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Friday Five: Victors and Values in Retail

Jeremy Glaser
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar. Welcome to The Friday Five. Joining me to discuss the top market news from the past week is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you so much for being here.

Jeremy Glaser: You're welcome, Christine.

Benz: Some of the big retailers released earnings for the fourth quarter this past week. Some of the big home-improvement chains released earnings. But before we get into their results, let's talk a little bit about the housing sector in general.

Glaser: We've seen some choppy data out of housing due to everything from changes to the way mortgage applications are processed to weather, and that's impacted the numbers. We saw that again this month, where existing home sales looked really strong, and new home sales were below expectations. Overall, Bob Johnson, Morningstar's director of economic analysis, thinks that housing is on track and that we are going to see it be a positive contributor to GDP this year, as it was in 2015.

One of the reasons we do track housing is that beyond just commissions on existing home sales or what's happening with new home sales, there are a lot of knock-on effects as people go to Home Depot or Lowe's to buy what they need to fix up their homes. We saw that this quarter with Home Depot results yet again looking very strong. They have been on a winning streak recently. Unfortunately, that's very much priced into the shares right now. We don't think that there is a lot of value there.

Lowe's on the other hand had a good quarter but not nearly as good as Home Depot. Lowe's had some other one-time charges that clouded results a little bit, and we actually do see more value in Lowe's today.

Benz: Another big retailer, Target, had a fairly good quarter. How has it done in terms of rebounding from some of the high-profile problems it had a year or so ago?

Glaser: Target has been having some issues. If you remember the credit card data breach weighed on them. They exited their ill-fated foray into Canada and took a big charge.

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We are seeing some signs that Target's promotional spending is driving people to their stores and to particularly its e-commerce site. They had a big jump in e-commerce in the fourth quarter. But Ken Perkins, who covers Target for us, thinks a lot of that extra spending is coming from those promotions--they are going to have to spend heavily in order to get people into their stores and to their website. He thinks good growth could continue in those areas, particularly online, but you have to put that in the context that Target's sales online are much smaller than some of their peers'. They are at about $4 billion right now. Wal-Mart is at $12 billion. Amazon is more than $100 billion. So, they have room to grow but still don't have nearly the scale that some of their competitors do. We still think it's a no-moat company and don't see the shares as offering a good margin of safety today.

Benz: By contrast, our analysts do like Wal-Mart.

Glaser: That's right. We think that they have more scale there. They do have a wide economic moat, and they are going to be able to generate that economic profit over time.

Benz: Let's talk about Macy's. What's going on there? Not as pretty a picture.

Glaser: Macy's has had challenged results recently, driven by some long-term trends like the decline of department stores as people do more shopping online and spend less on apparel. We've seen that they have struggled.

In the short term, they have had some issues where a strong dollar has hurt tourist spending, which is something that's important for them, given some of their high-profile stores in tourist locations. And also, warm weather [weighed on sales of] coats and boots and things that usually boost them in the fourth quarter. So that resulted in a 4% drop in same-store sales, which obviously is disappointing for them.

Management is making some investments in initiatives--things like their new off-price concept and trying to put some more money into mobile initiatives. Jewelry is an area where they think they can make some gains; they are putting dollars to work to try to gain some advantage there. But it's going to take a while for that to happen and flow through into the results, and we could see some more muted returns for some time.

The other big question mark is real estate. Macy's controls a lot of valuable real estate across the country, and how they are going to unlock the value of this has been an open question. Management has been talking about it. There are some discussions of, do you spin it out? Do you form a joint venture? How do you make the most of this real estate? That also will have a bearing on what happens to valuation over time.

But we still think this is a no-moat business. There is not a big margin of safety in the share price. These investments may become fruitful in the future, but it's just too uncertain to know. We think investors are better served looking elsewhere.

Benz: Outside of the retail sector, let's take a look at HP's results. Also quite lackluster.

Glaser: HP is another one of these companies that has been trying to turn things around. This is the part of the business that is focused on computers and printers, which are two things that have been in decline.

Windows 10 really hasn't resulted in a big upgrade cycle on the PC side, and HP is under a lot of pressure on printers from some Asian competitors that are coming in with very aggressive pricing, making it difficult for them to make money there.

Because of that, we saw another decline, a 12% decline in revenue year-over-year, which is substantial for them. So they are trying to accelerate things on the cost side. They figure, if we can't generate a lot of growth, we'll try to take a billion dollars out of the business in terms of costs by cutting jobs, by finding other ways to reduce costs, and they are making some progress there. They are trying to accelerate some of those efforts. But this is, again, maybe a little bit more speculative that the company will be able to do this. You can only cut costs so much before you really cut into the potential for future growth, and we just don't see any opportunity in HP today.

Benz: Stepping away from the earnings activity, there was some chatter this week about a high-profile merger potentially coming down the pike. Let's talk about that one.

Glaser: Honeywell approached United Technologies about a merger that United Technologies has basically dismissed out of hand for various reasons that we'll get into. This is potentially an interesting deal. Barbara Noverini, who is an analyst here, thinks that a deal like this makes a lot of strategic sense. Given their overlap in aerospace, given their overlap in building systems, there is potentially a lot of costs that you could take out of a combined Honeywell/United Technologies.

But she sees two big problems. The first one is that there are going to be antitrust issues. These are really big players in aerospace, and it's not clear that it would pass a regulatory review. They also have big common customers, like Airbus and Boeing, which would probably be very skeptical about that combination, and that's the concern that United Technologies raised when they said that this deal is never going to happen--that it's not worth spending the money to pursue something that's never going to actually occur.

The other problem, we think, is probably valuation. Honeywell would have to pay a pretty steep price in order to get this done if they were to overcome the regulatory issues. If you pay too much for it, you could have all the synergies in the world--it can make all the strategic sense--but it's not going to be a good thing for shareholders if you overpay. So, it's not clear that Honeywell will pursue this to the end of the earth. They have already said they have shareholder value in mind. They don't want to overpay for the asset. So even though there is some strategic sense to it, I don't think investors should be counting on this combination happening anytime soon.

Benz: Thank you so much for being here, Jeremy.

Glaser: You're welcome, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.