Apparel Retail Margin Expectations
Extrapolating Unsustainable Tailwinds Suggests Negative Risk-Reward
The XRT-rampoline
Below is the price chart for the S&P Retail ETF (XRT). The index had gone nowhere from 2013 to early 2020 where it took a nosedive, found a trampoline, and never looked back. Part of this can be explained by the underlying performance of some of its more questionable constituents, like GameStop (retail apes can send the hate mail directly to my analyst, Mark). Part of it can also be explained by turbo-charged consumer spending behaviour courtesy of stimmy checks and cancelled travel plans. Lastly, the shift-to-online narrative has also led investors to believe these margin improvements are permanent. We believe this narrative is mostly just that – a narrative.
Pre-vs-Post Covid Margin Estimates
The following group of mid-cap apparel retailers are getting walloped this morning, prompted me to write a short post. These stocks are well off their respective peaks but are still trading much higher than pre-Covid ranges. Begs the question – why?
Turns out, analysts expect post-Covid EBITDA and net income margins to be ~45% and ~100% higher, respectively. We feel these margin expectations are far too optimistic.
Unsustainability Explored
Recent margins have been unsustainably high for various reasons such as: a channel shift to online, heightened demand from stimmy checks, pricing power from supply challenges, G&A overhead expense reductions, lower rent payments, etc. We agree with analysts that some of the cost savings for specific companies will be permanent.
The immediate, and obvious, conclusion is to model higher margins. But sustainable margin profiles across an entire industry are not driven by company-specific factors. There may be winners and losers within that space. There may be short-term gyrations around that long-term average. But collectively, margins are driven by the strength of the economic moat for that industry. As such, apparel retail margins will likely revert to the mean.
Simply put, the pandemic did not erect new barriers to entry. It didn’t magically make cotton t-shirts a differentiated product. Can these brands collectively drive more pricing power? Probably not.
We understand channel mix shift to online and G&A optimization can drive margin improvement when you evaluate each company in isolation. But what happens when all competitors in a competitive industry benefit the same way to a similar degree? That advantage will get competed away. That’s how competition and competitive dynamics work.
We don’t believe the pandemic has caused any radical structural changes that will drive forward ROIs in apparel retail higher. Our base case is that stimmy check tailwinds will dissipate and cost saving advantages will get competed away as things normalize. Our expectation is long-term margin profiles for the industry as a whole will look more like 2016-19 than 2020-21.
Negative Risk-Reward
Unprecedented revenue and margin tailwinds have caused analysts to extrapolate positive fundamental momentum indefinitely. We think this degree of optimism is premature. Apparel retailers will once again have to compete for market share in a low-growth competitive landscape with very little product differentiation. This will ultimately drive margins and ROIs back down to long-term historical averages.
Will there be individual winners and losers in the space? Of course. Will more companies fall short of expectations than those that exceed them? Highly likely, meaning the margin for error for stock-pickers is slim.
These businesses appear cheap on an absolute basis but are close to peak valuation multiples relative to where they have traded in the past. Peak multiples based on peak revenues and peak operating margins suggests a negatively skewed risk-reward.
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