Surveying the Retail Carnage

 | Jan 06, 2012 | 7:30 AM EST
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Ouch! There is no delicate word to use when describing what went down with retail stocks yesterday (yes, we received a couple of intraday reversals, but the session was brutal). If each retail stock represented a person standing in the middle of a busy highway, than every press release issued by the underlying companies constituted a Mack truck on nitrous oxide occupied by a careless driver unwilling to stop on red.

Let's hit the retail rundown hard. First, was the mostly across-the-board slamming of the stock prices deserved? Second, would one be an intelligent investor by buying the dip? I will offer this guidance: Better pick and choose very carefully in retail, as the sole overarching message from the coal-filled December reports was that aggressive discounts, much to the dislike of bonus-seeking management teams, are here to stay.

This means you must possess a healthy comprehension of which retail management teams are managing inventory to support margin expansion, not sales -- that is, they are not giving the store away to grow sales. At the very least, the earnings hurdle rate has to be set low (it sort of is currently) in order to reflect the convulsions in the marketplace and realities of the post-recession consumer spending recovery.

The commentary by analysts on Thursday was devoid of thought-provoking material and guidance for investors. What is the next maneuver, either to make money in the wake of widespread calamity or to not lose your shirt? I will do my best to get you thinking and positioned correctly.

Myth No. 1: American Eagle Outfitters is the king-daddy specialty apparel turnaround story: Don't get me wrong, a new head cheese steering this giant teen apparel ship, improved merchandise offerings (tops categories in particular), momentum behind the aerie intimates business and well-managed inventories are worthwhile positives. Yet American Eagle's (AEO) severely disappointing fourth-quarter guidance suggests that even though merchandise has started to sing, the consumer needs a strong discount to trigger the sale. Heightened market expectations and sporadic merchandise margin traction are not ideal conditions for a long-only investment thesis.

Myth No. 2: Pacific Sunwear deserves an upgrade: The 13-month performance on Pacific Sunwear (PSUN) is a cool +42%. An analyst came out positive yesterday on the company, issuing the first upgrade I have seen on it in some time. I'm not a fan at all of Pacific Sunwear until management delivers merchandise that is consistently interesting enough for the company to regain market share it has ceded to Zumiez (ZUMZ). Moreover, the company would actually have to strongly hint that it could turn a profit on fewer stores in operation and fill the dry cash coffers, in turn removing liquidity risk.

Myth No. 3: Target is losing 100% because of Wal-Mart: Wal-Mart (WMT) has taken the fight to its big-box competitors, essentially preventing Sears (SHLD) and Target (TGT) from having a jolly holiday season. Credit goes to the revival of the layaway program, shelves stocked with food that people want, and a strong marketing push both on both television and social media. To say that Target is losing because of Wal-Mart underestimates the following realities:

  • Consumers are looking to buy electronics from Amazon (AMZN) and Best Buy (BBY) online, placing added pressure on Target in the form of weak volume and competitive pricing. Target's electronics department is very weak, in my opinion. For example, it lacks the strong mobile experience being offered by Best Buy.
  • Portions of the Target store still do not work; decorative home and kitchen gadgets come to mind. Bed Bath & Beyond (BBBY), Pier 1 Imports (PIR) and Macy's (M) are winning with brand-name goods at good prices. If a consumer is being forced to pay more, why not go with a great brand name?
  • Target stores are beginning to represent a grocery store with deflationary departments bolted on. Low-margin food sales plus low margins in other categories = bad.
  • Canadian store development is diverting management's attention and constraining operating margins.

Myth No. 4: Costco is the be-all, end-all retail investment: Costo (COST) is a great company, no doubt about it. Is the stock warranting its present relative premium valuation? Nope, and here is why:

  • The company is becoming increasingly aggressive on price within its "majors" division, specifically televisions.
  • Food showed the largest year-on-year comp increases in December. This may be a function of Costco's willingness to compete more on price with its energized peers (especially BJ's Wholesale on the East Coast).

The takeaway here: An increasingly low-margin category is selling briskly.

Overall, in my view, the breakdown in Costco's stock reflects not only near-term margin uncertainty but also slowing rates of comp growth in the U.S. and internationally, compared with two-year "stacked" trends (international comparing to significant dollar weakness). Since Costco is about to cycle sizable international comp gains in the next six months, and given the aforementioned margin pressure and the positive impact later in the year of the recent membership-fee increase, the market appears poised to readjust the forever-premium relative P/E multiple it assigns to Costco's stock.

Myth No. 5: Ron Johnson at JCPenney is a retail god: No matter what Johnson does, JCPenney (JCP) will never be Macy's. It will not have the brands. If it does get the brands, consumers won't immediately flock to the stores after years of stodgy assortments. JCPenney will not have Herald Square Macy's iconic status; that store does mega business. JCPenney will never own a Bloomingdale's. Until JCPenney is able to close the sales and margin gap with Macy's or stick it to the off-price channel, I can't be enthusiastic on the stock.

Near-Term Call on Retail

After this retail stock bloodbath, don't dive in head first. This spate of intense promotional strategies suggests that the market may have adjustments left to make in terms of sector valuation. Use the market's reaction to your advantage by seeking relative price winners on "Ugly Thursday" that have the fundamental stories to support the positive price action. Hot Topic (HOTT), Nordstrom (JWN), Macy's (top pick of yours truly) and Pier 1 (continue to be upbeat on) are safe to go on the watch list.



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