Analyzing Companies with the Five C's Framework

As economic pressures continue to drive consumption in the U.S., how will the health of the economy influence the soft lines industry? Head of Retail and Consumer Credit for Fixed Income Research Jenna Giannelli and U.S. Soft Lines Retail Equity Analyst Alex Straton discuss

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Jenna Giannelli: Welcome to Thoughts on the Market. I'm Jenna Giannelli, Head of Retail and Consumer Credit within Morgan Stanley's Fixed Income Research. 

Alex Straton: And I'm Alex Straton, Morgan Stanley's U.S. Soft Lines Retail Equity Analyst. 

Jenna Giannelli: And on this special episode of Thoughts on the Market we'll discuss soft lines from two different but complementary perspectives, equity and corporate credit. It's Tuesday, January 24th at 10 a.m. in New York. 

Jenna Giannelli: Our economists here at Morgan Stanley believe that tighter monetary policy and a slowing labor market will be the key drivers of consumption in the U.S. this year. Against this still uncertain backdrop where we're cautious on the health of the U.S. consumer, we're at an interesting moment to think about the soft lines industry. So let's start with the equity side. Alex, you recently said that you see 2023 as a 'tale of two halves' when it comes to soft lines. What do you mean by that and when do you see the inflection point? 

Alex Straton: So, Jenna, that's right, we are describing 2023 as a 'tale of two halves'. That's certainly one of the taglines we're using, the other being 'things are going to go down before they go up'. So let's start with a 'tale of two halves'. I say that because in the first half what retailers are facing are harder compares from a PNL perspective, an ongoing excess inventory overhang and likely recessionary conditions from a macro perspective. On top of that, what we've got is 2023 street EPS estimates sitting about 15% too high across our coverage. As we know, earnings revisions are the number one driver of stock prices in our space. So if we have negative revisions ahead, it's likely that we're also going to have our stocks move downwards, hence the bottom I'm calling for some time here in the first quarter, while that may seem like a pretty negative view to start the year, the story is actually very different when we move to the back half of the year. Hence, the 'tale of two halves' narrative and the 'down before up'. So what do I mean by that? In the back half, really, what we're facing is retailers with easier top line compares and returns that should enjoy year over year margin relief. That's on freight, cotton, promotions, there's a number of others there. On top of that, what we've got is inventory that should be mostly normalized. And then finally a recovering macro, I think with this improving backdrop and the fact that our stocks are the quintessential early cycle outperformers, they could quickly pivot off these bottoms and see some nice gains. 

Jenna Giannelli: Okay, Alex, that all makes a lot of sense. So what are the key factors that you're watching for to know when we've hit that bottom? 

Alex Straton: So on our end, it's really a few things. I think first it's where 2023 guidance comes in across our space. And, I think secondly, its inventory levels. Cleaner levels are essential for us to have a view on how long this margin risk we've seen in the back half of 2022 could potentially linger into this year. And then really finally, it's a few macro data points that will confirm that, you know, a recession is here, an early cycle is on the horizon. 

Jenna Giannelli: I mean, look, you touched on a bit just on inventory, but last year there was a lot of discussion around the inventory problem, right, which was seen as a key risk to earnings with oversupply, lagging demand weighing on margins. Where are we, in your view, on this issue now? And specifically, what is your outlook on inventory for the rest of the year? 

Alex Straton: So look, retailers and department stores, they made really nice progress in the third quarter. They worked levels down by about a little over ten points. But then from the preannouncements we had at ICR and using our work around our expectations for inventory normalization, it really seems like retailers might be able to bring that down by another ten points in the fourth quarter. But even though, you know, this rate of trend and clean up is good and people are getting a little bullish on that, I wouldn't say we're clean by any means. Inventory  to forward sales spreads are still nearly just as wide as they were at the peak of last year. And to give people a perspective there, what a retailer wants to be to assume that inventory levels are clean is that the inventory growth should be in line with forward sales growth. But I think looking ahead, you know, department stores could be in good shape as soon as this upcoming quarter, that's a fourth quarter, so really remarkable there. It'll then probably be followed by the specialty retailers in the first quarter. And then finally it'll be most of the brands in the second quarter or later. The one exception though, is the off price. And these businesses have suffered from arguably the opposite problem in the last couple of years, which is no inventory because of all the supply chain problems and the fact that it's just become this year when inventory’s been realized as a problem. So let me turn it over to you, Jenna, and shift our focus to high yield retail. The high yield retail market is often fertile ground for finding equity-like returns, and you believe there are a number of investment opportunities today. So tell me, what's your view on the high yield retail sector and what are the key factors that are informing that view? 

