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Red flags abound for retail stocks
Just when the back-to-school rush should be starting, malls are quiet -- even at trendy shops such as Wet Seal and Hot Topic. Here’s why Wall Street gets nervous when teenage girls stop spending.
By Michael Brush
If you feel you’re getting elbowed a lot less as you pick up trendy duds for your kids this year, you’re right. The back-to-school season -- which starts with the last two weeks in July -- has kicked off with a resounding thud.
Among youth-oriented retailers that announced sales or earnings disappointments in recent weeks were Abercrombie & Fitch (ANF, news, msgs), Wet Seal (WTSLA, news, msgs), Hot Topic (HOTT, news, msgs), Children’s Place Retail Stores (PLCE, news, msgs), dELiA*s (DLIA, news, msgs) and Gadzooks (GADZ, news, msgs).
If you think it’s all just another flighty teen trend that you can safely ignore, you’re wrong. The weakness actually portends trouble for the rest of retail -- and for the rest of the year.
Part of the reason has to do with the normal pecking order inside families when it comes to budgeting. When times are tough, fathers are typically the first to bite the bullet and rein in spending. They’re followed by the sons, the mothers and finally the daughters, says Dana Telsey, a retail analyst with Bear Stearns.
“If teen retailers are experiencing weakness, especially during the back-to-school season,” says Telsey, “we don’t think consumers are likely to spend too much on other types of discretionary merchandise for the balance of the year.”
Excuses, excuses
To be sure, several teen-oriented retailers have been doing well. Chains such as Claire’s Stores (CLE, news, msgs), Pacific Sunwear (PSUN, news, msgs) and Urban Outfitters (URBN, news, msgs), for example, have posted promising results.
And retail cheerleaders can cite a litany of factors that seem to rationalize the recent weakness. Last year’s massive federal tax rebate kicked in during July, but it won’t be repeated this year. The Texas school systems, second only to California in number of students, are starting two weeks late this year. And fewer states are offering sales-tax holidays this year.
In the end, though, these may turn out to be flimsy excuses, given the trends that were shaping up in July. For the month, half of retailers came in with sales below estimates. Overall, they posted a 2% increase in sales at stores open more than a year, compared with a 4.1% increase in June and a 3% increase last year.
Especially troubling was a sharp decline in sales during the last two weeks of July -- exactly when back-to-school shopping was supposed to start providing a boost. “We think the drop-off in the consumer at the end of July is scary,” says Stacy Pak, an analyst with Prudential Securities.
Retail-sector analysts at some mutual funds aren’t so bleak. “In the past two weeks, there was clearly a slowdown in more discretionary items,” says Bernice Behar, with John Hancock Funds. “The numbers at Best Buy (BBY, news, msgs) were pretty awful. But if you look at the overall numbers, there is a sense that back-to-school will probably be OK, but nothing gangbusters.”
T. Rowe Price retail analyst Frank Alonso agrees that it’s probably too early to throw in the towel on retail. “I think without a doubt, things are going to be a little more challenging because kids are getting a little less money from mom and dad. But spending is not going to go off a cliff.”
Prudential’s Pak, however, says that kind of thinking is part of the reason she has an “underperform” rating on so many retail stocks. “We think a lot of investors are still holding on to the consumer. As a result, we don’t think we’ve seen capitulation in the group yet, and we fear we still have more downside.”
One thing’s for sure: There’s still time for a rebound. A good part of the back-to-school season lies ahead and there could be a reversal in September, says Mike Niemira, an economist who follows the retail sector for Bank of Tokyo-Mitsubishi. But here’s why retailers will face continued challenges as the first day of school approaches.
Retail challenges
One of the main factors that affect spending is consumers’ confidence in the job market. And right now, job growth is weak.
“We don’t see anything that encourages us to think that new jobs will be created in the near future, and it would have to be in the near future for fourth-quarter spending to be robust,” says Kurt Barnard, of Barnard's Retail Marketing Report.
