News

Oct 19, 2023

After Bed Bath & Beyond, Will Another Retailer Fall? 2 Winners And Losers

MUENCHEN, GERMANY - MARCH 30: (BILD ZEITUNG OUT) The Abercrombie & Fitsch Logo

MUENCHEN, GERMANY - MARCH 30: (BILD ZEITUNG OUT) The Abercrombie & Fitsch Logo is seen next to the ... [+] front door of the Abercrombie & Fitsch store on March 30, 2020 in Muenchen, Germany. (Photo by Roland Krivec/DeFodi Images via Getty Images)

In April, Bed Bath & Beyond (BBBY) filed for bankruptcy after a botched merchandising makeover. More retail bankruptcies could be ahead, noted the New York Times NYT .

Given the low unemployment rate and continued growth in consumer spending, investors must distinguish the retail winners from the losers.

After reporting first quarter results, two things separate the rising retailers from the falling ones:

Read on for an analysis of two winners and losers: What is behind their strategies and how can investors profit? I’ve included a list of retailers considered to have an elevated risk of bankruptcy for those willing to bet on their declining stock price.

Bankruptcies are at the highest level since 2010 — and BBBY is the most prominent brand among the retailers suffering this fate. According to the New York Times, more than 230 U.S. companies filed for Chapter 11 — the largest number since 2010.

Since the Covid-19 pandemic began in March 2020, companies have been whipsawed by rapidly changing tailwinds and headwinds. Early in the pandemic, a combination of government stimulus, low interest rates, and the success of working from home created tremendous growth opportunities.

As inflation persisted — rising as high as 9.1% in June 2022 — the Federal Reserve Bank raised interest rates from near 0% to a range between 5% and 5.25%.

For heavily indebted companies dependent on consumers squeezed by persistent inflation, the drop in discretionary spending has contributed to their inability to meet their financial obligations.

Yet the economy has a big strength. In April 2023, the 3.4% unemployment rate and a 4.3% rise in consumer spending — which accounts for 70% of economic growth — kept GDP growing at a modest 1.1% in the first quarter of 2023.

This mixture of economic strengths and weaknesses aims the most pressure at specific industries. Retailers — such as BBBY and David's Bridal — as well as restaurants are filing for bankruptcy because they are "typically among the most sensitive businesses to challenging economic conditions," the Times noted.

However, my analysis of why BBBY went bankrupt suggests a gigantic strategy misfire was the primary reason for its failure, rather than a difficult economy. Last summer, BBBY burnt through $325 million in cash as revenue plunged 25%.

The reason was activists who took over BBBY's board saw private label goods as a way to boost the company's profitability. In November 2019, the board hired Mark Tritton, the former chief merchandising officer at Target TGT who had overseen a makeover that included loading up the retailer's shelves with private label goods.

Tritton — who neglected to consult store managers and customers ahead of time — bulldozed the private label strategy through BBBY. Before his arrival, store managers had the flexibility to stock up to 70% of their local shelves with goods that customers wanted — most notably, discounts on branded goods such as Cuisinart food processors and OXO cookware.

After Tritton forced stores to rid their shelves of branded goods and replace them with private label ones, consumers entered the locations, searched for and failed to find the branded products they wanted to buy. They instead began buying those items from Amazon AMZN .

More bankruptcies are on the way as banks cut back on lending. Joe Davis, Vanguard Chief Global Economist, warned tighter financial conditions will force companies to cut costs, part ways with workers, and ultimately file for Chapter 11. Bank of America predicted that about $1 trillion worth of corporate debt — 8% of the total — could default, reported the Times.

More retail bankruptcies are likely. As BBBY's Chapter 11 filing suggests, investors ought to analyze individual companies to distinguish the likely winners from the losers.

In my view, the winners will be companies with effective strategies that serve consumers eager to spend more while the losers will aim ineffective strategies at cash-strapped buyers.

Investors reward companies that exceed expectations. Two retail winners reported better than expected sales and profits, and raised their guidance.

Each of them share common traits: They target consumers who are eager to spend and they compete for market share through effective strategies featuring great products and tightly managed operations.

Here are two retail winners with a discussion of their stock prices, results, and growth strategies.

Mall retailer A&F enjoyed a 30% surge in its stock price on May 24 after reporting a surprise profit, raising its guidance, and beating Wall Street's sales and profit estimates, noted CNBC.

