first half of 2009 continues to produce bleak year over year retail figures.
Should the current pricing environment persist, reported US gasoline sales could fall to as little as $250 billion in 2009. This is a potential swing of $236 billion.
The magnitude of the drop is such that non gasoline retail and food service sales would have to increase by 6.5% in 2009, to make up for foregone gasoline revenues. A more likely scenario; is that total retail sales will fall well short of $4.4 trillion US for 2009.
It has been more many years since US census figures reported an overall 6.5% growth rate in total retail sales. 2009 likely won’t be the year to break that trend.
The big losers are of course, oil producers.
We are now at five year + lows for oil prices. Regional price differences and bulging storage tanks are resulting in many smaller producers getting discounted FAR below WTI. Unhedged refiners and consumers alike, benefit greatly from this price environment. As refiners are the only real users of crude, they are in a position to dictate what price they are willing to pay to constrained e&p independants, regardless of posted benchmarks.
Panic is now setting in throughout the oil producing industry…as well as the banks with loan exposure to oil producers. Assuming that oil prices remain at current levels, and assuming that oil producers sell for an average of 5X EV/EBITDA, total capital destruction in the e&p sector could surpass $1 trillion from peak to trough. This simply applies to the US oil industry.
Producers in all other countries will have to contend with similar valuation reappraisals.
If we can overcome the negative rhetoric, 2009 might be an excellent year for a CERTAIN subcategory of US retailers.
In the United States, hundreds of billions of dollars will NOT be spent on gasoline in 2009. This almost immediately works its way back to the economy. Some of the savings will certainly be spent in more profitable segments of the retail sector.
A direct stimulus generated by a spending shift away from gasoline, towards more profitable retail businesses, will eventually have a very positive ripple effect throughout the stock market.
Oil and gas companies sell for very low multiples on an Enterprise value basis. A $200 billion-$300 billion reduction in oil revenues should easily destroy $600 billion of value for oil producers. This assumes that the median oil producer sells for an average of 5X EV/EBITDA, and that EBITDA margins touched 60% for the industry at the top of the oil price cycle.
Let us also assume that retailers sell for an average of 10X EV/EBITDA. If consumers eventually shift 100% of the gasoline price savings towards other retail purchases, the US stock markets could ultimately see an aggregate improvement of more than $1 trillion trillion-$1.5 trillion dollars.
As previously noted, retail profits on gasoline sales are miniscule at best. Depending upon the subsector, EBITDA margins in the mainline retailers are anywhere from 3X-20X that of a gasoline retailer. Accordingly, the overall US retail sector will generate improved profitability in 2009, even if as little as 25% of the gas savings are ultimately shifted toward other purchases.
Profit pressures have been severe in retailers for more than 2 years. An eventual shift of as much as $200 + billion of sales, towards businesses with higher operating margins, will generate a disproportionate level of profit increase for the entire sector. The fortunes of the commercial real estate industry are closely tied to that of the retail sector. Commercial real estate is also heavily leveraged, and needs to see a broad based revival in retailing. In short, when retailers recover, a multitude of other sectors recover too.
Both bulls and bears alike are free to come up with their own models to suit. However, neither side can dispute one fact in the investment markets today:
The oil and gas exploration and production industry always sells for an EV/EBITDA discount to the retail industry.
A multiplier effect upon retail profits, and potential overall stock market values seems inevitable, when the spending shift from gasoline to other goods occurs. Oil companies lose and consumers win. We are already seeing the value destruction occur in oil producers. What we have not yet seen, is a valuation expansion in retailers.
I'm not describing a zero sum gain. The shift in spending, away from gasoline and to other retail items, will have a very positive net impact for the overall US economy, even after taking into account losses incurred from the oil and gas sector. To my way of thinking, the question of investing more aggressively into US retailers is not "if", but "when".
While all US retail sectors will ultimately benefit, why not pick the low hanging fruit now?
3 retail sectors reported sales growth in 2007. These were drug stores, grocery stores and food/beverage retailers.
Grocery store sales in particular, posted strong comps over the past 24 months. During the years 2006-2008, total US grocery store revenues increased by 10.1%.
Grocers have been maligned by investors, due to a lag effect when passing on price increases to consumers.
These firms have high fixed costs and low variable costs. During the past 24 months, rising utility charges and wage increases also diminished the benefits of sales increases. While grocery store chains continue to argue otherwise, it is fairly well understood that the industry suffers during periods of cost inflation.
Also, balance sheets at several of the publicly traded chains are dreadful. When interest rates were rising, increased interest expenses more than offset revenue gains.
All of the cost inflation has effectively been removed from the 2009 grocery store business model.
Recessions create an abundance of cheap labour, and removes potential wage pressures on a grocer. This is now a strong environment for a lower wage employer, capable of offering long term job security.
Utility bills will also come down in 2009, based upon the price of oil and gas. Transportation charges on inventory purchases and storage at distribution centers will come down dramatically.
Commercial rents on leased store locations are one of the largest fixed costs for grocers. With a burgeoning surplus of retail space forecast in 2009-2010, grocery store chains should be well positioned to negotiate lower rents.
Expense inflation should no longer be a concern for major grocers in 2009.
