2/24/2010
By Brian Sozzi, Research Analyst

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In this day and age of constant financial news flow it's very easy to overlook a piece of data that may be instrumental in formulating a long-term thesis on one's market of choice (derivatives, debt, equities, etc.).  For perspective, if only the investing class put stock in the news of a Bear Stearns hedge fund failing in the summer of 2007.  Traveling further back in time to the 1920s, what if exuberant investors at least questioned the model underlying investment trusts, which gobbled up corporations to collect the dividends (among other uses) despite the holders of these companies lacking sufficient capital to fund the businesses in the event of a sharp downturn in economic activity.  More recently, the market has bore witness to countless, well founded calls that Greece's debt position would put it over the edge and that even though no longer technically in recession, the wheels of the U.S. economy may be starting to slow from the peak of the high octane induced QE easing program from the Fed, their cheap money policy, and government stimulus.  Economic data abroad, erring on the side of weaker than expected, is serving as a prime example of what may happen here in the U.S. as the Fed pulls back the punch bowl and deficit spending by the Administration runs its course.

We opine on such topics to set a framework for our views on the retail sector entering 2010.  Unemployment is elevated, wage growth stagnant, and corporate pricing power virtually non-existent.  By and large, retailers navigated the external turbulence of 2009 by tossing the aggressive new unit growth/sloppy supply chain management playbook into the fireplace.  In its place, retailers went back to basics.  Getting back to basics for retailers included:

1. Paring four wall negative (profit/cash flow) stores.
2. Redoubling efforts to understand and connect to the consumer.
3. Using buying leverage to negotiate favorable trade terms with supply chain partners.
4. Cutting inventory to bring down operating costs and limit markdown risk.
5. Better managing employee headcount and hours.
6. Maintaining a "cash is king" mentality.

Thus far in the earnings reporting season for the retail sector, we do not sense a major shift in strategy by the executive teams that comprise our coverage universe.  Although consumers are opening up to making non-essential purchases (evident in the results from Target and Polo Ralph Lauren) there is a hesitance by retail executives to aggressively rebuild inventory, open new stores, and reinstate employee perks that were removed in 2009.  Some initial insights include:

1. Inventory plans for 1H10 are conservative.
2. Supply chain inflation increasingly prevalent as 2010 progresses.
3. Modest capex increase versus 2009; last year was one of maintenance capex, this year it's a combination of maintenance and investments in technology to enhance distribution center and store level productivity.
4. Demand for items outside of food and other staples have gained momentum.

The state of retail, as we see it, is interestingly solid on a fundamental basis.  Taking a sample size of 17 retailers that have reported 4Q09 earnings, average inventory is down close to 10% to begin 2010.  Sales on average fell 0.4% in 4Q09, but through the back to basic strategies we noted above, non-GAAP earnings have increased by 40%.  Of significant importance, however, is the $23.1 billion in cash and equivalents these companies boast.  Excluding Wal-Mart's contribution to our tally, total cash and equivalents is a robust $15.2 billion.  Keep in mind that this cash is exclusionary of the improved availability under credit revolvers as retailers paid down debt in 2009 and there being greater ability to tap the long-term debt/commercial paper markets.

In concluding our assessment, the data sets forth a case that the retail sector is beyond the worst for the cycle.  Companies have much stronger balance sheets and operating models, suggesting that even in a sluggish sales backdrop, which is likely to unfold, the sector is not at significant risk of a meltdown as the one evidenced from the second half of 2008 to the middle of 2009.

Brian Sozzi
Wall Street Strategies