By Ward Davis
Winter storms have caused quite a bit of havoc this year. Most of the country has already received more snow than for an average winter, and another whopper storm is forecast to sweep across the country this week! Snow blowers are completely sold out throughout the Midwest and the Northeast. Parking on city streets is nearly impossible, but the sharp drop in parking ticket revenue may bankrupt NYC and Chicago!
City and states, already facing major deficits, have burned through their total snow removal budgets. Retailers, restaurants, airlines and hotels have all experienced significant reductions to revenue on account of the numerous storms this season. Weather-related shortfalls may have something to do with the notable underperformance of consumer stocks so far this year. The XRT, the most closely watched consumer discretionary ETF, was down 4.3% for January (through last Friday) as compared the S&P 500 Index, which was actually up 1.5% for the month over the same period.
The snow and ice aren’t the only things causing investor angst towards consumer stocks. The commodity
cost storm is equally as severe. Several companies have lowered 2011 guidance due, at least in part, to
rising commodity costs. This list includes Proctor & Gamble, Clorox, Hanes Brands and Starbucks. As
discussed in our prior letters, we expect severe gross margin pressure throughout the consumer sector in
2011 due to surging cotton, food staples, packaging material, Asian sourcing and transportation costs.
More recently, the price of crude oil has surged to over $100 a barrel, with the Egypt crises being the latest
blow, offsetting relatively high oil production forecasts. The result has been a 37% spike in the price of
wholesale gasoline since late November 2010. The national average retail price of gasoline is now above
$3.00 for the first time since October 2008.
Gasoline inflation has a double whammy effect on consumer companies. Not only does it pressure
transportation costs upward, but, more importantly, it serves a tax on the consumer, particularly at the low
end. With many companies looking to raise prices early this year to offset gross margin pressure, higher
gasoline prices pose severe challenges. Most of the food and apparel companies we monitor have
discussed raising wholesale prices on their goods by 5-10% to offset commodity inflation. Levi Strauss
recently raised the wholesale price on its 501 jean from approximately $18 to $20. This 10%+ increase
still won’t be enough to offset the near doubling of cotton prices year-over-year. Margin pressure will be
severe for most apparel manufacturers even if proposed price increases stick. To match the wholesale price
increase Levi’s retail partners raised their price from $29.99 to $32.99. Prior to the change, retailers were
making a gross profit of $11.99 per pair, or a 40% pure gross margin. Post the price increase, retailers are
poised to make $12.99 per pair, or a gross margin of 39.40%. If pairs sold stay constant to last year a
retailer theoretically would be poised to make 8% more gross profit dollars. The problem is that the retail
price of 501 jeans has declined in real terms over the past 20 years. How will consumers respond to a
never before seen price increase, especially when gasoline used to get to the store cost 40% more than it
did a year ago? Almost certainly there will be a drag on pairs sold, which, in turn, will compel retailers to
reject at least some portion of the price increase. If the negative volume impact approaches 8% severe
earnings problems throughout the entire supply chain will ensue.
This Wednesday, February 2nd more people than usual will be tuned in to see the famous groundhog,
Punxsutawney Phil, emerge from his burrow. According to folklore, if Phil sees his shadow and quickly
retreats back to the burrow, we will experience another six weeks of harsh winter weather. If Phil doesn’t
see his shadow it is believed the winter’s end is imminent. The good news is that the weather forecast for
Groundhog Day calls for severe clouds across central Pennsylvania. The bad news is that the cloudy skies
are part of a winter blizzard due to hit that day. Like most shoppers this winter, Phil might just stay at
home in his burrow and leave us all (including retailers, restaurateurs and producers) guessing how long
this winter of storms will last.
Ward Davis is founder and portfolio manager of Caerus Global Investors, a $210 million global long/short equity hedge fund in New York. This column was adapted from a recent letter to his investors.