Motley Fool Hidden Gems Investing - Retail Shrink Gets Bigger?

Episode Date: August 22, 2023

Dick’s is the latest retailer to feel the pinch of shrink – just remember all theft is shrink, not all shrink is theft.  (00:21) Asit Sharma and Dylan Lewis discuss: - Zoom’s customer-driven approach to AI and how the company’s cash hoard is showing up in its earnings.  - How a decrease in DIY is impacting Lowe’s results. - Dick’s management joins the ranks of retailers dealing with theft affecting results.  Companies discussed: ZM, LOW, DKS Host: Dylan Lewis Guests: Asit Sharma Engineers: Dan Boyd  Learn more about your ad choices. Visit megaphone.fm/adchoices

Stop wasting your nights on a mattress that doesn't get you. Experience the most comfortable mattress in the world. The Sleep Number Smart Bed. At the touch of a button, you can personalize your comfort. Choose firmer or softer. Adjust cooler to warmer. And right now, save up to $2,500 during our massive Labor Day event. Hurry into your local Sleep Number store today.

Because we have your number. Dillon Lewis, and I'm joined over the airwaves by Motley Fool analyst, Asit Sharma. Asit, thanks for joining me. Asit Sharma, Motley Fool Analyst Thank you for having me. We've got updates on DIY spend, another retailer feeling the pinch of theft. But we're going to kick off today looking at everyone's favorite e-conferencing everything company. It's for meetings, it's for talking to your relatives, it's Zoom. Asit, the company reported results, shares up 4% after what looked like a pretty decent quarter for Zoom, almost 4% year-over-year growth on the top line. We saw net

income up to $182 million compared to $45 million in the quarter ago. What jumped out to you in the company's results? Dylan, I think that the deceleration that we've seen with Zoom is starting to even out a bit. Enterprise business, that's part of the business which you're selling to enterprise customers, large contracts, contracts over $100,000 a year. Those seem to be growing. I note that the contact center business, which is something that Zoom basically built in-house, has now reached over 500 customers. They were discussing this in the call in just six quarters. While we don't have a company that seems to be rejuvenated on the top line, it becomes increasingly interesting from an earnings

perspective, from a cash flow perspective. This is a company that looked like maybe net income would start to wobble a bit, but a very solid quarter. On the bottom line, Zoom had $182 million in net income. More to talk about here, but I see stabilization as my main takeaway from this earnings report. You mentioned the growth profile there. Management reiterated the full-year guidance, implying 2% growth for the year. This is definitely a different look business than maybe where they were a couple of years ago. Some of what we were seeing in terms of their full-year outlook and even what we were seeing in terms of the earnings look this year was reflective of the fact that this is a company making

some pretty heavy investments in artificial intelligence. When talking through the call, CEO Eric Wan outlined that the company's philosophy on AI is a little different than I think what we would expect some companies to be going after, basically saying that they are a business that does not want to hide anything on the AI side behind price hikes for customers. They want it to be part and parcel of the product for customers. Asit, what do you think of that approach? Asit Sharma. Eric Yuan has always had a customer-centric focus. He's pretty product-obsessed. I like that Zoom is actually getting out in front of all this generative AI stuff and saying, we're not going to use any customer

data to train our models. They could very easily do that, but they're putting customers at ease. Also, they have this aversion to play around with price too much. They have stated on this call and previous calls that while there is a competitive pressure now with great rivals like Microsoft Teams, they're going to hold firm to their pricing. They would rather introduce features as add-ons and not try to upsell customers with a sudden raft of new features, they want to be able to add on bit by bit and prove out that value proposition so by the end of the year or several-year term, when enterprise customers are renewing, they feel really good about signing on the line again.

I think that philosophy makes sense during a period where we know a lot of those customers are probably going to be a little bit more cost-conscious than they have been in previous years. One of the things I couldn't help but do with this company's results and really just processing where their earnings were and where this business is, is take that step back and look at where they are as a business and really the financial picture for this company, given that the growth profile is so different now, Asit. As it stands, they're a $19 billion company, and they are sitting on $6 billion in cash and equivalents. We mentioned that that top line for them is in the single digits. Do you think that there's

the possibility that now that we are looking at a business that has some real financial fortitude in terms of the balance sheet, they may be a little opportunistic with cash, or they may look to find areas to reinstill that growth on the top line. It becomes interesting if you're sitting in the driver's seat at Zoom, if you're the CEO and the CFO, to try to decide what to do with all that cash. They did have the contact center acquisition that fell through a while ago. As I mentioned, they built a contact center in-house. They've had some smaller acquisitions, Dylan. But nothing out there that screams, hey, we should deploy $3 billion to $4 billion and buy X company. Because they're so product-focused,

there is nothing really for them to buy with many of their billions. Now, they could engage in more of these bolts on acquisitions. But I'll give you the flip side to the decision-making. Zoom got such a boost during the pandemic, it piled up so much money on their balance sheet, if you can get 4% to 5% on that money, why would you do anything with it? Would you even think of repurchasing shares? I note that in the press release today, other income, we don't know what it is yet until the quarterly report is filed, but this is $41 million of extra money on the income statement. Remember, I said that net income was $182 million, so $41 million of that is other income. We're going to see when we can pour through the

