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As second quarter 2022 earnings season wraps up, this week has proven to be an important one for the Retail sector. First, investors got the chance to hear from some of the top retailers such as Walmart (WMT), Target (TGT), Home Depot (HD) and Lowe’s (LOW). Next, US national retail sales for July were released.

The data points to a confusing environment where some segments of the US consumer are under pressure, but others are holding up surprisingly well despite a slowing economy. While elements of a “K” shaped economy are evident, with high end consumers still spending strongly and low-end consumers pulling back, overall expenditures have been better than Wall Street feared. For July, Retail Spending ex Automobile sales and gasoline rose +0.7% versus expectations of +0.4%.

Overall, though, inflation has been a headwind for the US consumer in 2022. This has caused many people to feel squeezed as overall wage growth has lagged inflation despite a tight labor market. As seen on the chart below, this has resulted in a sharp drop in Consumer Confidence.

Chart 1: CB Consumer Confidence Index

One of the effects of this drop in consumer confidence is that low wage earners have been forced to concentrate their spending on essentials as well as trade down in terms of price points. WMT, a good proxy for overall consumer spending, noted this in its most recent quarter reported this week stating that consumers felt squeezed and were purchasing less higher profit discretionary items and instead focusing on basics. For example, households earning under $100,000 a year appeared to drive double-digit growth in WMT’s food categories. As a result, the company reported sales growth of over 8% in the quarter. This might have been aided by the recent move of Oil prices back below the $90 per barrel level. All of this led WMT to forecast +3% same store sales growth in the back half of the year. While WMT’s technicals have improved in the short term, we believe that WMT will continue to underperform versus the S&P 500.

In its most recent quarter, Target reported weaker than expected results. They noted that margins were impacted because of aggressive adjustments to reduce inventory levels, lower than expected sales in discretionary categories, and higher shipping costs. Both Target’s CEO and CFO are hopeful that they are past the excessive inventory issues and are hopeful for the rest of the year. On the other hand, we remain cautious on Target’s stock and believe that it should be avoided. TGT’s price action looks weak, shows a lot of heavy selling, and should continue to lag the market for the rest of the year.

Most retail sector stocks have been mixed this year, with many stocks experiencing significant technical damage. As a result, most retail stocks will not form classic William O’Neil bases for three to six months. Despite this, we believe that there are some pockets of strength that are actionable and have strong fundamentals. Specifically, there are three areas we would encourage investors to focus on given the uncertainty of the US economy.

Given the previously mentioned squeeze on the pocketbooks of the bottom half of Americans, we continue to favor US Retail Discounters. If the US economy was to enter a more pronounced downturn, these Retailers should perform better on a relative basis versus most areas of Consumer Cyclical and Discretionary. For example, in the Great Financial Crisis (GFC) US Retail Discounters were able to outperform the S&P 500 in 2008.

Chart 2: U.S. Retail Discounters vs. the S&P 500 During the Financial Crisis (2007-2010)

Two discount retailers that have been performing well on a relative strength basis are Dollar Tree (DLTR) and Dollar General (DG).

Dollar Tree (DLTR; $38B market cap): Dollar Tree is a leading operator of discount variety stores in North America. The company operates ~16.2K stores across 48 contiguous states and five Canadian provinces, supported by a coast-to-coast logistics network. It is likely to be a relative winner in the near term, given the specter of continued high inflation rates in the U.S. As a value-oriented retailer with pricing power, and indeed with a newly revamped management team, we expect the stock to outperform. The stock’s strong and robust technical ratings reflect leadership. It has a Relative Strength (RS) Rating of 97 and an Accumulation/Distribution (A/D) Rating of B. The O’Neil Industry Group Rank steadily improved to 13 from 99 over the past eight weeks.

Dollar General (DG; $58B market cap): Dollar General is a U.S.-based discount retailer operating ~18,130 stores across 46 states, making it the largest retailer in the country by store count. The company employs an Every Day Low Price (EDLP) strategy; Its products are typically priced at a 20–40% discount to mainstream retailers. As discretionary spending power reduces in the upcoming quarters, Dollar General’s offerings will resonate more with the U.S. consumers and drive sales. The stock has broken out of a stage-one eight-week long cup-with-handle base and is currently trading 6% above the pivot. It has a robust fundamental profile. EPS rank of 80, SMR Rating of C, and Composite Rating of 89. Technical ratings are also solid. RS Rating of 91, A/D rating of C- and Up/Down Volume ratio of 1.4x.

