Best Buy, Home Decor, Home Depot, and Lowes heavily exposed to rising transport costs
Autozone, O’Reilly Automotive, Costco, and Walmart have little exposure
In a February 2018 research report titled “Freight-ening Headwinds,” a team of seven Morgan Stanley equity analysts led by Simeon Gutman found that rapidly rising freight costs will pressure retailer/manufacturer margins in 2018. Morgan Stanley expects hardline retail and food producers to be most at risk, where they see 25/45 bps of margin risk in the base case and 45/70 bps in the bear case.
Assuming a 70:30 contract:spot mix in trucking, Morgan Stanley’s Freight Transportation team believes that freight cost inflation will reach anywhere from 15-25% year over year in 2018. Transportation industry observers are well aware of the two factors Morgan Stanley identified as driving this cost inflation: the ELD mandate and the general shortage of professional truck drivers. FreightWaves reported on the retail apocalypse and its impact on freight movements earlier this year.
Morgan Stanley’s analysts devised a framework to determine which companies are most and least exposed to rising transport costs. Determining factors included 1. the mix of in-house vs. outsourced transportation operations, 2. size/leverage with freight vendors, including proportion of multi-year contracts, and 3. the weight and size of the transported merchandise itself. Morgan Stanley believes that the companies most exposed to rising transportation costs are those that outsource all of their logistics, have less than $3B in cost of goods sold (COGS), and earn a gross margin below 40%. The investment bank believes that large retailers with scale, leverage over suppliers, and some insourced logistics should pull away from their smaller competitors. In general, hardline retailers selling incompressible, bulky items face more downside risk than specialty apparel retailers, for instance.
The analysts lowered their 2018 earnings-per-share (EPS) estimates for 7 hardline retailers by an average of ~4.5%: GNC, Vitamin Shoppe, Inc., Michaels, Williams-Sonoma, At Home, Lumber Liquidators, and Ulta Beauty. Home improvement, electronics, and furnishings are the retail categories most at risk, according to Morgan Stanley.
Morgan Stanley’s bull, base, and bear case outcomes (from a shipper perspective) are a 5%, 15%, and 25% increase in transportation costs (calculated at a 70:30 contract:spot mix). If the base case holds and transport costs increase by 15% in 2018, Morgan Stanley calls for a -17.6% headwind against Vitamin Shoppe, Inc.’s EPS and a -9.9% headwind against Lumber Liquidator’s EPS. Both of those companies outsource 100% of their transportation to third party providers.
There are other dimensions that affect a shipper’s exposure to transport costs. The value of a company’s merchandise—specifically the gross margins it generates—when combined with the ease of moving it, also give insight into how vulnerable companies are to rising freight prices. Companies with lower gross margins and heavier, bulkier merchandise will experience out-sized impacts from high trucking costs: Best Buy (BBY) rates the lowest on these two metrics, with gross margins under 25% and a Morgan Stanley-assigned ease of shipping score of 2/10. Home Decor, Home Depot, and Lowes occupy the same region on the graph.
Of Best Buy, Home Decor, Home Depot, and Lowes, Lowes and Home Depot have failed to recover any of the ground lost during last month’s correction. Lowes (LOW) stock is still down 18.7% from its high at $107.40 on January 26. Home Depot has fallen 12.1% from its Jan. 26 high at $207.23 to $182.16 on Friday, March 9; Best Buy dropped to as low as $68.02 from its January 26 high at $77.84, but has since recovered to $73.81. Best Buy, Lowes, Home Depot, and Home Decor all outsource 100% of their transportation needs.
Hardline retailers with less exposure to the spot market include companies like Autozone (10% outsourced), Costco (10% outsourced), O’Reilly Automotive (20% outsourced), and Walmart (30% outsourced).
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