Why Morgan Stanley Is Downgrading Pier 1

In a report published Wednesday, Morgan Stanley analysts downgraded

from Equal-weight to Underweight and reduced the price target from $13 to $11. The analysts don't foresee a positive profit inflection in the near future. PIR is trading off retail sales, which generate higher margins, with low-margin e-commerce sales. In the report Morgan Stanley noted, "Though product margins are similar in both channels, e-commerce gross margins continue to be heavily impacted by fulfillment & distribution costs, which we estimate to be $45-$50 on an average order of $160. We expect PIR to realize efficiency gains in fulfillment and lever fixed costs as it rapidly grows e-commerce sales next year, but retail losses should outweigh e-commerce gains, in our view." The analysts expect the retail business to de-lever significantly with some decline in sales. Before FY14, the company's comps were at 8 percent -11 percent against the industry average of approximately 4 percent growth. The growing e-commerce sales are expected to take away a large chunk of retail sales. "With fixed costs, including $300M of rent (~18% of retail sales) and store payroll to support omni-channel efforts, store-level EBIT margins may contract ~200 bps in each of the next two years, absent store closures and/or expense reduction," the analysts added. While Pier 1 hopes to save on fixed costs by closing brick and mortar stores, the analysts believe that the savings generated through store closures will not make any meaningful impact in the near term. Although Pier 1's stock is trading at low multiples, the analysts expressed their concerns related to the "still-in-flux channel profitability issues" being faced by the company. "There is also a near-term risk of markdowns of excess inventory to clear through merchandise brought in as part of PIR's mid-teens top-line growth plan," the report added.