A&F benefited from strong demand from wealthier millennial shoppers buying return-to-office clothes from its namesake brand. As CEO Fran Horowitz told Yahoo Finance Live, "We really changed the brand from what people used to reference as a T-shirt and jeans brand to a lifestyle brand." She said growth is increasing because consumers are buying more product categories from A&F.

While Hollister — A&F's more economically sensitive product line — did not do as well, it exceeded analyst expectations. Moreover, A&F boosted its profit margin by better matching inventory to demand. This helped lower A&F's product and freight costs, and enhance its margins.

Analyst Neil Saunders said A&F management has improved the company's merchandise selection. He cited the company's "elevated casual offer," "range of relaxed styles for men and women," and "great strides in apparel growth areas such as activewear."

For fiscal 2023, A&F raised its guidance for sales growth and operating margin. Specifically, it now expects "net sales to grow between 2% and 4%, compared with a previous range of 1% to 3% [with] operating margin to be in the range of 5% to 6%, compared with its previous outlook of 4% to 5%," CNBC reported.

The sporting goods retailer reported better than expected sales and profits on May 23 — sending its shares up slightly. CEO Lauren Hobart said "its core customer base of athletes purchased more, purchased more frequently and spent more each trip," according to MarketWatch.

Dick's competitive strategy contributes to its superior performance. The company's strong vendor relations give it better merchandise. Strong internal operations enable Dick's to earn double-digit profit margins while its weaker rivals are falling short of sales and profit targets as they struggle with higher inventories, D.A. Davidson analysts noted.

Two clothing industry brands blamed cash-strapped consumers for their failure to meet investor expectations.

Analysts at UBS confirmed the problem. They found consumers are deferring clothing purchases more than any other category. Specifically, the apparel purchase deferral rate increased to 42% since the beginning of the cycle, compared with 23% for other discretionary categories, MarketWatch reported.

The specialty apparel retailer reported wider-than-expected losses and cut its guidance in a May 24 report. In a statement, CEO Jane Elfers blamed forces outside the company's control, noting: "Our first quarter results were negatively impacted by the ongoing macro-tension which resulted in outsized pressure on our core customer by limiting their purchasing power."

My guess is that merchandise selection and insufficient control of operations contributed to the disappointing results. Core customers spent less in the first quarter with same store sales down 8.2%. Moreover, higher costs of good sold contributed to a 9.2 percentage point drop in its gross margin, noted TipRanks.

Children's Place blames macroeconomic headwinds for a lower 2023 revenue forecast. After a 10.8% drop last year, the company expects revenue to fall another 12% in the current fiscal year.

Shares of the clothing and accessories retailer fell 20% on May 25 after it reported revenue and earnings per share that met expectations and forecast a drop in second-quarter revenue, according to CNBC.

American Eagle lowered its operating income and full-year revenue guidance. Specifically, the company "anticipates full-year revenue to be flat to down low single-digits, lagging the flat to up single-digits it projected before" while it forecast a 10% drop in operating income — to a midpoint of $260 million — compared to its March 2023 estimate, CNBC reported.

American Eagle has opportunities to improve the appeal of its merchandise to consumers and to boost efficiency. In a news release, CEO Jay Schottenstein said the company should "chase profitable growth" and become more efficient by imposing "inventory discipline" and cutting costs.

I think investors should evaluate their risk and reward preferences before deciding whether to bet on either retailers that are doing well or against retailers that are struggling.

My hunch is the potential for gain is greatest for investors who are willing to take a risky bet that an at-risk retailer will file for bankruptcy.

Investors willing to take this risk could borrow shares in the company, sell them in the open market, and hope the company's stock plunges on the way to bankruptcy. If that happens, they can repay the stock loan by buying back the shares in the open market at pennies per share and pocket the difference.

Retail Dive considered six retailers to be among those with an elevated risk of bankruptcy on March 6, 2023.

They are ranked in descending order of their likelihood of going bankrupt based on their Financial Health Rating, which measures their risk of default by March 2024 — ranging from 0 (highest risk) to 100 (lowest risk).

For each company, I have included its short interest, stock price performance, cash burn and ending cash balance for the most recent period, according to the Wall Street Journal.

While the two winners I mentioned above could keep rising, investors who do not wish to bet on the decline of weak retailers may be better off choosing a sector propelled by a powerful tailwind — such as the adoption of generative AI — rather than in shares of successful retailers fighting strong economic headwinds.