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  • Walmarts shrinking operating margin is an industry-wide problem.
  • Snap's deteriorating business could mean all of technology is in trouble.
  • Stay focused on the business cycle and your investment plan.

Last week, carnage swept through retail as a one-two punch of disappointing quarterly results were released in back-to-back days by Walmart  (WMT)  and Target  (TGT) . Today, social media niche player Snap Inc.  (SNAP) , unleashed another wave of selling in technology stocks when it warned of rapidly deteriorating conditions in the ad market. 

Since those reports, Walmart is down 16%, Target's down 32%, Snap is down 41%, and the S&P 500 is flirting with a new 52-week closing low.

What are these companies saying that makes investors so nervous about stocks?

Let's focus on Walmart and Snap, beginning with Walmart, the largest retailer in America. In its earnings conference call last week, management detailed three reasons why its operating profit and earnings fell shy of expectations at Walmart and Sam's Club stores.

No. 1: Wage expenses.

Like Target and everyone else, the company hired like mad last year to make sure products were on shelves and registers were open. That hiring was smart because nobody knew if COVID mutations would cause employees to miss more work. However, it's proven to be a double-edged sword. Workers have bounced back faster than anticipated, resulting in overstaffing and surging wage expenses, particularly given increasing pay.

Here's what Walmart said:

“The first item is wage expense. That issue was resolved during the quarter, primarily through attrition.”

Attrition is code for "people quit because we stopped scheduling them."

Those 'attrition-ed' likely found other jobs quickly last quarter. However, it could be a different story in the coming months because all retailers are probably experiencing the same overstaffing problem. 

As a result, it wouldn't surprise me if widespread headcount rationalization starts resulting in unemployment claims. That's bad for the economy, and thus, sales and profit growth for most companies.

Secondly, Walmart blamed the product mix for its earnings woes.

Specifically, it explained that consumers were dedicating more money to necessities like food, which offer low margins, and less money to discretionary, high-margin items, like clothing.

Back to Walmart:

“The second item relates to our general merchandise inventory level, [general merchandise] was a lower percentage of total sales in Q1 resulting in an unfavorable gross margin mix. …the rate of inflation in food pulled more dollars away from [general merchandise] than we expected, as customers needed to pay for the inflation in food.”

The shift to staples is because wages, which outpaced inflation exiting 2020, have now trailed inflation for over a year.

CHART-Street-Smarts_2_0524

Since wages aren't keeping up with rising costs, and inflation remains north of 8%, it's unlikely the situation is improving for consumers. Anecdotally, it cost $1,000 to fill my heating oil tank last month, nearly double last year. That bill alone takes a big bite out of discretionary cash for the average Jane. Similarly, gas prices have re-accelerated, further straining wallets.

CHART-Street-Smarts-0524

Rising costs for necessities make it unlikely that Walmart is selling a lot more general merchandise this quarter than it did last quarter, despite the spin they attempted in the conference call regarding inventory levels:

“We like the fact that our inventory is up because so much of it is needed to be in stock on our side counters but a 32% increase is higher than we want. We'll work through most or all of the excess inventory over the next couple of quarters…We started being aggressive with rollbacks in apparel for example, during Q1”

Working through excess inventory means more margin-unfriendly markdowns, and I doubt they like doing that. How much will they need to discount goods to move them out the door? It could be more than they're planning. I suspect that's not a problem limited to Walmart or Target.

No. 3: Transportation expenses

Walmart also struggled because of increased transportation costs, including shipping containers, trucking, and fuel.

Spot transportation rates are finally below contract rates, so contract rates should improve, but that could take time. In addition, bloated inventory probably means there's less need for shipping overall, which should lower expenses this quarter (bad news for shippers, though!).

Nevertheless, Walmart hinted Q2 could still be rough, "we've taken and are taking steps to contain those cost pressures to the first half of this year [emphasis added]."

The real issue is Walmart, arguably the best operator with the most scale and resources available, can't entirely pass higher costs on to tight-fisted consumers. That suggests consumer discretionary as a whole is struggling.

My takeaway? We will see more headcount attrition, and it's likely to spread, further straining consumers. As a result, early-cycle discretionary stocks still aren't the place to be yet.

Cloudy skies in technology

Technology stocks are also early-cycle plays, and they could report disappointing second-quarter results too.