Also, unlike many retailers, grocery store turns are very quick. Pass through inflationary increases on most of the inventory should already be worked through most major chains. So, while prices on many goods should come down sharply in 2009, 100% of the inventory cost saving won’t flow down to consumers.
Finally, firms that are considered to be credit worthy, will benefit from lower funding costs at some point down the road. Corporate spreads for credit worthy borrowers are once again starting to narrow. Firms with exceptionally strong balance sheets will be poised to expand.
The world’s largest bond investing firm, Pimco, is already noting improvements in the short term funding market for corporate debt.
Selected grocery store chains could go from being the perennial dogs of Wall Street, to potential darlings.
Balance sheet strength and an ability to compete against Wal-Mart supercenters will be the key to generating long term returns in this sector. I consider the macro environment to be clearly turning for the better in this retail subsector. The end result could be potential positive profit surprises among certain companies.
One large chain with the potential for positive surprises in 2009 might be Delhaize Group (DEG-NYSE:$61.5).
The blog model portfolio presently holds a market weight position in this company. I have written about Delhaize in a previous article on this blog, so won’t seek to fully duplicate that review.
With 103.1 million shares outstanding (fully diluted) Delhaize’ market cap is about $6.34 billion US. Total liabilities (09/30/08) were reported as $6.7 billion US (using Euro exchange rate of $1.31 to $1 US dollar).
Delhaize generates positive free cash flow. 2008 year end liabilities might be as low as $6.5 billion. This produces an EV of $12.85 billion. An estimate of 2008 EBITDA looks to be about $1.85 billion US. (My previous article estimated a higher level of EBITDA, based upon a higher Euro exchange rate).
Accordingly, Delhaize appears to be selling for 7X the trailing 2008 EV/EBITDA ratio. Provided that my forecasts for 2009 are met, DEG might be selling for as little as 6.4X the 2009 exit EV/EBITDA ratio. This suggests a 15.6% EBITDA return on the entire capital structure.
Better known US peers include: Kroger Corp. (NYSE-KR: $24.50) which sells for roughly 8.4X my estimated 2008 EV/EBITDA ratio. Safeway (NYSE-SWY: $22.85) sells for 7.7x my estimated 2008 EV/EBITDA ratio.
Smaller grocery store chains include: Ruddick Corp (NYSE-RDK: $27.59) which sells 7.4X my estimated 2008 EV/EBITDA ratio and is cash flow positive. Whole Foods (NASDAQ-WFMI: $12.35 sells for 7.5X my estimated 2008 EV/EBITDA ratio and is cash flow negative.
Despite currency headwinds in the first nine months of 2008, Delhaize may have posted an excellent fiscal year.
The firm generates far more than 68% of its revenue from US operations. During the years 2003 to the third quarter of 2008, the US dollar declined vs. the Euro. In each fiscal report, Delhaize had to convert the US dollar revenues into Euros, making negative currency adjustments when doing so.
In the past year, the firm continued to report positive store comps overall. The store base is quite modern, and Delhaize continues to expand. Some of the store count is distorted due to a proportionate holding in Alfa-Beta, a fast growing Greek grocery store chain. Nevertheless, the overall store count in the Delhaize chain grew by almost 5.5% during 2008.
Delhaize has some currency TAILWINDS at its back in 2009.
On January 16th, 2009 Delhaize will report its year end financial figures. The 4th quarter of 2008 will be the first period in many years, where the major US division will not be subject to a currency translation penalty. This could lead to a modest earning surprise.
Going forward, currency tailwinds might persist for at least a portion of 2009. Should the US dollar simply maintain a fraction of its 22%+ gains on the Euro incurred in the last 6 months, Delhaize may report very strong comps in 2009. Finally, as a major lessee of stores in the US, management might soon be able to obtain preferential rates for multiple years.
Delhaize has announced a slowdown in the total number of planned store openings for 2009. This implies that free cash flow growth might accelerate in 2009. Intrepid investors might want to think about the implications of Delhaize purchasing minority shareholdings in their Alfa-Beta Greek subsidiary. Such an action would clean up the minority interest accounting on the Delhaize balance sheet.
Only one Wall Street firm provides coverage on Delhaize.
The lack of coverage for a retailer with more than $25 billion of revenues, is in stark contrast to peers. Kroger has a total of 13 Wall street houses providing coverage. The median recommendation on Kroger is "buy". Safeway is covered by 17 Wall Street firms, and is rated as a "hold". Ruddick, a firm just 1/6 the size of Delhaize, is covered by 3 firms, who rate the stock a "buy". Whole Foods, a firm less than 1/3 the size of Delhaize and cash flow negative, is covered by 16 firms. They rate the stock a "hold". Even Supervalu (NYSE-SVU:$17.88) a heavily leveraged retailer, is covered by 10 Wall Street houses. They rate SVU as as better than a hold.
DEG is one the few major retailers that is clearly cash flow positive and in no need of an investment bank for funding. The sole US firm providing coverage presently rates Delhaize as less than a hold. I am unsurprised.
Delhaize announcement of 4th quarter revenues beating expectations, may be found here:
The general corporate website for Delhaize may be found here