Barclays on Broadline/Hardline Retail: 'It's About To Get A Lot Harder'

Margin expansion appears unlikely for many retailers, Barclays said while initiating coverage of U.S. Retail Broadlines/Hardlines sector with a Negative industry view. "Over the last several years, there has been meaningful improvement in underlying operating margins for many retailers, particularly within the home improvement and auto retailing segments. However, we note that there has also been operating margin deterioration at specific types of retailers such as home furnishing and broadline retailers," analyst Matthew McClintock wrote in a note to clients. "We believe that retailers benefitted from many tailwinds over this time period, including improvements to labor staffing systems and processes, lower gas prices, improved credit card profit sharing streams, and underlying leverage from a largely beneficial sales environment. Going forward, we expect many of these tailwinds to dissipate." Barclays assumed coverage of Wal-Mart Stores, Inc.

and Costco Wholesale Corporation

at an Equal Weight rating, but downgraded Target Corporation

to Underweight from Overweight. McClintock continued: "In our view, companies are up against two inevitable situations: 1) there will be another economic downturn at some point; and 2) the retail industry is still in early stages of the biggest disruption in 30+ years (i.e. digital). All companies will likely impact by the former but only best-in-breed companies tend to survive the latter." Within U.S. Retail Broadlines/Hardlines, the analyst is biased towards companies with strong/stable management teams, execution, and shareholder returns. He favors the Auto Part and Home Improvement sectors and is cautious on the Big Box and Home Furnishings sectors. Following are the brief views of Barclays on various stocks in the U.S. Retail Broadlines/Hardlines sector: O'Reilly Automotive Inc

(Overweight, $300 PT): Already was best positioned to take market share given best-in-breed supply chain but now is over earning even that at the expense of Advance Auto Parts disruption. Substantial room to lever up to accelerate repurchases. Home Depot Inc

(Overweight, $150 PT): Dominates Pro business as the consumer base that has discretionary income age and shift more towards do-it-for-me (DIFM) spend. Gross margin upside to materialize from Project Sync investments. Best Buy Co Inc

(Overweight, $45PT): Barclays value pick Consumer electronics industry challenging but company now stabilized, margin opportunities remain, and shareholder returns accelerating. Tractor Supply Company

(Overweight, $100PT): Rare high-growth company in retail with a defensible business model and proven track record. AutoZone, Inc.

(Overweight, $870PT): Highly shareholder friendly company that should continue to outperform in an attractive industry. Costco (Equal Weight, $180PT): Though bullish on the potential benefit from the new credit card arrangement with Visa, the recent announcement regarding higher starting wages for employees has made the brokerage temper expectations. Walmart (Equal Weight, $70PT): Walmart is in the midst of a major restructuring and as a result Barclays do not expect meaningful growth in the near term. Walmart's sales will decline slightly over the next few years, reaching $468.04 billion in 2020. Target (Underweight, $70PT): Highest exposure to sales shifting out of general merchandise industry (smallest food mix) and cuts in investment spending (capex, advertising) are major disconnects with company's recently raised long-term 3.0% comp goal. Advance Auto Parts, Inc.

(Underweight, $130 PT): Constructive on turnaround, but years of underinvestment (and no leadership) point to longer than expected timeline. Williams-Sonoma, Inc.

(Underweight, $45PT): Already on path to losing growth company status (given mature store concepts ex. West Elm) before investors consider late cycle risk. Lowe's Companies, Inc.

(Equal Weight, $85PT): Optimistic about the upcoming margin benefit from delivery cost improvements, yet cautious on flow through given a recent history of falling slightly short of margin goals. Bullish on the company's opportunity in Canada but question if the business is large enough to significantly move the overall needle. Party City Holdco Inc

(Equal Weight, $16PT) Like the company's overall category dominance and focus on vertical integration. Yet the risk from high levels of debt leverage combined with muted comp store sales makes it stay on the sidelines for the time being.