9/7/2010
By Brian Sozzi, Research Analyst

It's amazing how a batch of better than expected (note the results beat lowered analyst estimates) monthly same-store sales data could brighten, ever so slightly, sentiment on retail sector names.  Since the issuance of August same-store sales last week, the S&P Retail Index has unshackled itself from the early July to late August trading range, assuming a position to run to its first resistance point at 440 (currently resides at 420).  Let's say for a brief second the 440 mark is eclipsed on a closing basis, driven, perhaps, by positive analyst notes next week (following Labor Day shopping, and after kids return to school and maybe drag their parents back to the malls on the weekend).  If this were to transpire, the trading activity in the sector may be implying the holiday season will sidestep a scrooge like outcome.  Therefore, one would have to wonder, is a retail stock rally into the end of the year possible?  I assign a better than 50/50 chance of that rally ensuing, and here are some of my supporting reasons.

The S&P Retail Index shed 23% of its value from April 24 to July 2 as investors booked profits in one of the hottest sectors from the March 2009 market bottom.  With earnings visibility diminishing amidst a sea of souring economic reports, I can't blame investors for logging gains.  The carnage from the end of April to the start of July has left many names in retail land yielding a safe, and attractive, dividend yield (attractive relative to bonds, historical norms, and other sectors in the market).  For example, Home Depot (HD) yields 3.2%.  These dividend streams are safe, in my view, given that retailers are not planning to embark on store opening or hiring binges anytime soon, in addition to cutting significant structural costs in two years.  Investments for retailers are currently in technology to support greater online functionality and improved productivity within the existing store fleet.

First pieces to the puzzle: The relative value of retail stocks due to safe, and likely rising, dividends.  Share buybacks are a further factor in the equation.

Another consideration is sentiment, which is under wraps.  I have gone back to television video clips from July and August, zeroing in on consumer related segments.  The key takeaway...a consensus has been formed amongst the analyst community, meaning there are very few expecting, or seeing, positive reasons to put money to work in the retail sector.  When this happens, I certainly take notice.  The general consensus that has materialized is that excess inventories, tougher sales/earnings comparisons, higher supply chain costs, and volatile data create uncertainty.  Moreover, the holiday season is alleged to be dour.  While I cannot disagree that retail has issues on its hands, I am fast buying into the notion that the market has priced in a fair degree of potential negative news.  Top names in the sector are trading on forward P/E multiples in a range of 9x to 13x (below historical averages and other areas of the market), in spite of strong cash rich balance sheets and monthly/quarterly numbers that are circumventing disaster scenarios.

Will earnings growth moderate in 2H10?  Yes, as retailers experienced a strong snapback in 2009 off a depressed base of figures.  However, in a holiday environment where the consumer is cautious (cautious and having access to savings is different than cautious and no savings, which happened in 2008), and discounts at retail are nowhere near the mania that was 2008, can retail stocks creep higher?  I surmise yes, as the market has priced in next to nothing regarding 2011 financial possibilities.  As I see it, what's on tap for 2011 includes:

1. Zero, to tepid new unit growth for many equates to cleaner expense lines
2. Moderation in supply chain costs by mid year
3. EPS benefits of shuttering underperforming stores after holiday 2010
4. Flow through of more attractive lease rates
5. A consumer that may boast a 5% plus savings rate, reduced balance sheet leverage, and slightly renewed confidence
6. Tax credit for first-time homebuyers filtering through

I still think it's wise to go best of breed in retail, those with clear sales momentum, margin enhancement opportunities, international growth levers, and controlled inventories.  Turnaround plays, be weary.  That said, the sector may begin to attract contrarian investors given the value investing angle the sector is rounding into for 2011.

Brian Sozzi
Wall Street Strategies