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Retailers Balance Caution and Catalysts

A lot of progress has been made since the recession's retreat, but retailers haven't escaped yet.

Philip Guziec, CFA, 10/26/2010

Retail stocks got hammered during the recession and still face serious challenges, but there are pockets in which savvy investors can find some value. In August, we sat down with members of Morningstar's consumer stock research team (associate director R.J. Hottovy and analysts Joscelyn MacKay, Zoe Tan, and Peter Wahlstrom) to get a sense of which way the retail space is headed.

Q: What's the general outlook for retail right now?
R.J. Hottovy: The good news is that the worst is likely behind us and that consumers have generally shown a willingness to spend. The bad news is that we don't think the strong retail sales growth we saw in the first half of the year is sustainable. We think trends are going to get choppier from here; consumers are facing a number of economic headwinds, including unemployment, stagnant wage growth, less availability for home equity withdrawals, and decreased housing prices. As a result, we think retailers are going to have to work harder to get consumers into the stores and drive traffic. Consumers have shown a willingness to shop, but they still need a catalyst.

Joscelyn MacKay: Spending is still tight, due to high unemployment and low consumer confidence. We're seeing traffic increase in certain pockets, but that really consists of people going into the store to get the products that they really need. As a result, retailers are seeing smaller transaction sizes.

Q: So, people are shopping when they have a particular need, not just saying, "Let's go shopping." RJ, you mentioned that consumers need a catalyst. What would that be?

Hottovy: The consumer is extremely event- driven right now, meaning that they're shopping for big events such as holidays. In this past quarter, we saw Memorial Day and Father's Day being key events. But in between these periods, there aren't a lot of reasons for consumers to shop right now. Looking at the back half of the year, especially the holiday season, which is obviously critical for retailers, I think that consumers will be willing to spend. But the problem is that they're going to wait until the absolute last minute to take advantage of the lowest absolute price. I think consumers have become more savvy over the years, and they understand that if they wait, retailers will be forced to mark down prices to clear inventories.

Pete Wahlstrom: Speaking of catalysts, in the first half of the year we had a number of government stimulus programs, whether it was homebuyer credits or appliance rebates, so consumers had that incentive to go out and spend. On top of that, a lot of consumers received tax rebates this year, so that was a one-time event that's not going to be repeated either in the back half of 2010 or next year, at least not to the extent of what occurred this year.

Q: If companies keep dropping prices to attract customers, what are the implications for the industry?
Hottovy: I think it could really weigh on merchandise margins in the back half of the year as consumers hold off their purchases until the price is right for them. Certainly, it's something we're monitoring; at the same time, I think that inventories are relatively clean for a number of retailers--not every one, but for a number of retailers. So, the mark-down risk and potential profitability hit likely won't be as pronounced on margins as they were in 2008 and early 2009. Retailers have adjusted inventories for a new level of consumer spending at this point.

Zoe Tan: In the specialty apparel space, we've seen a slight difference from an inventory standpoint. In some of the retailers, especially in the teen apparel retail space, inventories remain high because this sector has been hurt more than others, mainly because of elevated unemployment rates among 16- to 19-year-olds. We're expecting higher levels of promotional activity coming from this category, especially during the back-to-school season, so it will hurt these retailers both from a top- and bottom-line perspective. We're also seeing a lot of promotional activity in the department stores, putting downward pressure on their prices. So, in turn, this will likely hurt off-price retailers, because the pricing gap will be narrowed, pulling some traffic from the discount/off-price channels into department stores.

Philip Guziec, CFA, is Morningstar's derivatives investing strategist. He leads Morningstar's OptionInvestor service, which applies Morningstar's fundamental research methodology and fair value estimates on 2,000 stocks to uncover option investing opportunities. Guziec joined Morningstar in 2003 after a career as an engineer and management consultant. Learn more about OptionInvestor.

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