quarterly report that a large part of that is interest income. When you got $6 billion and you can put that to work at several percentage points, that's a strength. You should probably celebrate that with the market and let investors know we can be an earnings-driven company. Part of that is having this, in a high interest rate environment, this big asset that we're sitting on. Does it seem like we are firmly in the next chapter of Zoom's story, where we've gone from the crazy growth period now to a focus on the bottom line and maybe some of the flexibility that having that cash on hand offers? I think we're turning the page, but something that you bring up gives me pause from saying

it's a slam dunk. There still could be some growth that we just don't expect out of Zoom. I don't know if we'll ever see the amazing growth they had during the pandemic. But these investments in AI. As they become better and better with these tools and this deliberate approach, I think they have the ability to pull some market share away from competitors like Microsoft Teams. They have a few products already they've rolled out this year that corporate customers are playing with and really like. The Zoom phone keeps getting more robust. They have a product called Zoom One, which pulls everything into a unified platform, almost looks like a competitor to Microsoft Teams itself. But that's going to be rich with AI features in the coming years. While I think

the preponderance of the investment case is now on the earnings side, and I think they can grow those earnings faster than most would believe. Look at the market, they should be trading at 15 times forward earnings. That may be cheap, but there is a little bit of juice left in the tank to speed it up a bit more. Stabilization now, but don't count them out to show a bit better growth on that top line in a year or so. Let's switch our gaze over to retail updates. We had earnings from Lowe's and Dick's before the bell on Tuesday. Starting with Lowe's, a mixed result quarter for them. Earnings came in ahead of expectations, but revenue lagged slightly, earnings per share at just over $450 billion, and revenue just below $25 billion.

It's always interesting to take this company, and with the benefit of Home Depot reporting earlier in the earnings season, stack these two businesses next to each other. This is a business that is a little bit more subject to the whims of the DIY market than its competitor, Home Depot Asset. It seems like we saw that materialize a bit in the results that the company reported. Totally. The consumer is getting a little more cautious, as management likes to say at Lowe's, not really canceling projects, just delaying them, which sounds a lot like some of the software companies we look at when management says, yeah, we've got some of the sales in the pipeline, we didn't close them. But the good news is, they aren't being

canceled. It's just, we're going to close those deals next quarter. Lowe's is going to close some DIY deals next quarter, I think, when consumers feel healthier. But the market likes what Marvin Ellison has been able to achieve. I was just scanning the results today, operating income was 15.57% as a percentage of sales. That's a little bit better than the same quarter last year, which came in at 15.39%. That's a small difference, but it supports this idea that Lowe's is becoming more and more efficient with handling their goods as it goes from supply chain to the floor out the door. There's a lot of great tech that the company is invested in. Some of their distribution now is becoming automated. They're

investing in robots. All this long-term investment starts to show during times like this. I think that's why investors feel comfortable even though these results are backwards. Net sales are not where you want them to be. They're down, actually. Net earnings also from $3 billion this time last year to $2.7 billion. Investors don't seem that phased by it. They have some faith in the model that when that consumer uptake starts to happen again, those results will flow through to the bottom line. I'm not surprised that low shares are actually up a little bit today. Kudos to them for learning how to manage their business a little bit better than in years past.

Both in Lowe's report earlier this year and Home Depot's report earlier this year, they cut full-year guidance and then held firm on those adjustments when they provided their update this quarter. I feel like the macro picture, especially with respect to home improvement and the housing market broadly, is in the eye of the beholder. It's whatever you want to be seeing in terms of forces and opportunities. With rates being higher, we're probably not seeing quite as much interest in housing and financed housing projects. But on the same side, people aren't necessarily looking to move, which to me would indicate they're more likely to improve the homes they're in. Asit, how are you thinking about some of the macro forces affecting these

businesses? Asit Sharma The first one I'm looking at, Dylan, is lumber deflation. That hit Home Depot's results, and it also hit Lowe's results a bit. When the price of lumber goes down, that's less of a sale for these companies. That's something that we should keep in mind, but it also is an indicator that the projects are getting more affordable. Lumber was so expensive during COVID, it's finally coming down. If you look at that one macro factor, that projects that when consumers feel a little bit more comfortable, they'll go ahead and engage in that deck project or maybe building one small room. No one thinks in terms of extending their house by 25% anymore because

stuff is so expensive and it takes so long just to contract the labor. But whatever those small projects are, I think there is more of an appetite. The other macro factors are just interesting as you point out. You've got consumer debt that is at an all-time high in the United States, and yet you have this really tight job market. There's a scenario where the credit cards are maxed out, but people feel the wealth effect because they are employed. The economy itself against all odds and predictions is humming along. Employers probably have a little bit of leeway to at least raise their earners up to the rate of inflation. Let's say that the true inflation rate somewhere this year is going to be 3% to 4%. I'm not saying that