“The biggest factor is that the new job growth has been very anemic so far,” agrees Rajeev Dhawan, an economist and labor-market expert at Georgia State University's Economic Forecasting Center. “I don’t expect it to get into a decent range until next spring.”
This obstacle, plus stock-market losses and discouraging news about economic growth, has cut into consumer confidence. “Consumers were reasonably optimistic this spring, but that optimism has faded as of late,” says Frederick Breimyer, an economist at State Street Bank. “People are not being encouraged by much that they see around them.”
Consumers have been spending more, but that pattern may end up contributing to the problem. Recent years have brought an increase in the share of income Americans are willing to spend. Breimyer suspects a hangover from the consumption binge eventually will rob future growth.
One potentially alarming development to watch: Charge-offs for bad debt at credit-card companies jumped in the first quarter, and regulators are increasing restrictions on some credit-card companies to be on the safe side. Keith Leggett, an economist with the American Bankers Association, says it’s too early to know whether these are trends that will significantly limit spending.
Retailers also suffer from overcapacity, notes one analyst at a mutual fund. “The whole industry is growing so fast, and they are all chasing the same pie,” he says, citing stores such as Abercrombie & Fitch, Wet Seal, American Eagle Outfitters (AEOS, news, msgs) and Hot Topic. “Everybody needs to close stores right now.”
Even the weather may work against retailers this back-to-school season. Merrill Lynch retail analyst Mark Friedman says that weather forecasters at Planalytics predict above-average temperatures during August and September, which would weaken demand for fall apparel.
Stores also face potential disruptions from International Longshore and Warehouse Union strikes at West Coast ports, as well as a shortened holiday calendar with six fewer shopping days (Thanksgiving comes late this year).
And how will shoppers react to the anniversary of Sept. 11? Will they feel guilty about shopping and take more time to reflect on life and their families, staying out of stores? No one knows, but it’s a possibility.
Some positive trends
Despite the numerous red flags, not all is gloomy on the retail front. The decline in mortgage rates has sparked yet another wave of refinancing, which is boosting the amount many people have to spend, even if job growth is weak, notes Carl Steidtmann, an economist with Deloitte Research.
And retailers are keeping leaner inventories, which means they don’t have as much merchandise to move at clearance prices. So profit margins are higher. That may change if the back-to-school season winds up being a dud and retailers panic by cutting prices ahead of the holiday season, says Marshal Cohen, a retail analyst with NPD Fashionworld. So far, that’s not a scenario he expects.
Meanwhile, sales at discount chains are strong. “People are looking to save money and they are prone to look at the price tag before they look at the product,” says Barnard, of the Retail Marketing Report.
July same-store sales (trends at stores open for more than a year) at discount chains such as Big Lots (BLI, news, msgs) and Fred’s (FRED, news, msgs) were up 17% and 10.2%, respectively -- compared with declines of 5% to 6% for department stores like Federated Department Stores (FD, news, msgs) and May Department Stores (MAY, news, msgs). (Not all discount chains are doing well, though. Wal-Mart Stores (WMT, news, msgs) missed its sales numbers for July. Business has been weak at BJ’s Wholesale Club (BJ, news, msgs), as well.)
Another fairly safe haven in retail can be found among the chains offering staples, as opposed to discretionary goods. Stores such as CVS (CVS, news, msgs), Rite Aid (RAD, news, msgs) and Walgreens (WAG, news, msgs) have been posting relatively good results.
And many retail stocks have come down so much that some investors are beginning to see potential “value” plays in the group. A scan of the data shows that retailers such as The Gap (GPS, news, msgs), Tommy Hilfiger (TOM, news, msgs) and Children’s Place are selling at price-to-sales ratios of around 0.6, well below historical averages of between 1.2 and 2.
Prudential analyst Pak, however, notes that many retailers still trade above historical averages. She wonders whether that may change if retailers guide earnings estimates lower when they announce second-quarter profits. You can watch for yourself this week and next, as most retailers spell out their quarterly results.
At the time of publication, Michael Brush did not own any long or short positions in the stocks mentioned in this week's column. |
