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Stock Strategist Industry Reports

With Pockets Full of Cash, Will Retailers Spend Wisely?

Specialty apparel retailers' more prudent use of cash should boost returns.

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Faced with plummeting top lines at the end of 2008 amid a severe drop-off in consumer spending, most specialty apparel retailers responded aggressively by cutting capital expenditures, slashing operating expenses, running on ultralean inventories, and suspending share repurchase programs. These efforts, coupled with modest top-line growth in late 2009, allowed many retailers to generate substantial amounts of free cash flow over the past year. On average, we estimate that these specialty apparel retailers will end fiscal 2009 with free cash flow around 8% of revenue, which is double the 4% posted in the previous year.

Despite improvements in consumer spending trends, a slow revival of the job market, and elevated household debt levels are likely to lead to a muted recovery, leaving specialty apparel retailers cautious. In our view, these companies will continue to take a defensive approach this year, maintaining a sizeable cash reserve, with only modest increases in capital expenditures. Store growth is not likely to return to the levels we saw from 2005 to 2007 anytime soon, and specialty retail chains will probably take a more measured approach to expansion plans in the longer term. Many of these retail chains are now focused on improving productivity in existing stores and growing through less capital-intensive channels such as e-commerce. Should these efforts pay off, we would expect returns on invested capital to improve. Only a handful of companies have reinstated share repurchase programs or increased their dividend payments over the past six months; however, we expect more news on this front in the coming year as retailers gain a stronger footing amid a more stable stock market and economic climate.

Zoe Tan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.