11/25/2009
By Brian Sozzi, Research Analyst

As the Macy's day parade floats prepare to descend on New York City, we felt it appropriate to pen a short note that aggregated pre-holiday themes and those apt to emerge as the season treks along.  Most of the Black Friday stories have centered on another year of assumed consumer madness as soon as the clock hits 12:01 AM on Friday.  Or, better still, once the clock strikes 12:01 AM on Thanksgiving as a raft of major retailers will open their doors in order to spread out the deal-seeking crowd flow.  After all, nobody wants a repeat of last year's tragic debacle of a person getting trampled at a Wal-Mart location.  This time around there has been a strong effort by retailers to reinforce security and rethink how consumers in fact enter the stores in their search find the hottest deals.  (Don't get us started on the practice at Sears of putting limited quantities of products on sale for Black Friday in the backroom; this is pure craziness for a retailer with the buying leverage of Sears.  It's old school retailing at its finest, or lowest; draw in the consumer through mouth-watering deals only to up sell them once they find the deal item is no longer in stock, or was never in the store to start with.)

That said, we shall provide a checklist of last year's themes in retail, those already known this year as the calendar turns to December, and those likely to surface.

2008

* Panic driven markdowns throughout the mall as a combination of unfavorable weather and an economic downdraft caused a build in inventories.  Sales and profits hit very hard as a result.
* Lack of guidance throughout the holiday season as management teams simply had no visibility into demand trends.
* Lack of trend in specialty apparel sector.
* Discounters ruled supreme, though were not immune to the pricing pressure throughout the industry.

2009 Known Quantities

* Tight inventories across the retail sector: We estimate that inventory per square foot for specialty apparel retailers is down about 10.0%.  For discounters, the figure is closer to 5.0%.  There will be out of stocks, especially at those companies who do not have the balance sheets to support in-season shipments.
* Weather conditions: Thus far, Mother Nature has not been helpful to most specialty apparel retailers (see markdowns on outerwear), but the absence of snowstorms and rain as seen last year should drive favorable traffic comparisons.  Fortunately, first markdowns appear to be holding initially given the prospect for colder weather and the need for consumers to shop outside their closets (new styles are much different than the last time they shopped...in 2007).
* Promotions: Retailers have planned promotions, unlike last year when the swift decline in the economy caused reactionary stances.  Perhaps one could say an aura of normalcy has returned to retail, i.e. management teams are able to build in promotions and more accurately forecast sales and earnings.

Crystal Ball Themes

* Robust sales of technology gear creates a halo effect to others in consumer facing sectors (think restaurants, specialty apparel retailers, mom and pop shops, etc.)
* Sales for the overall season track higher year over year following deep discounting and traffic declines a year ago.
* A lessening importance on Black Friday for major retailers as consumers continue to migrate online for product discounts, free shipping, and product reviews.
* Lack of noteworthy bankruptcies following holiday season.
* Inventory per square foot planned higher in first half 2010 as retailers look to rebuild sales base.
* The need to replenish inventories creates a shift in yearlong favorable input costs.
* Facebook pages and iPhone applications (such as the ones by Polo Ralph Lauren, Target, and Gap) are becoming forces in how retailers engage consumers.
What About the Stocks?

The risk associated with exposing a portion of a long-oriented portfolio in retail stocks has increased exponentially.  From the March nadir in the equity markets, the S&P Retail Index has appreciated some 77.0%, despite the risks inherent to future earnings from a 10.0% unemployment rate and modest wage growth, among a plethora of fears.  As demonstrated by the data set below, specialty apparel retailers are expected to go from very weak bottom line results in 4Q08 to much better figures this year.  For 2010, the EPS expectations by the sell-side are robust as well, on sluggish sales growth no less, as consensus has retailers continuing to control costs and selling inventory into a more full-priced oriented demand backdrop.  Some companies will be hard pressed to meet such heightened outlooks, a viewpoint we have stated frequently in prior months. 

On the contrary, the best risk reward profile remains within the discount retail sector.  Companies such as Target, Wal-Mart, and Costco have removed real structural costs from their operating models, and with tame inflation, well-managed inventories, and strong cash flow generation, the framework is there for these companies to best consensus earnings estimates in 2010.

Final Words

We continue to believe the November/December sales timeframe will bring higher sales year over year, modest in nature of course.  But, within the number that is likely to grab the headlines, we expect discounters to outperform specialty retailers in terms of quality of earnings and outlooks entering the first half of 2010 (this is on average; not to hedge our bets, but there are a few in specialty apparel retail that will have solid holiday quarters and project good tidings post holidays).  Exposure to discounters, which sport solid dividend payout ratios that are poised to rise in 2010, not to mention share buybacks coming back online, offer the best value at this point in time in our view.

Top Pick:
* Target Corp. (TGT)
One to avoid:
* Bebe Stores Inc. (BEBE)