‘Earnings misses are coming,’ retail analyst says

Wells Fargo Senior Retail Analyst Ike Boruchow joins Yahoo Finance Live to discuss retail earnings expectations, rising inventories, consumer spending, inflation, and recessionary risks.

Video transcript

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BRIAN SOZZI: Retail earnings season is set to kick off next week following a grim outlook from companies like Target and Walmart. This as retailers grapple with rising inventory and a pullback in discretionary purchases by shoppers.

Joining us now to discuss is Wells Fargo Senior Retail Analyst Ike Boruchow. Ike, good to see you here this morning. So look, we've gotten a series of warnings from major retailers in recent weeks. Do you think those warnings are a sign of things to come? Or we could actually see some pretty big earnings misses in a couple of weeks?

IKE BORUCHOW: Yeah, I think we've been calling out for a while there's earnings misses coming. And you're already kind of seeing that trend. The amount of negative preannouncements we're seeing so far is not surprising given we know what the backdrop is, but I think you're going to see more and more numbers at risk.

Now, I think what's more important-- because we're talking about the stocks here on top of the businesses-- is how much of this is priced in. And I think heading into this earnings season a couple of weeks ago, we were actually trading below recession trough multiples on a lot of these names, which is why you're seeing earnings cuts actually-- in some cases, actually going up. I mean, look at Bath & Body Works. They issued a 40% earnings miss in Q2. Their stock's up about 20% since then in the last two weeks. So the setup is actually quite interesting.

BRAD SMITH: We were discussing with one of our earlier guests just about the strength of certain companies that we should be paying attention to and where companies, especially within retail, should be focusing on where they can retain margins, to the extent that they may, and market share. How much does that matter in retail right now? And do they actually have pricing power that they can continue to pass through to consumers, especially if consumers start to bucket some of the pricing?

IKE BORUCHOW: I think where there's probably the most risk is in the apparel space, for sure. I mean, that's where we-- based on the work that we've done, store checks, et cetera, we see a lot of inventory out there. You're probably going to see that get hit first and foremost at the retail level, probably in the mall-based apparel guys, so think about Gap and Urban Outfitters, department stores, those types of names.

And those companies also carry not as much pricing power historically as others. The margin structures are very low. So there's a lot of earnings that can get kind of wiped away pretty quickly. Our favorite names in the space would be Bath & Body Works, Tapestry, and Capri, the owners of Coach and Michael Kors and Versace, because they're category leaders.

The margin structures are very high. There is pricing power in those balance sheets and cash flow [INAUDIBLE]. So I think you need to be very selective because with some of those cheap stocks, they might actually not be as cheap as you think when all is said and done.

JULIE HYMAN: Hey, Ike, it's Julie here. Obviously, inventory management is a really important piece of this. Do you think that retail-- you don't cover them where you had Target and then, with a delay, you had Walmart effectively saying the same thing, which is we have too much stuff. Is the rest of the industry on the same page? And are they able to act quickly and decisively enough to try to fix the problem?

IKE BORUCHOW: Yeah, I think that's a great question. I think that a lot of our companies in our space-- what's the right word-- I think they were a little too confident coming into this year. Demand was so strong the past 18 months heading into 2022, supply chain bottlenecks have been a problem, so people started pulling forward inventory. Let's get ahead of the bottlenecks. And unfortunately, that kind of happened right at the wrong time when demand started to slow down, and we started to see the consumer come under a little bit more pressure.

And even though the consumer is healthy, their spending is shifting. We're going away from goods and back to services, to some extent. So I think companies are starting to realize they have a little too much product. We're starting to see more inventory go to the off-price channel. We're starting to see markdowns come back.

I mean, based on some of the reports that we put out, markdowns and promotions are at a 12- to 18-month high again. So we're right back to where we were two years ago. So I think companies have been slow to adapt. And I think that's one of the key reasons we've been calling out a lot of earnings risk on the horizon for the rest of the year.

BRIAN SOZZI: Ike, I've had some folks tell me that Gap is likely to have a very, very bad back-to-school shopping season and holiday shopping season. And they're also coming off a very disappointing second quarter, and they have no permanent CEO. And they also might have to raise some cash. So do you think we're at the point where Gap is going to have all these bad periods, maybe a couple of more bad quarters, this is dollar stock coming out of the holiday season?

IKE BORUCHOW: Look, I think the place you don't want to be is apparel. I certainly think low-end apparel makes it more problematic. And I certainly, certainly think low-end apparel with a lot of management turnover and too much inventory is probably the worst place you could be.

So look, Gap is a very cheap stock. You know, it's actually up since their negative preannouncement. But in terms of a fundamental thesis on the company, high-quality businesses with a lot of earnings support and pricing power trading at all-time low multiples, or close to it, I don't think you need to go into the dumpster to try to find things that are really problematic to try to make a real return. There's plenty of companies out there where you can do that with much better visibility into the management team, strategies, and the earnings power.

BRAD SMITH: Another company that you cover here and track, Lululemon. Particularly as they are looking to spend even more to grow out their shoe and footwear business at a time that we already know that this category is extremely competitive and seeing more entrants, do you expect them to continue to say to their investors, to analysts that we're just going to continue to invest despite what this may actually look like on our margins and on a balance sheet because we know that the opportunity is there in the future? And how would you evaluate that in the near term?

IKE BORUCHOW: You have to give them credit. I mean, they've been great-- great at execution. But at the end of the day, in my space right now, I'm certainly not interested in paying any kind of premium multiple for any business, especially those businesses where sentiment is actually pretty good. There is no-- expectations on Lulu are very-- are healthy. People expect them to continue to execute.

And I think that we need to kind of look at the other side and say, well, what could go wrong here? And what could go wrong? They're going into a lot of new categories. They've got-- in my opinion, they've got too much inventory. They're in a category that not-- not only did apparel overearn for the last two years, but active within apparel overearned.

And now you're seeing active brands across the board start to struggle. Lulu has not. But again, the market is forward-looking here. So I think big picture, a lot of inventory, very competitive space, gross margins have now gone negative for these guys. They actually missed in lower-- lower gross margin last quarter. That just-- that's not risk that I think I need to take right now. I certainly don't need to pay a healthy multiple for that right now.

JULIE HYMAN: "We made too much" section of Lululemon, a.k.a. sale. Good to catch up with you, Ike. Thanks so much. Ike Boruchow, Wells Fargo Senior Retail Analyst. Thanks a lot.

IKE BORUCHOW: Thank you.

JULIE HYMAN: Well, we