Faced with rapidly growing demand for cloud-based hardware and software solutions and services due to remote work because of COVID lockdowns, hiring surged, and pay went through the roof. Five-and-six figure stock and pay retention bonuses and pay increases have been common. So, if growth wanes, technology companies may discover that SG&A is simply too high.

On Monday, Snap warned its business outlook looks very different than when it reported first-quarter results – checks notes– one month ago.

Specifically, Snapchat wrote:

“Since we issued guidance on April 21, 2022, the macroeconomic environment has deteriorated further and faster than anticipated [emphasis added]. As a result, we believe it is likely that we will report revenue and adjusted EBITDA below the low end of our Q2 2022 guidance range.”

I've followed companies professionally for over 25 years. They don't issue guidance on a whim. Instead, they create a range of expectations and then knock them down so they can over-deliver.

Assuming that's true at Snap (why wouldn't it be?!), then the fact management's saying – only one month later – it will miss the low end of its outlook is bad.

Snap makes its money selling ads. For instance, a beauty company can engage users via a campaign allowing someone to try on makeup in its augmented reality services virtually, or an apparel company could post an ad in a user's feed. 

In Q1, SNAP's revenue grew 38% year-over-year because of higher ad prices and more advertisements. However, it acknowledged business was slowing throughout the first quarter.

It grew about 44% before War in Ukraine; then growth slowed to the mid-30% range before finishing the quarter at about 32%. So, management likely thought it was conservative when it predicted second-quarter sales growth would slip to about 20-25%.

However, now we know it wasn't nearly as conservative as it should have been. Especially given personnel costs were up 52%, and it lost a whopping $360 million last quarter (Note: losses can be OK when business growth is rapid, not so much when growth is decelerating the cost of capital is rising).

The "faster" and "further" deterioration in its business suggests consumers slamming the proverbial brakes are already impacting suppliers, who are, as a result, ratcheting ad spending to stem expenses while reevaluating campaigns and margins.

At a minimum, Snapchat's disclosure increases uncertainty. Investors now have to worry about "who will guide lower next." 

As Real Money Pro's Bob Byrne opined today, "I'm sure plenty of folks will connect the ad market dots and suggest that based on SNAP's expected shortfall, the fair value for Twitter is significantly lower than where it's currently trading."

Ostensibly, SNAP's news isn't just bad for Twitter, though; it's bad for all media relying on advertising and, more broadly, all companies dependent on consumer spending.

At a maximum, SNAP's disclosure suggests that the technology sector may continue to experience devaluation as investors reduce profit assumptions in their models. This is particularly worrisome for unprofitable companies trading at double-digit price to sales ratios, like Snap.

As Real Money's James DePorre wrote this morning, "The Snap report is problematic for the entire market because it is further confirmation that consumers are starting to weaken substantially."

The Smart Play

It's not surprising that early-cycle stocks like discretionary and technology aren't doing well in the late-cycle (perhaps, recessionary-cyle) when inflation squeezes sales and margin and Fed tightening slows GDP. Historically, it's defensive stocks, like healthcare, that outperform.

This too shall pass, though. 

Cycles are cycles for a reason. They don't stay moored in one stage forever. Eventually, the Fed will accomplish its mission, and early-cycle will regain its momentum again. 

One silver lining of the recent disappointing earnings news is that it shows that the Fed's plan is working. Given how hawkish the Fed is and how well forecast its plan is to investors, it's reasonable to assume that the next chess move – whenever it may come – will be for a tilt dovish, not more hawkish.

Of course, that doesn't mean investors won't endure more pain.

Remember, the NASDAQ 100 (QQQ) fell 84% from high to low in 2000-2002, and it fell 54% from peak to trough in 2007/2008. I'm not saying that to scare, but to show that markets can lose more than expected. 

It's also worth remembering that while it felt horrible to own stocks during those bear markets, the QQQ is up 1,340% since its 2002 low and 1,036% since its 2008 low.

For now, the bear market is in control. It won't fall in a straight line, though. Instead, there will be relief rallies, and economic data will cause pops and drops. Being mentally prepared for volatility is key to surviving it. 

If you're a long-term investor, stick to your plan. I suspect things will improve later this year or early in 2023. And if you're a short-term investor, stay focused on the business cycle, hold cash, avoid margin, and concentrate on low-beta value stocks.

  • Walmarts shrinking operating margin is an industry-wide problem.
  • Snap's deteriorating business could mean all of technology is in trouble.
  • Stay focused on the business cycle and your investment plan.
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