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Changing Fortunes for These Four Retailers

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. At long last, things seem to be looking up a little bit for the consumer. But what about consumer retail stocks? Here with me to dig into that a little bit is Morningstar's Paul Larson. He's the editor of Morningstar StockInvestor and an equity strategist. Thanks for joining me, Paul.

Paul Larson: Pleasure to be here.

Stipp: So it seems like we are getting some good news on the consumer front. Has the consumer turned the corner, finally? What are the signs out there?

Larson: Well, I think that the consumer has indeed turned the corner. We see same-store sales up very strongly in most recent weeks. Then, also, we see consumer confidence, which has really bounced back from the lows that we saw a couple months ago in the depths of the recession.

Stipp: Sure. So the confidence is what they're thinking, but it's actually nice to see that backed up with some improving sales as well, which we got that data recently.

So it may seem, from an investor's perspective, the consumer's out there spending again. This must be great for retail stocks. You can't lose with a retail stock when the consumer's coming back, right? But that's not always the case. You sort of see a division here. Tell me a little bit about that.

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Larson: Right. The last year was definitely very interesting for retailers, where we saw the retailers that were focused on the frugal consumer actually doing the best. Two stores in particular, Dollar General and Ross Stores, did very well. They were positioned in a very good place while we were going through the worst recession in a generation.

For instance, Dollar General had same-store sales of 9% in calendar 2008, and close to 10% last year, and this in a recession. Those are very, very strong numbers. But we think that as the economy improves, that these two companies, the Dollar General and Ross Stores, are not going to be able to maintain that sort of same-store sales growth momentum that they've had in the last two years.

Stipp: So is the market seeming to indicate that they will, then? I mean, are people basically looking at that great performance in a downturn, which is even better because it's in a downturn, and how are they priced? Is the market expecting that to go on?

Larson: I think you hit the nail on the head. We see the retail environment shifting from abysmal to more normalized. And the market seems to be taking the situation that we had in the last year and thinking it's going to last in perpetuity that these two stores that are counter-cyclical are going to continue that same-store sales growth. And we don't think it's going to last, and that's why we have 1-star ratings on these two names.

Stipp: But if the consumer is out there spending again, surely someone in the retail area is going to benefit. Is there good news? Are there any picks in the retail space that you're seeing, and where might investors look for those opportunities?

Larson: Right. On the flip side of this coin, we do have two retailers that had it very, very rough over the last couple of years; Home Depot and Lowe's. These are the big box home improvement retailers that have had four years of negative same-store sales growth, just compounding on each year. Also, their profitability has dropped fairly significantly, going from operating profit margins in the double-digits down closer to 6-7%.

But we think that as the economy improves, that they're going to get some of those sales back, that same-store sales are going to normalize closer to positive 3%, and that their operating profit margins are going to also expand mildly from trough levels. But the market doesn't seem to be pricing in that sort of improvement. Just like with the counter-cyclical value retailers with the somewhat-discretionary names, the market just doesn't seem to be pricing in the change.

Stipp: So if you have the ability to look a little bit further ahead and see, people are going to eventually have to remodel their kitchen or buy some new cabinets or something like that. Market's not quite looking that far ahead, but if investors do, might be an opportunity for them.

Larson: You said it better than I could.

Stipp: Thanks for joining me, Paul.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.