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Here’s Why Merchandise Margin Trends Could Reverse in 2022

Many retailers enjoyed booming sales growth last year as consumers ponied up and paid full price for goods, but 2022 could see pressures that will impact sales and, consequently, merchandise margins.

There are three factors that are expected bring about this shift, according to UBS softlines analyst Jay Sole. They are inflation’s negative impact on demand and costs, the lack of fiscal stimulus this year versus the same year-ago period, and general merchandise margin contraction as the retail sector returns to normal promotional levels.

Sole is forecasting a 2 percent decline in 2022 year-over-year sales growth for U.S. apparel and accessory stores. “Regarding margins, the lesson of 2021 was how much full-price selling can boost merchandise margins. In our view, one of the main 2022 themes will be the trend reversing when retailers buy too much inventory,” the analyst concluded.

Sole said he’s bearish on the softlines sector in general, mostly because of inflationary pressures. Some growth stocks—such as Nike Inc., On Holding AG, Deckers Outdoor Corp. and Skechers USA Inc.—should beat the stock market’s expectations and are most likely to outperform in 2022. Other apparel firms he expected to do well include American Eagle Outfitters Inc., Ralph Lauren Corp., Capri Holdings Ltd., Under Armour Inc. and Kontoor Brands Inc. In contrast, fashion firms with low-growth potential will probably miss expectations. Examples of the latter are the sell-rated Nordstrom Inc., Dillard’s Inc., Kohl’s Corp. and Macy’s Inc.

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The analyst expects earnings for the softlines industry in the U.S. to grow 1 percent, hurt by weak sales growth and margin pressure.

“Our view is sales will be pressured by mainly tough compares, as the industry laps fiscal stimulus, and inflation, which causes consumers to reduce purchases of discretionary items such as apparel and footwear. We also think rising interest rates will be a headwind on demand,” Sole said. “Lastly, we expect high cost inflation and a return to a more normalized promotional environment to cause margin contraction. We anticipate these factors will more than offset price increases.”

Inflation

UBS has its own Evidence Lab’s Apparel Consumer Spending Intention Score that relies on proprietary market research. The spending intent shows consumer demand for softgoods has deteriorated over the last few months, likely due to rising concerns about inflation, the analyst said. In fact, 51 percent of consumers mentioned it as a negative factor in December 2021, up from 38 percent four months earlier.

“We envision a series of events unfolding during [calendar year 2022], which catalyze downward EPS (earnings per share) revisions and keep sentiment negative,” Sole said.

The analyst also said that he believes other sell-side professionals are more optimistic than he and the UBS softlines team regarding how price increases can offset rising costs and allow companies to maintain peak merchandise margins.

Sole’s view is that inflation will “get worse before it gets better.” He also noted that almost every company within the softlines’ team coverage is “planning price increases next year, which are bigger” than the ones taken this year.

“Our recent expert call suggested inflation had a negative impact on demand in December for some apparel companies. We think this effect will get amplified as prices increase,” Sole concluded.

Fiscal stimulus

“We expect industry sales will begin to contract as companies lap last year’s stimulus and pent-up demand. Our minus 2 percent softlines industry 2022 growth forecast presumes that apparel spending patterns will return to the historical trend line,” Sole said.

Separately, Sole is anticipating that companies beginning in March and April will guide this year’s earnings conservatively, which will prevent the market from becoming bullish on softlines stocks. He also expects inflationary cost pressures to peak in June, and that industry gross margins will contract as price increases fail to fully offset the inflation headwind.

Inventory growth

By mid-year, possibly July, supply chains could begin to normalize in a way that could see product flow improvements. But Sole also believes that the normalization could occur when consumer demand slows, a shift that if it were to happen would lead to “significant gross margin pressure as inventory growth outpaces sales growth.”

Sole said that his channel checks indicate that some retailers and brands aren’t attributing big boosts to sales in 2021 to the federal government’s fiscal stimulus program.

“These companies believe their results have been propelled by a strong consumer benefiting from low unemployment, wage gains, and high asset prices. As a result, we believe they assume the strong growth rates they experienced in [2021] will continue in [2022] and are buying inventory for this scenario,” the analyst said. “We think these companies are underestimating the macro headwinds and as a result will get caught with too much inventory and this will lead to gross margin eroding markdowns, especially since [2021] was a year with a historically low amount of markdowns.”

In addition, the market expectation is that the Federal Reserve will begin to raise interest rates this year to combat inflation spikes. Fed chairman Jerome Powell on Wednesday indicated at a press conference that rate hikes would be coming soon. Investment strategists expect the hikes to begin in March, with the total number in 2022 to be four, but possibly as high as six. Economists at Wells Fargo said on Wednesday following Powell’s press conference that the monetary tightening would likely begin in “March with a 25 basis point rate hike.”

Sole said that the number of hikes by September will likely boost mortgage interest rates, and that could also have an impact on consumers’ disposable income.