Be Cautious of Retail Stocks

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Earnings season for the major retailers has mostly wrapped up. Here with his take on the results is Matt Coffina. He is editor of Morningstar StockInvestor newsletter.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: How would you characterize the earnings you saw from the retailers in the first quarter?

Coffina: Not good, certainly. Retailers had a very difficult fourth quarter and that really continued into the first quarter. I think there are both temporary cyclical factors at play here, but also some longer term secular threats that we need to be worried about.

On the temporary side, it was a very harsh winter. There was a lot of snowfall, a very cold weather, especially in the Northeast and the Midwestern parts of the U.S. and that kept people home and away from shopping malls and away from stores. More generally, I think consumers remained hesitant, so economic growth hasn't been all that robust. Unemployment's been coming down, but overall, job growth hasn't been all that robust for what we might like to see at this point in the recovery. So, I think consumers remained hesitant and then the weather only added to those troubles.

More on the secular side, I think we need to be concerned about the growth of e-commerce for a lot of retailers. This was the first really big holiday season when we saw people do a lot of their shopping online, and I think that's carrying over into the first quarter where people are buying more and more online. That's also keeping them away from malls. Maybe you're not going to Wal-Mart or to Kohl's or wherever. That's keeping you from going to the specialty retailers in the same locations, the Aeropostales and Staples and whatever else it might be.

Really across the board, whether its office supplies, pet goods, mass merchants, or department stores, retailers had a very difficult first quarter. I think a lot of that is temporary and cyclical and not necessarily representative of what we can expect going forward. But I think investors do need to be aware about these secular threats that are out there, as well.

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Glaser: Does that mean that there are parts of the retail sector that you find interesting right now. Are these temporary issues producing some values?

Coffina: Yes. I think investors do need to be cautious. I think there a lot of negative moat trends in the retail sector right now, so a lot of competitive positions that are deteriorating. I would say a lot of the mass merchants, a lot of the department stores, certainly office supplies, fit into those categories.

In general, there are categories where online competition is very viable. Often, these are everyday goods that you maybe order routinely online. There are bigger purchases, electronic stores would be another example. People are shopping around for those big ticket items like TVs, and they're relatively commodified across products. So you can tell exactly what you're getting, and you're more likely to shop for price online. So those are the categories that I think have more secular threats. Also things like office supplies maybe have other elements of secular decline as more and more things move online.

On the other hand, you have other kinds of retailers like home improvement where online competition really hasn't gained much traction; you're often dealing with bulky, expensive-to-ship items. Often there is a service element where people want to go into the stores; they want to talk to a sales professional.

We own Lowe's, for example, in our StockInvestor Tortoise Portfolio. I think that's a category that's relatively well-insulated over the long run and the headwinds at Lowe's and Home Depot we saw in the first quarter were much more on the weather-driven cyclical side.

I think Lowe's CEO said something to the effect of the spring season is like Christmas for home-improvement retailers. That's when a lot of people stock up on supplies to do these big spring renovation projects, and a lot of that got pushed out of the first quarter and into the second quarter because of poor weather.

Home improvement I still see as relatively well-positioned.

Somewhere in the middle would be, for example, pet supplies. Often, bulky pet food is too expensive to ship through the mail, but on the other hand, you have increasing competition from grocery stores and mass merchants. So, a company like PetSmart looks interesting. It's undervalued based on our analyst's fair value estimate. But I would say it's a notch below Lowe's, but somewhat better protected than a Staples or a Best Buy would be.

Glaser: There could be some opportunities out there, but investors definitely need to be cautious and make sure that those businesses are going to be able to defend themselves from online competition?

Coffina: That's a good way to summarize it. I would say the other two retailers that we own in Tortoise and Hare portfolios would be Wal-Mart. That is a company that's very well-protected by its tremendous amount of scale, which gives it bargaining power for suppliers as well as operating cost leverage.

Wal-Mart still has 5 times the revenue of Amazon, which is a significant scale advantage and hard to overcome. I think Wal-Mart's relatively well-protected, but still a negative moat trend company, where we think its competitive position is getting somewhat weaker over time as you have competitive threats from all sides, not just Amazon, but also dollar stores and the retail environment in general being very, very competitive.

We also own Lowe's, I just talked about, and then CarMax would be the other one. This is a company that I think is very, very well insulated from online competition. Certainly, there are people getting more and more information online about what kind of used car they want to buy, but if anything that's helping direct them to CarMax where they have often some of the better pricing, they have the best selection, very high-quality customer service, and no-haggle pricing. And so I think they are very well positioned to compete in a world where information is more freely available online.

Glaser: Well, Matt, thanks for your update on earnings today.

Coffina: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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