Inflation, Supply Chains & a Pandemic — How are Retailers Navigating an Uncertain Environment?

Shopping for last-minute holiday gifts or completing home improvement projects? You may encounter some challenges this year as pandemic-related headwinds persist for many companies. As we analyze retail and consumer discretionary companies, we believe it’s important to evaluate events over the past two years to understand how businesses are navigating the current environment as we look to identify the companies we believe are best positioned for the long term.

The State of Retail Today

COVID-19 not only reshaped our personal lives but also the global economy – how we work, how we spend our free time, how we shop and what we buy. The pandemic forced non-essential retailers to temporarily close and essential retailers to focus on securing staple products to meet consumer needs during lockdowns. Early on, purchasing patterns abruptly changed as consumers adjusted to employment layoffs, significant reduction in consumer mobility and extreme financial market volatility.

In response, governments and central banks across the globe implemented unprecedented levels of support to stimulate economies. In the US, efforts to maintain low interest rates, multiple rounds of stimulus checks, elevated unemployment benefits and other emergency relief actions provided broad-based aid for consumers. These stimulus actions coupled with reduced discretionary spending caused a spike in personal savings rates, which has just recently returned to pre-pandemic levels. Elevated savings for the past 20 months along with low interest rates allowing for rising asset prices, such as housing, has led to much healthier consumer balance sheets. Consumer spending gradually recovered throughout 2020 and has accelerated significantly in 2021 as vaccinations became available and restrictions eased – retail sales in October 2021 were 24% above 2019 levels.¹

The dramatic economic slowdown and subsequent rapid recovery has created a dynamic environment for consumer discretionary companies to navigate. At the onset of the pandemic, many companies cancelled orders to conserve capital amid cratering sales trends and limited visibility into a recovery. Consumer spending has recovered at a blistering pace and travel and entertainment spending continues to be lower than normal, leading to outsized demand for tangible items. However, lingering impacts from the abrupt changes to the global economy have created emerging challenges for companies, including widespread inflationary pressures, supply chain disruptions and labor shortages. Companies are feeling inflation not only in transportation and material costs but also in higher wages, as finding enough labor has been challenging. The recent supply chain disruptions are a result of a multitude of factors – some companies have experienced product manufacturing issues due to COVID-related factory shutdowns or delays in receiving materials, while others are dealing with transportation delays from port logjams and container shortages. Despite the previously mentioned challenges, elevated demand and tighter inventory levels have allowed many retailers and brands to cut back meaningfully on promotions and generate higher profits, putting 2021 on track to be the most favorable retail environment in recent memory.

Short-Term Noise, Long-Term View

As we analyze retail and consumer discretionary companies, we form financial assumptions by analyzing competitive factors, sources of revenue growth, investment opportunities, profitability dynamics, pricing power during inflationary periods and the impact of secular trends. We look to understand the value a company provides to its core customer and the sustainability of its value proposition. For retailers, value can be in the form of low prices, product differentiation, better customer service or greater convenience. For brands, consumers may perceive value due to higher-quality materials, greater brand recognition or its mission and purpose.

Strong consumer demand in recent quarters has pulled forward performance for many businesses with varying degrees of sustainability. The pandemic has allowed some discount-heavy retailers to clean up distribution, but we are not convinced this change is permanent. Others have used excess price increases or cut significant costs out of the business to maximize near-term profitability. As long-term investors, we seek companies making the necessary investments and strategic decisions to improve their long-term competitive positioning rather than squeezing out near-term value, as we know the return of promotional activity and a more normalized spending environment is inevitable. Additionally, we are focused on companies that have used the pandemic to sustainably increase their normalized free cash flow, whether it is due to exposure to more relevant product categories, accelerated e-commerce reach, enhanced supply chain operations or improved relationships with vendors or suppliers.

A few examples of businesses that we believe are making good long-term strategic decisions include Home Depot, TJX Companies and Hanesbrands.

• Home Depot – We believe the company is well positioned to continue gaining share in the home improvement industry due to its premium real estate locations, strong operations, advantaged supply chain and long-term oriented management team. Despite home improvement being a pandemic beneficiary, we have a positive secular view of the home improvement industry and believe Home Depot’s decision to invest heavily in its supply chain, digital presence and professional customer services has only strengthened its leading competitive position.

• TJX Companies – We have a favorable long-term view of TJX’s ability to gain market share through various economic backdrops. Off-price is an established part of the retailing ecosystem and provides branded goods at low prices. TJX’s recent sales growth despite minimal e-commerce exposure has displayed the power of the company’s vendor relationships and nimble merchandising organization. We appreciate management’s long-term focus on driving traffic but also applaud their recent willingness to modestly increase prices without jeopardizing its value proposition to defend profitability amidst cost pressures.

• Hanesbrands – We believe Hanesbrands is making the right strategic decisions to position itself for long-term success. As an apparel manufacturer that primarily sells goods through retailers, its competitive advantage of owning most of its manufacturing has proven valuable during recent supply chain disruptions. We applaud the new management team’s rational decisions to forego near-term earnings upside in favor of increasing marketing behind its brands and to exit non-core operations. If management continues to successfully execute its plan, we believe the market will gain greater appreciation of the future free cash flows Hanesbrands should be able to generate.

Conclusion

Retail and consumer discretionary companies have always been, and will continue to be, highly competitive due to ever-changing consumer behaviors and the proliferation of retail concepts. During unique times like today, we believe companies will be best served by making the appropriate investments and strategic decisions to solidify or even strengthen their competitive positions. Our job as investors is to diligently identify quality businesses trading at a discount to intrinsic value and patiently wait for the market to recognize the value. The bottom-up framework we use at Diamond Hill positions us well to assess transitory factors and understand how they may impact our assumption of normalized fundamentals. With the current environment containing plenty of near-term headwinds and tailwinds to consider, we believe our disciplined philosophy allows us to focus on the key long-term drivers of the business.