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Another area where consumers are being forced to make changes is with new and used cars. This has been driven by three factors. First, supply chain issues continue to plague the auto manufacturing industry. This has resulted in fewer new cars available on dealer lots. Next, this has driven new car prices up to record highs with many selling at premiums to MSRP. Finally, this lack of supply and higher prices has resulted in higher used car prices. While these prices have begun to pull back recently, they are still up markedly since the start of the pandemic as shown in the chart below.

Chart 3: U.S. Consumer Price Index for New and Used Vehicles

With the rising prices of new and used vehicles, consumers have been forced to keep their current vehicle and maintain it. This has greatly aided automobile parts retailers. As a result, the industry has had strong stock performance versus the broad market.

Chart 4: U.S. Auto Parts Retailers have outperformed the S&P 500 YTD

One such company that we believe is well positioned to continue to benefit from this trend is O’Reilly Automotive (ORLY).

O Reilly Automotive (ORLY; $47B market cap): O’Reilly Automotive is a specialty retailer of automotive aftermarket parts, tools, supplies, equipment, and accessories in the U.S. and Mexico. The company sells its products to both DIY (59% of sales) and professional (41% of sales) customers. The company operates ~5.8K stores in 47 U.S. states and 25 stores in Mexico. Over the past five years, sales have grown at a 9% CAGR, while EPS has grown at a 24% CAGR, driven by store rollout and high-single-digit comparable growth. In the long term, we believe O’Reilly can get to 6.7K stores and deliver above-market rates of comparable growth, given its competitive advantages. The stock is forming the right side of a stage-one cup base (pivot at $749) and has strong O’Neil Ratings and Rankings. It has EPS Rank 88, a Composite Rating of 95, a Sales Margin Ratio Rating of A, and an RS Rating of 91, and its RS line is trending upward. Up/Down Volume ratio is 1.5 with an A/D Rating of B-.

Another well-known operator in the space is AutoZone (AZO).

AutoZone (AZO; $45B market cap): AutoZone is one of the leading retailers and distributors of automotive replacement parts and accessories for cars, SUVs, vans, and light trucks in the Americas. AutoZone offers a strong hedge against inflation as it operates in a needs-based industry and experiences low price elasticity. We believe as discretionary spending power reduces and people choose to maintain their cars over upgrading them, AutoZone, a high cash flow generating company with strong growth potential, would benefit and generate alpha. It has a strong fundamental profile with highly stable earnings growth, especially over the pandemic period, EPS Rank 94 and Composite Rating of 94. It is trading at an all-time high and is extended from an ideal buy range. Technical ratings are solid. RS Rating of 94, A/D rating of B- and Up/Down Volume ratio of 1.6x. Institutional sponsorship has consistently risen in the past nine quarters, highlighting the stock’s appeal during uncertain economic conditions.

Finally, there are always individual companies with specific trends that enable them to grow regardless of the overall economic environment. One such company is WW Grainger, which is benefiting from a sharp consolidation in its industry.

WW Grainger (GWW; $28.6B market cap): Grainger is a leading broad-line distributor with operations primarily in North America, Japan, and the U.K. It offers more than 2M maintenance, repair and operating (MRO) products in its High-Touch Solutions assortment and more than 30M products through its expanding Endless Assortment offering. It recently reported strong Q2 2022 results. Revenue increased 20% y/y to $3.8B, 3% above consensus, while EPS was up 68% y/y to $7.19, 8% above consensus. Looking ahead, the company sees 2022 EPS of $27.25–28.75 versus consensus of $26.56. The stock was up more than 14% last week and broke out of a stage-one consolidation base. It is actionable in the range of $530–557. The stock has strong O’Neil Ratings and Rankings: EPS Rank of 94, Composite Rating of 98, SMR Rating of A, RS Rating of 93, and its RS line trending upward. It also has an Up/Down Volume ratio of 1.5 and an A/D Rating of C+.

While a volatile market can discourage stock investors, there is usually something working somewhere even in sectors that are overall under pressure. Staying focused on stocks with strong fundamentals with positive technical patterns can help diligent investors discover such opportunities.

Irusha Peiris, Executive Director, Research Analyst, at William O’Neil and Company, an affiliate of O’Neil Global Advisors, made significant contributions to the data compilation, analysis and writing for this article.

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