Jenna Giannelli: So, look, we have a very nuanced and very bottoms up company specific approach to the sector, we're looking at cash flow, we're looking at liquidity, we're looking at balance sheets and all in all in the whole for 23 things look okay. And so that's our starting point. So going into 2023, we're taking a slightly more constructive approach that there are some companies in certain categories, in certain channels up in quality that actually could provide nice returns for investors. So from a valuation standpoint, you know, look, I think that the primary drivers of what frame our view are very similar to yours, Alex. It really comes down to fundamentals and valuation. From the valuations and retail credit, levels are attractive versus historical standpoints. So to give some context, the high yield market was down 11% last year, high yield retail was down 21%. And this significant underperformance is still despite the fact that the overall balance sheet health of the average credit quality right now in this sector is better than in the five years leading up to COVID. So essentially, simply put, it means you're getting paid more to invest in this sector than you would have historically, despite balance sheets being in a generally better place. You know, from a fundamental standpoint, we fully incorporate caution on the consumer in 2023. We do take a slightly more constructive view on the higher end consumer. Taking that all together, you know, valuation’s more attractive, earnings outlook is actually neutral when we look at the full 2023 with pressure in the first half and expected improvement in the second half. 

Alex Straton: All right, Jenna, that's a helpful backdrop for how you're thinking about the year. I think maybe taking a step back, can you walk us through what the framework is that you use as you assess these companies more broadly? 

Jenna Giannelli: Sure. So we use a framework that we've dubbed our five C's, and this is really our assessment of the five key factors that allow us to rank order our preference from, you know, favorite to least favorite of all the companies in our coverage universe. So when we think about it, what are those five C's? What are these most important factors? They're content, they're category, channel, catalysts, and compensation. You know, in the case of content, this is probably the most intangible, but we're looking at brand value, brand trajectory and how that company's product really speaks to the consumer. Oftentimes when I talk to investors we're discussing: does it have an identity, what is the company and who do they and what do they represent? In the category bucket we're assessing whether the business is in a category that's growing or outperforming, like beauty is one that we've been very constructive on, or if it's heavily concentrated in mid-tier apparel, which has been, you know, underperforming. In the case of channel, look, we like diversification. That's the primary driver. So those that offer their products everywhere, similar to what the consumer would want. When we're thinking about catalysts for a company, as this is very important on the kind of the shorter term horizon, what are the events that are pending, whether with, you know, company management acquisition or restructuring related. And then of course, finally on compensation, this may be the more obvious, but are we getting paid appropriately versus the peer set? And in the context of the, you know, the risk of the company? And if you don't rank highly, at least in most or all of those boxes, we're probably not going to have a favorable outlook on the company. 

Alex Straton: Now, maybe using these five C's and applying them across your space, what are the biggest opportunities that you're seeing? 

Jenna Giannelli: So we definitely are more constructive on the categories, like a beauty or in casual footwear, right? Companies that fall in that arena. Or again, that have exposure to more luxury, luxury as a category. Look, there's been a lot of debate around the high end consumer and whether we're going to see, ya know, start to see softening there. Within our recommendations, we are less constructive on those names that are heavily apparel focused. Activewear is actually a negative, because we're lapping such really significant comps versus, you know, strength in COVID. And so there's still some pressure of lapping that strength. I think long term, the category still has some really nice upside and potential, but short term, we're still seeing that, you know, that pressure from the reopening and return to occasions and work and social events that keep the demand for that category a little bit lower. There are also companies that might have exposure to occasion based apparel. So that is where we would be more constructive. It's a little bit more nuanced, I'd say, than just general apparel, but where we're most negative, it's sort of in that mid-tier women's apparel where brands are particularly struggling. 

Alex Straton: Well, Jenna, I feel like I learned quite a bit and so thanks for taking the time to talk with me. 

Jenna Giannelli: Thank you, Alex. Great speaking with you. 

Alex Straton: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people to find the show.