7/8/2010
By Brian Sozzi, Research Analyst

More Articles by Brian Sozzi

Within our retail sector coverage universe, the ratio of June same-store sales beats to misses is positive, believe it or not.  The performance is on the back of the following catalysts:

* Memorial Day calendar shift (appears to have had a 150 to 300 bps positive impact on specialty retail; somewhat of a similar negative result for discounters as stores were closed)
* Father's Day
* Pre July 4 buying
* Buying closer to appropriate weather instead of investing beforehand

In other words, what we saw were a batch of strong numbers, right?  Well not to be a Debbie Downer as the weekend approaches, but I must ask the question.  Comps came in anywhere from four basis points and higher compared to consensus, so where are the upward earnings guidance revisions for 2Q10?  Is it a case of management teams playing it close to the vest, attempting to drive earnings upside when results are posted in mid August in order reawaken slumbering share prices?  Could be.  However, the feeling of cautiousness I am sensing this morning may in fact be warranted as many retailers pulled out all of the stops with respect to promos in June.  During our store walks throughout the month, the level of promotions picked up, in our view, relative to previous months.  Full-price selling, while existent on items that consumers perceived to have value, leveled off.  Companies with great assortments, say an Ann Taylor (ANN), was trying to move product by offering visible promos throughout the month.  I think what is happening is that retailers in earnest want to clear through goods prior to back to school/fall because their receipt plans are elevated compared to 2009.  Oh, yes, the inventory reduction story of 2009 will officially be over in the second half of the year, with retailers on average increasing per square foot inventory about 5% year over year to rebuild same-store sales.  With that inventory investment and uncertain sales backdrop, the downside risk to earnings is tangible.  This is but one reason for the pullback in broader retail stocks since the last week in April.

How to Obtain Pulse on June Numbers

When receiving a truly mixed bag of messages within same-store sales data, which is the case today, determining the next direction in the underlying stocks could be tricky.  For instance, on one side of the coin Abercrombie & Fitch (ANF), out of the blue, reported a comp 3x higher than consensus forecasts.  However, the usually non-promotional retailer had to ramp up promotions to drive the acceleration in its business, so what does that say about the true health of the consumer?  Elsewhere, there was Gap (GPS), delivering perhaps the dourest commentary on its business in over a year.  According to management, traffic was "difficult" and as a result, merchandise margins will take a hit in July in an effort to clear inventory in front of back of school.

June 2010, therefore, is a bag full of mixed messages to the market.  The messages are so mixed I am unsure if any questions regarding the psyche of the consumer were answered prior to back to school flows arriving next week.  Consumers have indeed hit the pause button on discretionary spending relative to holiday 2009/first months of 2010, and this view is supported by the need for retailers to enact promotions in June and within the dollars per transaction metric data.  Most of our coverage universe reported lower average transaction value (AUR for American Eagle Outfitters was down a troubling double-digit percentage), in part to promos and sales mix, but also in our view to consumers saying "who, let's catch our breath here, we still are uncertain on the future."

Now What?

That is the million dollar question.  Do investors put cash to work on beaten down retail stories?  If inclined to do so, one believes that back to school will not match the doom and gloom.  Or, do investors avoid the sector altogether, believing that analyst earnings estimates are still too rosy for the definitive risks that present themselves?  Here is how we would think about investment opportunities in retail:

1. Comp inventory must be running below comp sales (now is not the time to be a hero and invest aggressively in inventory to rebuild sales)
2. Valuation compares very favorably relative to five-year averages and competitors
3. There must be a strong story underneath that could provide shock and awe to the stock

Aeropostale (ARO), Home Depot (HD), and The Knot (KNOT) is where our analytical radar is fixated on, with Urban Outfitters (URBN) also on the list for being best of breed.

Brian Sozzi
Wall Street Strategies