next year everyone gets a 3% to 4% raise, but a lot of employers who stay competitive give something to their employees. That mental wealth effect will keep people coming into these stores. As you point out, if the housing market is tight, you're going to upgrade some things. I have just a few pennies to rub together this year, Dylan, but I'm upgrading stuff too. I'm going into Lowe's and Home Depot and I find myself wondering, why am I doing this? I should be saving more. But this is the retail habit that we're all in. Finally, a little bit of retail therapy as well. I think I mentioned this last week on a podcast here, but there is some element of just spending out of relief that the bottom didn't fall out in our lives and economy. For most of us,

it's still tough out there, I should say, though. This isn't to say that everyone is enjoying the benefit of a tight labor market. It's uneven as it always is across the globe, in terms of what people are experiencing. One retailer that had a slightly different story with the results, and I think maybe hit a little differently by some of the consumer spending trends, was Dick's. Shares down 20% after reporting, profits down 23% year-over-year, and a miss on the top line in its quarterly update. Management was quick to point out a couple of culprits for that earnings miss and that struggle on the top line. One of them being struggles in the company's outdoor segment, which is where a lot of their higher-priced items tend

to live. The other was retail theft, which is something that we've started to hear more and more about. This was something that was specifically talked about with respect to the company's profitability. Which one do you want to dive into there first, Asit? Asit Sharma I guess that outdoor segments, these are discretionary items that maybe go hand-in-hand with the delaying of projects on the low side. I think that makes a lot of sense. If you're just taking a pause, maybe this summer, perhaps in the fall, they get a little bit of a boost. But the spring and summer for many retailers seemed soft to me in terms of bigger ticket items. That's not a surprise. What do you make of this theft thing, though? It's not something

we usually associate with Dick's, although there is a growing wave of this conversation in big retail. I'm curious, Dylan, your thoughts first. Well, this is admittedly a company that I catch up on around earnings season. But in my research for the show, this is the first time that theft has been mentioned on a company call in about 20 years, according to people that have been tracking this for quite some time. Management looked to put some numbers to the shrink story, saying margins fell 34% compared to 36% a year ago, and that a third of the margin reduction they saw was from shrink. It is possible that that shrink gets worse over the course of the year. There's a part of me that

says we're seeing this from multiple retailers. Anecdotally, we're seeing a lot of news stories around this. I think it's something that we have to be watching in the retail space. But one of the things I want to ask you about this, Asit, is as stories become industry-wide trends, they also can become convenient ways for companies to talk about results that aren't so good. How do you look at retailers that are talking about the shrink story? Now, we know retailers already have this great excuse in terms of the weather. So, the weather was bad in the Southeast United States this quarter. Those rainy days caused people not to come to the store, and that's why we missed our expectations. You had this other

nebulous category that you can now blame things on. Why I say it's nebulous, shrink doesn't just encompass theft. Shrink actually, if you are an accountant, a CPA, you already know this, it encompasses so many other things that have to do with the condition of your merchandise inventory. If you are having, let's say, fresh goods, Walmart, shrink also means spoilage when the tomatoes go bad on the way. But if you mishandle your own inventory, that is shrink. If you order stuff and it's obsolete, customers don't want it, that can also be written off as shrink. There's a lot of things in there and it's a category we don't have visibility into. We don't see the accounting entries. Could this be another

way to say we didn't really handle our cost of goods sold very well? We just weren't tight enough in our own procedures. We did have some real theft here. Let's just call it all shrink without going any further. We'll use the word theft in the paragraph in the press release. I'm not saying Dick's is doing this, but to answer your question on how this could work. Then the microscope just goes off of us. Yeah. I think it's important for us to remember, Asit, that all theft is shrink, not all shrink is theft. Yeah, totally. I love that. Then the flip side becomes for people who are analyzing as investors, well, now you've just created a lot of uncertainty for me. As we were talking about,

Dylan, I think some of this haircut that Dick's is getting today is from just the uncertainty of it. They've never really talked about shrink in recent memory, and now they're pulling back on the total year outlook, but it's ill-defined. Thoughts on that? Yeah. I feel like I'm a little bit in Dick's management shoes here, where we're not used to talking about shrink too much, and I'm still adjusting to it myself. I think for me, it's something where I would like to get a better sense of the measures that companies are putting in place for this stuff. I don't want to see companies anchor too heavily to it as an excuse for what's happening in their results. But I do understand, you know, we look back to

the results that Target put up. I think that was kind of an eye-opening moment a couple quarters ago, saying they lost $500 million in shrink. That was seemingly a wake-up call that this is going to be something that retailers are talking about. And it kind of opened the floodgates for a lot of this discussion, probably for the next several quarters, if not the next couple of years. Totally. Last quick thought on that. Maybe that's the way forward, is to quantify it. what you had this quarter that was related to, let's say, the theft line item in your shrink, and what you might see. Just quantify that going forward. We'd be a lot more comfortable with that,

but we'll leave that to the retailers. Sounds like you're calling for some GAAP accounting rule changes, Asit. If I had my ways, Dylan. Always the accountant, always the CPA. Asit, thank you so much for joining me today. It's a lot of fun. Thanks so much, Dylan. Dylan Lewis As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis, thanks for listening, we'll be back tomorrow.