Fashion is always in fashion, but investing in retail may have gone out of style … for now.
Analysts say the retail sector will likely be a stock picker’s market in the near term — with luxury and specialty apparel stocks investors’ safest bets — as concerns over the state of the consumer market continue to control a stock market that is moving into the typically sluggish summer months and has already proven indecisive in the first four months of the year.
While more activity on the mergers and acquisitions front could have a positive effect on certain retail stocks as the year progresses, a cautious and at times confusing macroeconomic picture, which is affected almost daily by ever-present high energy prices, could be offset by stronger top-line growth, thanks to easing same-store sales comparisons beginning in June. Those factors combined, however, could leave stock valuations by yearend generally flat. And with previously hefty gains in retail stock prices during calendar year 2004, part of this year’s stock performance could have already been negatively impacted by simple, old-fashioned profit-taking.
“It seems clear the challenges for relative performance of the retail group continue to increase rather than decrease,” wrote Legg Mason Wood Walker analyst Richard Jaffe in an April 29 research report. “Retail stocks typically act well about a year after the dollar strengthens, when interest rates drop and when consumer spending accelerates. None seems likely to us looking at 2005.”
By far, one of the biggest positives for retail shares going into the summer months would be any more mergers and acquisitions announced from within the sector, said Jim Rice, senior retail sector analyst at Bernard Sands LLC. That’s in addition to the more than a handful of deals that have already helped prop up the sector since last November when Kmart Holding Corp. and Sears, Roebuck & Co. fueled the M&A frenzy with their $11 billion merger announcement.
“I think there’s going to be a couple more deals,” said Rice recently, but prior to Neiman Marcus Group’s May 2 news that private equity firms Texas Pacific Group and Warburg Pincus will acquire the 37-store chain in a $5.1 billion leveraged buyout.
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“There seems to be a lot of money out there looking for a place to go,” said Rice. “That would boost stocks more.”
Clearly, though, investors lately don’t need a concrete deal to rationalize an investment in retail shares. Even M&A-related rumors floating around the market have had positive impacts, Rice noted, demonstrating the market’s favorable attitude toward mergers. For instance, shares of J.C. Penney Co. popped 8.4 percent in late March, the day a WWD report said two private equity firms were investigating a plan to take the department store chain private in a $16 billion to $18 billion leveraged buyout. In reaction, shares of Dillard’s Inc. added 3 percent in the same session following the March 31 report.
But if M&A activity has helped heighten interest in retail stocks, two of the retail sector’s broad stock indices don’t show it. Could they be foreshadowing a decline in valuations, possibly due to post-holiday profit-taking and given that the first quarter is typically the strongest time for retail shares? Both Standard & Poor’s Retail Index and the Retail HLDRS Trust, which trades on the American Stock Exchange, are down from mid-November highs. The S&P Retail Index reached a Nov. 15 high of 464.39, while the Retail HLDRS rose to a high of 98.24 (adjusted for dividends and splits) the same day. They are now trading at around 410 and 90, respectively.
From an economic perspective, U.S. consumers appear to be unsure of themselves, which also makes economists and equity analysts cautious on recommending purchases of retail stocks. What is, at least partially, to blame? The infamous uptick in energy prices, which has mainly reduced the amount of disposable income lower-income consumers have to shop at more moderate retailers such as Wal-Mart. Deborah Weinswig of Citigroup Smith Barney noted recently that Wal-Mart’s store sales are negatively influenced 0.77 percentage points for every 10 percent increase in gasoline prices.
“I do think it has affected consumer sentiment,” President Bush said of gas prices during an April 28 press conference. At that time, the President noted that energy consumption in the U.S. is growing 40 times faster than energy production. Crude oil prices are expected to remain above $50 a barrel through 2005 and 2006, according to the government’s Energy Information Administration.
The latest consumer spending figures released by the government show that, although personal spending rose 0.6 percent in March, consumers had to pay more for the goods they wanted. Adjusted for inflation, personal spending in March rose just 0.1 percent. Meanwhile, consumer confidence, as read by The Conference Board, dropped in April for the third month in a row. And the Commerce Department recently said the economy expanded at its weakest pace in two years during the first quarter of 2005.
Aside from those statistics, John Lonski, senior economist at Moody’s Investor Service, is most concerned about the overall U.S. employment picture and its ramifications on consumer spending. With the average monthly increase of nonfarm payrolls in the first quarter recently revised up to about 190,000 on average and 211,000 year-to-date, it’s probably too soon to know whether a similar pace is sustainable for the rest of the year. And thus too soon to know how it will have an impact on consumer spending.
“We still are generating jobs at a pace that is surprisingly low, given the age of the current economic recovery and given the far better growth of corporate profitability. As long as employment grows at a subpar pace, the outlook for consumer spending will be uncertain,” Lonski said.
“Apparel store sales will benefit if payrolls grow with a capacity that is typical of an economic recovery….Newly hired people who change jobs are more likely to update their wardrobes,” added Lonski. “Provided that we improve on that particular [nonfarm payrolls] statistic, consumer spending should live up to expectations…then, overall, that will steady the share prices of retailers.”
With federal interest rates at their highest in three and a half years, a factor that tends to affect consumers psychologically, inflation fears getting more noticeable, consumers spending more for the goods they need and economic weakness frequently reflected in the multitudes of monthly U.S. economic indicators, retail profits can be pressured. That’s in spite of moderating sales comparisons from June onward against the back half of 2004, which had reflected a lackluster back-to-school selling season.
For Lonski, the question is how long the economic slowdown will last, which is why he views the second half of this year with caution.
“You always have to be sensitive to a possible loss of economic activity and consumer spending to even higher energy prices,” he said, adding, however, that “it’s too early to panic.”
Aside from specific stocks gaining on acquisition-related rumors, the specialty apparel and luxury markets are two sectors that analysts think could withstand a softening economy and weak consumer spending.
In the specialty space, Howard Tubin, an analyst at Cathay Financial, said certain companies have “pretty strong momentum” because fashion trends are where they should be.
“As long as they continue to offer compelling, differentiated fashion, then I think the momentum can continue,” said Tubin, who is bullish on shares of Gap Inc., Abercrombie & Fitch Co., Limited Brands Inc. and American Eagle Outfitters Inc.
Kimberly Greenberger, a specialty retail analyst at Citigroup Smith Barney, is also bullish on shares of Gap as well as Chico’s FAS. And Liz Pierce, an analyst at Sanders Morris Harris, likes Abercrombie & Fitch, Bebe Stores Inc. and Urban Outfitters Inc.
“When people get concerned about consumer confidence and consumer spending, I think the knee-jerk reaction is not to want to own retailers,” added Tubin, who has an “outperform,” or “buy,” rating on five of the eight specialty apparel retailers he covers.
In the luxury space, stocks like Nordstrom Inc. and Coach Inc., are seen as continuing their upward climb because the companies are largely immune to changing economic forces, thanks to core shoppers who are clearly comfortable with $400-plus purchases.
Citigroup’s Weinswig recently noted at a roundtable discussion that shares of Federated Department Stores could be a stock to scoop up in light of the company’s increased focus on serving consumers who aspire to buy luxury through its Bloomingdale’s chain. Federated also recently acquired Lord & Taylor, which caters to more aspirational shoppers.
In the end, “I don’t think retail is going to get killed; I don’t think it’s going to be anything huge,” Bernard Sands’ Rice said of his expectations for retail stock performance during the rest of the year.
Given Rice’s ho-hum outlook, perhaps the old saying, “Sell in May and go away,” fits best for now. That is, at least until the holidays come around again and all eyes return to the retail sector.
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