Retailers Balance Caution and Catalysts

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.

Q: Are retailers facing rising costs?
Tan: Starting earlier this year, we've seen raw material prices going up--cotton in particular--and distribution costs going up for retailers. That's something that retailers have mentioned when we've spoken with them; because they buy products six to nine months before they hit the shelves, we'll see these prices start to trickle through in the fourth quarter and really hit home in the spring of 2011. Because it's more difficult to raise prices in a difficult consumer environment, it's something that retailers are watching closely and working with their manufacturers to try to contain. But in certain sectors, like children's apparel, cotton is a big part of their costs, so they would have to price strategically.

Q: Are Internet sales matching the trends in bricks-and-mortar retail?
Hottovy: Actually, e-commerce sales have outperformed the bricks-and-mortar retailers. We've seen some pretty lofty sales numbers out of the e-commerce channel for a number of retailers, including department stores.

Q: Such as?
Hottovy: Wal-Mart WMT has seen some good numbers, Macy's M has seen some good numbers, Best Buy BBY--it's a pretty long list of retailers that have seen some exceptional growth in the e-commerce channel. And, frankly, we're not surprised. E-commerce is going to be an increasingly critical driver of profitable growth over the next several years. It's a cost-effective way to gauge consumers' interest in new products and new concepts; it's also an easy way to liquidate excess inventory. So, I think that we'll continue to see e-commerce outpace the bricks-and-mortar side of the business for an extended period of time.

Q: Is this e-commerce growth isolated to a particular type of retailer, or is it pretty much across the board?Hottovy: It's pretty broad-based, but if you had to point to one area of explosive growth, I would probably highlight the apparel category more than anything else.

Tan: There are a few interesting things that apparel retailers have been doing online. Teen retailers like Aeropostale ARO and American Eagle AEO, which are trying to launch their kids' apparel concepts (P.S. for Aeropostale and 77kids for American Eagle), have opened their e-commerce websites before they opened physical stores. J. Crew JCG is trying to expand into Europe; they do not have stores there, but they are building up their e-commerce base in Europe to build brand awareness and test market demand.

Apparel retailers have been a little slower in this area relative to the electronics sector, so they're playing catch-up, for the most part, especially with the downturn and the uptick in consumers going through that channel. I think e-commerce is a big focus for most retailers.

Q: Let's talk about your favorite areas within the sector.
Wahlstrom: One of the areas we really like is the home-improvement retail market, so that leads us to Lowe's LOW and Home Depot HD, two companies that we think are very well-positioned for a multiyear recovery in the U.S. housing market. Currently, they're constrained with a couple of near-term headwinds, such as high unemployment, low consumer confidence, and low housing turnover. The silver lining is that both Home Depot and Lowe's continue to be profitable: They have healthy dividends; they throw off enough cash to fund those dividends and fund their internal growth plans. On top of that, Lowe's, through the first six months of this year, has repurchased more than $1.2 billion worth of stock; Home Depot has repurchased $1.4 billion, and management said it was going to repurchase at least $3 billion worth of shares this year. After a three- or four-year period of showing declines in comparative- store sales, we've had two quarters where the comparable-store-sales trends have ticked up, which is encouraging.

Q: What's your thesis for why that's happening?
Wahlstrom: Both of the companies have done a good job of, number one, staying rational-- they're the two biggest players in the home-improvement market, and they don't need to beat each other to death, so they've maintained a steady "good, better, best" product suite, catering to the consumer preferences. They've also done a good job with some supply-chain restructuring initiatives. Over the past 18 to 24 months, each has cut millions of dollars from infrastructure spending, whether it's related to inventory management, merchandise flow, or the design of some rapid distribution centers.

Q: Any other retail areas you like?
Hottovy: I'd say sports apparel and footwear is another area we're optimistic about. In a more-cautious consumer-spending environment, sporting activities are a relatively cheap form of entertainment. Another factor is that there were a couple of big-sporting-event catalysts this year, including the Winter Olympics and the World Cup, that helped drive a lot of sales in this business. Throw in new product innovations, such as the women's toning-shoe product that you can't go anywhere without seeing these days and new golf products, and this category should hold up well. We expect to see sales outperformance in sporting goods this year.

Q: What particular companies?
Hottovy: We like Nike NKE; we think they're well-positioned and that they've got a great product lineup across a number of different categories. Some of their more-emergent brands, such as Hurley and Converse, also are doing very well right now. They've done a lot of innovative things on the product front. We like Adidas as well; we think they're doing some very interesting things with the Reebok side of the business. Reebok's a name that's been long-forgotten, but they've been at the forefront of this toning product that has really resonated with women. Under Armour UA has done some really innovative things, too. They've gotten back to the basics with the apparel side of the business while they retool the footwear side.

Q: What are some of the retail areas you don't like?
Tan: Off-price retailers. Over the past year, they've really benefited from consumers trading down to this channel and from a load of excess inventory from department stores. But we think that their level of productivity and margin expansion is not sustainable. Department stores having to lower their pricing might really affect traffic. Also, with manufacturers' inventory management becoming more disciplined, we won't see such levels of good and cheap inventory available to retailers such as TJX TJX and Ross Stores ROST. They'll also be lapping some pretty tough same-store sales comparisons, running anywhere from the high single digits to the low double digits. We've already seen a deceleration in the second quarter. We expect that to continue in the third quarter and throughout the end of the year.

So, we think that these companies are slightly overvalued at this point.

Q: As you've mentioned, there are a lot of headwinds for the retail sector. On top of it all, there's fear of a double dip. In the retail space, is there any way to gain some protection in case of further economic turmoil?
Hottovy: We've been encouraging investors to take a look at high-dividend-yield stocks, as a way to protect against a double dip and augment returns. Three names that we've been looking at with relatively high dividend yields are American Eagle, which has around a 3% dividend yield, Home Depot, and VF Corp. VFC, which is the company that owns Lee, Wrangler, and the North Face apparel brands, among others. We think that those are strategic names to take a look at in this environment.

Jerry Kerns is executive editor of Morningstar Advisor magazine.