U.S. discount retailers on discount?

Signals about the economic health of the U.S. have been befuddling. The overall picture painted by the U.S. Census Bureau Index of Economic Activity shows that the largest economy in the world remains far from a recession. Looking at employment and consumption, nonfarm payroll figures were robust and there had been increases in both personal income and personal consumption expenditures.

At the same time, some experts have formulated the view of an imminent recession. Regardless of whether a recession will happen, the only certainty about the current macroeconomic backdrop is its uncertainty. These two dichotomous economic outcomes bring about opposite consumption patterns and behaviours. An upbeat outlook likely favours more premium segments while the converse buttresses normal and/or inferior goods. In this piece, we switch gears from analysing the luxury industry to navigating the performance of everyday retailers.

Heading to the basement

Discount retailers sell consumer goods at bargain prices which typically cater to value-seeking customers on a tighter budget. Some notable names include Dollar General Corporation (NYSE: DG) and Dollar Tree Inc. (NASDAQ: DLTR), but even major powerhouses such as Walmart Inc. (NYSE: WMT) are also considered to be discount players.

Despite higher sales at U.S. retailers, consumer spending shows signs of floundering. Earning results for discounters have taken a hit and accordingly, their share prices have been pummelled. To illustrate, BJ’s Wholesale Club Holdings (NYSE: BJ) and Target Corporation (NYSE: TGT) are down 11.2% and 27.0% over the past six months, respectively. On a year-to-date (YTD) basis, returns remained in negative territory although losses were more muted. For some others such as Dollar General, its share price took a nosedive in both periods, falling by 28.3% in the last six months and 37.1% year to date. What contributes to this lackadaisical market performance?

The short answer is that U.S. consumers are becoming more conscious of their spending. In the first half of 2023, total spending intentions have trended downwards from -13% at the beginning of the year to -17% in April 2023. The proportion of consumers with plans to delay larger purchases also inched upwards from 43% to 45% in the same period. Interestingly, this is off the back of a more confident outlook where fewer respondents expect their financial situation to deteriorate within next year, stronger labour market, and higher personal savings rate.

In any case, the reduced propensity to spend seems to be disproportionately affecting the lower income populace more, which have been found to be the more typical shopper profile at discounters. Reduced benefits from the Supplemental Nutrition Assistance Program (SNAP) – food stamp program to assist lower income households – and lower tax refunds were listed as chief reasons causing customers to be under greater pressure. These lead to more selective shopping behaviours where customers prioritise stretching their monies such as buying items at or below the US$1 price point. In fact, penny pinching tendencies were not just limited to discounters but were also witnessed at warehouse clubs such as Costco Wholesale Corporation (NASDAQ: COST) where the usual shopper is more affluent. For example, customers were switching from more expensive options to budget alternatives, such as substituting beef to poultry, purchasing canned products, and buying more private brand items.

Weakness in consumer spending adversely impacted merchandise retailers. Discounters like Dollar Tree revised their 2023 earnings per share guidance downwards. Similar revisions were provided by Dollar General across key operating and financial metrics, such as net sales growth, same-store sales growth, and EPS. Taking a step back and analysing the consumer staple merchandise retail space as a whole, margins had slightly improved from the pre-Covid era of 2019 to June 2023, with the exception of earnings before interest, tax, depreciation and amortisation (EBITDA) margin.

In our piece discussing the luxury segment, it was observed that the compound annual growth rate (CAGR) over a two-year period pre- and post-Covid had ballooned. Using the same period for consumer staple merchandise retailers, we see the two-year CAGR for EBITDA margin from 2017 to 2019 was 0.4%. Contrastingly, this number dove post-Covid to -1.9%, which corresponded to the period between 2020 to 2022. Since market valuation is often positively correlated to growth rates, one would expect this industry to trade at a discount. The reality shows the opposite.

Not so cheap?

Once again, we strive to keep to a like-for-like comparison with the luxury segment by comparing changes in trading multiples across the same time period. From 2019 until now, both the revenue (EV/Revenue) and EBITDA (EV/EBITDA) multiples have increased. The former crept up from 0.7 times to 0.8 times while the latter rose from 10.3 times to 11.3 times. The earnings multiple (P/E) went up even more steeply from 23.1 times to 28.8 times.

A possible explanation for this counterintuitive observation is that the market is forward looking and is thus pricing in recessionary behaviours especially among those earning lower incomes. However, this reason fails to account for the dimming outlook where earnings forecasts are slashed. The hypothesis centred around a synthetically inflated multiple due to shrinking denominators such as revenue, EBITDA, and net income also do not hold true. This is because the expanded multiples are on a historical instead of forward basis. Therefore, a plausible factor could be market exuberance.

The MSCI All Country World Index (ACWI) captures the performance from 99% of the investible global equity market. Comparing this to the MSCI USA Consumer Staples Index, it is plain that the MSCI ACWI has lagged behind its U.S. counterpart since 2019. A similar narrative is spotted across major regional indices around the world. Ever since the World Health Organisation declared Covid-19 as a global pandemic, the U.S. market proxied by the S&P500 outshone indices from other regions such as the FTSE100 and Hang Seng Index. Warning signs about the stretched valuations in the U.S. have also been flashing.

The fifth perspective

Amidst the climate of uncertainty, investors could consider adopting a similar attitude to consumers by tightening their purses. Rather than depend on calculated guesswork such as estimates and projections, investors may want to rely more on concrete evidence, including valuations coming down to reasonable levels based on improved earnings, margins and growth. The more conservative approach may be to only take action when the discounters get discounted.

Tan Ke Xuan

Ke Xuan holds a Bachelor of Business Management from SMU. He identifies as a value investor who prefers to combine both macro and micro analyses when learning about businesses. He believes there are opportunities to be uncovered in every stage of the economic cycle.

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