Optimism Improves Ahead of Q3 Retail Earnings

Just about everything seems lined up for large U.S. retailers to report solid third-quarter earnings, including energetic consumer spending, a brief late summer drop in borrowing costs, and improved U.S. confidence and sentiment readings. Even so, certain retailers could benefit more than others, with home improvement stores likely to continue feeling pressure from the slow housing market.

Retailers with the biggest e-commerce platforms likely have an advantage.

"E-commerce continues to outpace brick-and-mortar companies in terms of U.S. growth, primarily driven by online marketplaces like Amazon, Walmart, and Target," said Alex Coffey, senior trading strategist at Schwab. "Amazon can essentially leverage 200 million or more Prime members, accounting for around 30% of U.S. e-commerce sales. If that's growing fastest, it's a pretty good barometer of the consumer and retail economy."

Walmart (WMT), he added, has an e-commerce platform around 20% the size of Amazon (AMZN), meaning it alone can account for 5% to 6% of U.S. e-commerce sales. And Target's (TGT) recent partnership with Shopify (SHOP) gives it new momentum in digital shopping.

The bulk of retail sector earnings hit the aisles later this month, but a sneak preview came October 31 when Amazon reported better-than-expected third-quarter earnings. While Amazon is better known on Wall Street for its profitable cloud computing business, millions of customers think of it mainly as an online shopping destination.

The retail earnings season follows a September U.S. retail sales report that outpaced analysts' expectations with a 0.5% monthly increase for items excluding automobiles. Borrowing costs fell that month, which could factor into retail results as shoppers might have felt a bit more padding in their pocketbooks.

Mortgage rates also fell in September before jumping in October, perhaps a temporary boost for home renovation retail firms like Lowe's (LOW) and Home Depot (HD). Also, the most recent consumer confidence report from the Conference Board and consumer sentiment reading from the University of Michigan exceeded expectations.

On the downside, retail companies have spent much of this year practicing price restraint after years of inflation. Margins have been rising, but it's unclear how long that can last. When companies lose pricing power, it can hurt their margins. Amazon's retail business rebounded in the third quarter from a slight disappointment the quarter before, with annual growth of 9% in North America and 12% internationally. The prior quarter, North American revenue growth fell short of the company's internal estimates, in part due to consumers practicing caution. Free same-day delivery growth of 25% from a year earlier helped drive retail demand in the third quarter, while operating margins rose thanks in part to inventory improvement. Better robotics and automation also helped retail at Amazon, executives said. till, the company's retail customers haven't necessarily changed their cautious tune that had them focused earlier this year on lower-priced products from the giant firm.

Customers are "looking for deals and are price conscious," said Andrew Jassy, Amazon's CEO, in the company's October 31 earnings conference call.

Overall S&P 500 third-quarter consumer discretionary earnings are expected to rise just 1.7% year over year, according to consensus from FactSet in late October. The sector includes retailers like Amazon, Target, and Walmart but also airlines and automakers. Revenue growth, seen at 4.8%, according to FactSet, looks better, but relatively weak earnings growth combined with relatively strong revenue growth suggests margin compression.

Analysts see third-quarter margins in consumer discretionary at 9.3%, with 76% of consumer discretionary firms likely delivering margin decreases in the third quarter versus a year earlier, FactSet said. That's the highest percentage of declining margins expected for any sector in the third quarter.

That could improve in the current fourth quarter, with consumer discretionary earnings expected to rise 11.8% from a year ago, followed by an estimated 11.5% earnings growth next year, according to FactSet.

Expectations of weak third-quarter earnings per share (EPS) growth didn't appear to hurt shares of consumer discretionary firms, with the Consumer Discretionary Select Sector Index ($IXYTR) up 10% over the last three months as of late October, outpacing the 7% growth of the S&P 500^® index (SPX) over that span.

Even with EPS estimates on the low side, the consumer discretionary sector got some friendly news the last few weeks from companies reporting before the retail earnings season began in earnest. Nike (NKE), Hasbro (HAS), Deckers Outdoor Corporation (DECK), General Motors (GM), Tesla (TSLA), and Domino's Pizza (DPZ) all reported better-than-expected earnings.

