8/5/2010
By Brian Sozzi, Research Analyst

Far be it from me to wax negatively in a discussion on retail.  I thoroughly enjoy playing the role of consumer, whether it's for me (Banana Republic, J Crew) or family members.  There is a certain thrill in finding that perfect fitting button down shirt for a night out on the town or that metallic Michael Kors bag for a special someone come the holiday season.  Obviously, my joy for the chase of apparel and accessory euphoria is shared by many of those throughout the country that are excluded from the 9.4% unemployment rate.  However, for those still struggling paycheck to paycheck (and this includes teens) or are unemployed, discretionary spending is far down the list of priorities.  Even amongst those gainfully employed, such as myself, there continues to be this persistent fear in the air (I am eager to see the 2Q numbers and FY guidance from Tiffany & Co...).  The fear resides in the long-term employment and overall financial prospects of individuals, and this fear has reared its ugly head in the latest consumer confidence measures.  It's also on display within the recent personal income and spending data, which fleshed out a savings rate of 6.4%.

Ponder that savings rate figure for a brief second.  With that type of savings rate, it essentially equates to fewer dollars being spent at the nation's malls, outlets, grocers, and movie theaters.  In July, customer traffic continued to be lower at high profile retail chains;  Gap, Banana Republic was but a few to report soft traffic for the month.  Where there is sluggish traffic there will be retailers frightened about aging inventory sitting in the stock room, particularly around a major selling period such as back to school.  As a result, discounts ensue.  We received average unit retail price declines (AUR) ranging from down low-single digit percentage to down 15% (talk about deflation!); these declines only happen if the traffic is not there and retailers feel a need to move goods.

If one digs deeply into the July sales data the message is apparent; the consumer, after spending somewhat freely in 1H10, has paused.  Whether it's due to the recent economic news or something else on a personal level, sales trends in the latter half of July were weak.  The momentum into the peak back to school season is absent, and this is one reason why the sector is selling off on today's news.  There is uncertainty prevalent.  Consumers have called the bluff of retailers, balking at the full ticket prices on back to "essentials."  Households are waiting for the discounts offered by retailers in August that will be matched up to tax holiday events in many states.

So if you are an investor looking to capitalize on the 16% pullback in the S&P Retail Index (RLX) since late April what is the course of action?  First, let's place all of the cards on the table:

1. Many retailers missed widely 2Q consensus revenue forecasts.  Volume existed to a certain degree but the pricing aspect remained very competitive.
2. Earnings raises for 2Q were few and far between and when the raises did occur, they were only in line to consensus estimates.
3. Companies are still missing consensus comp estimates; very little consistency month to month.
4. 2H10 is a crapshoot; for some the demand momentum is there but will be met by higher COGS, increased operating expenses, and the conundrum that is difficult year earlier comparisons (makes growth appear slower).
5. Inventory management turned sloppy for select specialty retail companies, therefore expect promotions and gross margin pressure.

I have gotten creative in how I suggest retail stocks for this back to school season.  There is just too much volatility in the numbers to make a blanket call.  Key investment criteria include:

* Product that is either holding at full price longer than competition or holding at first markdown.
* Low inventory levels.
* Exposure to Europe (numbers have been strong from Polo Ralph Lauren, Columbia, Timberland; counter to industry concerns that were baked into share prices)

Top Picks

Guess (GES; long)
* Stock has sold off since April high on fears European demand would dry up.  Thus far in the earnings season, those retailers that have exposure to Europe have reported strong results (COLM, RL, TBL) as noted above.  I think Guess is one the best run specialty apparel companies and has a product assortment that continues to be leading-edge (not to mention, the cast of Jersey Shore looks as if they shop there).

Coach (COH; long)
* Reported earnings early in the week.  While I think there were some valid concerns within the report and commentary, the company has a strong growth engine in China and a very powerful balance sheet.

Pacific Sunwear (PSUN; short)
* I expect them to have the worst back to school shopping season among teen apparel retailers; the assortment is just not there and I don't think the new management team has properly articulated its turnaround strategy to analysts and investors.  Persistent losses have me concerned about the company's cash levels and what that means to getting product from suppliers.

Brian Sozzi
Wall Street Strategies