2/4/2010
By Brian Sozzi, Research Analyst

Should we become excited by all the positive January comps (note January small percentage of annual sales)? Or, how about the swath of raised EPS outlooks for the now completed 4Q, is that worth breaking out the pom poms?  With the book officially closed on holiday 2009, it's safe to say that the retail sector got back to basics, managing inventory and margin, while basking in the slight ray of hope that was the reemergence of the U.S. consumer to the malls, outlets, and discount centers.  Sector inventory levels entering the new fiscal year are rather lean as January clearance events, and a little extra money in the wallets of consumers that tempted some to buy non-essentials, did the trick. 

Here are the key takeaways from the month:

1. Specialty retailers are now in an inventory build mode following a year of aggressive working capital management.  In 2009, inventory was a source of cash, but that is becoming less so for 2010.  Ann Taylor (ANN) and American Eagle (AEO) brought the rebuilding of inventory to support comp growth in 1H10 to light prior to the holidays.  This morning, Wet Seal (WTSLA) noted inventory per square foot was up dramatically exiting the fourth quarter.  Against a backdrop of still uncertain consumer spending, and the call out of strong profit growth in 2010 for retailers by the sell-side, there may be angst as to whether managing to comp is an ill advised strategy.  Managing to margin, as was the case in 2009, had almost become ingrained.  But, in order to drive sustainable earnings, it's imperative for a retailer to bring in sales through normalized prices and increased traffic.
2. Big upward EPS guidance revisions by Gap (GPS), Aeropostale (ARO), and TJ Maxx (TJX).  The Street has been dour on Gap recently, citing an increased ad budget for the holidays that would hinder EPS upside.  Guidance from the company clearly supports the notion that Gap leveraged its greater marketing spend through effective margin management.  It might be time to reenter the stock (though we have maintained our buy rating).  As for Aeropostale and TJ Maxx, well, so much for those chirpings that "value" was dead in 2010.  Consumers remain very price focused, and this is one reason that Aeropostale and TJ Maxx are likely to continue to outperform sector average comps.
3. Heavy rainfall in California negatively impacted sales trends. 
4. Sales of home furnishings did well post holiday, suggesting the consumer is opening up even more to discretionary purchases.

January Wrap-Up and Investor Toolkit

Back to the question we posed at the onset; are the January numbers a cause for optimism on the consumer?  I hate to don the analyst jargon hat, but I think cautious optimism is reasonable as we enter spring and summer.  In November, December, and January we learned:

* Consumers that have jobs are in a better position to spend after a year of balance sheet de-leveraging and savings rebuilding.
* Incomes are being bolstered by stimulus and modest wage growth (though wage growth is below inflation rate...)
* Low inflation (as measured by headline and core CPI) has caused consumers to see the value inherent on most retail shelves.  We have had a year of food deflation and promotional motivating events at specialty stores, which have kept prices down.

In order to transition from a state of cautious optimism on the consumer to full-fledged optimism, it's critical that the jobs market turns.  Those individuals that don't have jobs need to find them, and those presently employed but yearn to advance in their field of interest must be able to do so.  Simply stated, expect ups and downs in consumer spending patterns for the foreseeable future.  We have devised a checklist on properly investing in the sector for 2010.  It's indeed a stock pickers market this year when it comes to the retail sector as most will return to double-digit percentage EPS growth (on tepid sales...).  To be a successful sector investor, it's critical to decipher which company has the highest probability of usurping consensus EPS forecasts, and which ones are likely to disappointment.

Sector Investment Checklist

* Company shows strong probability for sales to increase, helping to overcome a rising cost backdrop (transportation, supply chain, investments in technology).
* Companies that have transformed how they conduct business (for example: Target is reducing SKU count, Costco has reengineered package sizes and shipment sizes, and American Eagle Outfitters will have dramatically lower lead times for spring merchandise) will generate industry leading operating margins as sales return.
* Market share gainers, fueled by close to full-price sales, as the retail sector continues to shrink through store closures.
* Attractive price to sales multiples relative to historic averages and sector averages (fits in with our attention on sales this year; a grower of the sales base should create multiple expansion on a P/S basis).

Things to keep in mind for 1Q

* Retailers begin to cycle margin boost from inventory management and sourcing midway through.
* Easter arrives earlier as opposed to a year ago.  Should favor March sales (stores closed on Easter, which is on April 4; happens to be my birthday:))

Comp Trend (for companies under coverage)

* Specialty apparel January: +1.65% (first sector positive since April 2008)
* Discount retail January: +3.78% (sector positive for five consecutive months)