"Deckers showed monstrous growth with its Hoka shoe brand," Coffey said, noting the nearly 35% quarterly increase in Hoka net sales last quarter.

Though that's a sole example, it does help investors understand how retail works. General trends may play less of a role for individual company results based on how specific products perform.

"In this space more than any other, when your product is popular and gets a lot of growth, you see the stock awarded," Coffey said. "If your marketplace is tough, like Nike, it can last a long time." That said, Nike, which has struggled in a slumping Chinese economy, showed signs of life in its most recent quarterly report. 

Recent strength from Nike, Hasbro, and Deckers might suggest strong consumer demand for toys, apparel, and athletic equipment. Those types of products come back into focus when the big boxes report later in November. However, global online marketplace Etsy's (ETSY) recent earnings were a bit of a mixed bag as general merchandise sales fell 4.1% year over year.

Back in the second quarter, there was a sharp gap between general merchandise outlets like Target, Best Buy (BBY), and Walmart and home-renovation-oriented Lowe's and Home Depot. Each of the latter disappointed investors with their outlooks for the rest of the year for weak home improvement spending. The pandemic pushed many projects forward, meaning less demand now for renovations. Higher costs are another factor dragging on home project demand.

Target also presented a cautious outlook last time out, but Walmart and Best Buy impressed analysts with their forecasts last quarter, which seems in sync with stronger retail sales since then and improving consumer confidence. The labor market also appears solid, with jobless claims remaining low and job growth surging in September, all of which could support consumer demand.

That said, all these firms face potential margin pressure, as they've lost some of their previous ability to raise prices. Target lowered price tags on thousands of items earlier this year, and Walmart emphasized recent price cuts in its August earnings call, saying it has rolled back more than 7,200 prices across categories.

The U.S. economy grew 2.8% on a seasonally adjusted annual basis in the third quarter, down from 3% in the second quarter, according to the government's latest estimate. That's historically solid, especially considering personal spending rose a massive 3.7%. The U.S. employment picture is less robust than a year ago in terms of jobs growth and unemployment, but neither shows signs of a recession. All this could be good news for a company like Target with its strategy of catering to more affluent customers.

On the other hand, ever since COVID-19, many in the United States feel like they're struggling regardless of what recent positive consumer confidence data may indicate. How all this plays out in the long run has implications for two of the biggest brick-and-mortar companies.

"Walmart and have diverged the last few years due to product mix," Coffey said. "Walmart is more staple-driven, with a big grocery department. If the consumer is more stretched, it will probably impact Target more because their products are higher priced and more discretionary. These big names need to balance costs with the amount they're charging—it's the margin story. The last few quarters have been about margin expansion, as costs are starting to alleviate but prices didn't go down. Margin could be a tailwind this quarter for retail."

Amazon and other U.S. internet retailers also face increasing competition online from Chinese discounters. A report earlier this year from trade publication The Information said Amazon plans to open a special section on its shopping site featuring cheap items that ship directly to overseas customers from warehouses in China. In a statement, Amazon said, "We are always exploring new ways to work with our selling partners delight our customers with more selection, lower prices, and greater convenience," CNBC reported.

Guidance is particularly important this quarter as retailers approach the holiday season, typically their busiest time of year. Increasingly, the holiday season no longer includes purchases just for Thanksgiving and Christmas but also for the football tailgating season and Halloween, The New York Times reported. Etsy guided for a low single-digit decline in current quarter gross merchandise sales, but Amazon's guidance for fourth-quarter net sales of $181.5 billion to $188.5 billion compared favorably with Wall Street's consensus of $186.36 billion. Amazon shares rose after it reported.

Another way to get a sneak preview of retail earnings season is to peek at credit card providers' earnings. Both Visa (V) and Mastercard (MA) surpassed analysts' third-quarter projections, and because most retail transactions take place electronically, that could be a good sign for the big boxes reporting in coming weeks. For the major retail firms reporting over the next two weeks, analysts expect the following, according to Yahoo Finance:

• WMT EPS of $0.53, up 12.7% from a year ago, on revenue of $167.58 billion
• TGT EPS of $2.30, up 9.5% from a year ago, on revenue of $25.95 billion
• Home Depot EPS of $3.64, down 4.4% from a year ago, on revenue of $39.12 billion