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A Crimp on Holiday Cheer?

By Frank Benassi While the 2004 holiday season promises to be merry for the U.S. retail sector, favorable comparisons with last year's results -- the strongest since 1999 -- will be a stretch. Although Standard & Poor's Ratings Services believes retail prospects remain good, concerns about the economy, geopolitical issues, and energy prices may have a moderately dampening effect on sales for the upcoming season.

Last year's holiday sales (November, 2003, to December, 2003) increased a solid 5% over the prior year. We estimate that this year's increase likely will be no better, falling somewhere in the 3.5% to 4.5% range. The critical holiday-sales period typically accounts for about 23% of retailers' annual sales and an even greater piece of their profits.

THE RESULTS. We recently polled top retail managers for their views on the upcoming holiday season and their outlooks for next year. The results of our survey indicate optimism for holiday sales, stemming from an improved economic climate, even though recent trends in consumer confidence are not as positive as they were earlier in the year. Compared to last holiday season, 40% of the managers polled expect sales for the 2004 holiday season to be stronger. However, nearly 46% of the survey respondents have a less favorable outlook now for the 2004 holiday season, compared with their outlooks six months ago.

First, a word about the survey. An e-mail message containing a link to a Web-based survey recently was sent to senior financial executives at 175 retail companies. Of those, 22 sent back surveys. We believe this number of respondents (almost 13% of the survey base), while fairly small, offers the opportunity for a directional reading of the opinions of the marketplace. Of the 22 respondents, 12 are retailers with more than $1 billion in revenues. On a sector basis, 6 of the 22 respondents are department stores, discounters, and/or supermarket/drugstores; 12 are specialty retailers; and the balance are restaurants.

MIXED ECONOMIC SIGNALS. On the economic front, signals for continued consumer spending are a bit less positive, as consumer confidence has declined since very strong June and July Conference Board survey results. Perceptions of an improving job market are vying with concerns about rising interest rates and higher energy costs. Also, same-store sales since May generally were softer than expected, notably at Wal-Mart Stores (WMT) and Target (TGT). In a continued trend, high-end retailers continued to significantly outperform the overall sector.

A majority of survey respondents (57%) have indicated that same-store sales plans for the 2004 holiday season reflect levels between 2% and 5% higher than last year, while 25% expect sales to be flat or at decreased levels.

Consumers continue to lead the economy, despite the drag of higher oil prices. Although households are now spending an average of 5% of after-tax income on energy (up from 4% in early 2002), they have compensated by reducing saving, rather than cutting back on other spending. Consumer spending is expected to rise 3.7% this year (2000 chain-weighted dollars), from 3.3% in 2003. Next year, growth is expected to slow to 3.1%, as the boost from tax cuts disappears and higher oil prices continue to bite. The savings rate is expected to reach a new record low, of 1.2% in 2004, down from 1.4% in 2003.

MOOD TO BUY. GDP results for the third quarter of 2004 also reflected retail sales strength, including 4.9% real consumption growth. The domestic deflators appear to have been only modestly affected by the sizable run-up in wholesale energy prices. Consumer spending was extremely strong: it rose 4.6%, as was expected, given the strong retail sales data. We expect sales growth in the fourth quarter to come in slower than in the third, but to clock in at a still-solid rate of 3.8%.

Excluding autos, October retail sales rose an impressive 0.9%, and well above expectations of a 0.5% gain. Continued strength is reflected in year-over-year numbers, as total retail sales are up by a strong 8.5% excluding autos.

To confirm the buying mood, the University of Michigan reports that consumer sentiment rose to 95.5 in November, the best reading three months, and above the October 91.7 reading and expectations of 92.5. Lower gas prices, improving labor markets, and a postelection bounce helped explain the rise.

SQUEEZE ON MARGINS. While a solid sales outlook is expected to translate into improved profits for many retailers this holiday season, promotions are expected to be heavy as usual, but not greater than last season. The Standard & Poor's market survey indicated that an overwhelming majority of retailers (71%) expect 2004 holiday promotions and sales to start at about the same time as last year. In addition, the majority of survey respondents (64%) expect promotional levels for the 2004 holiday season to be about the same as last year.

Although prospects for sales growth for the upcoming holiday are favorable, and discounting is expected to remain stable (albeit at high levels), cost pressures continue to squeeze retailers' margins. Standard & Poor's market survey confirmed that an overwhelming majority (73%) of retail executives believe labor-cost increases -- such as workers compensation, employee benefits, and health-care costs -- are not leveling off. To reduce costs, a majority of the respondents indicated they would increase the amount their employees pay for health insurance and pressure for better lease terms.

Apparently taking a cue from last year's good results, a majority of the survey respondents (64%) indicated their companies are positioning 2004 holiday season inventory about the same as last year's. Looking beyond the current holiday season, our market survey clearly indicates a positive retail outlook and business environment for 2005. Relative to 2004, most survey respondents (55%) expect 2005 to produce a stronger retail environment. In addition, the majority (76%) expect an increase in company profits in 2005.

NEW YEAR'S CHALLENGE? Our early view of 2005 also is favorable for retailing, but we are a bit less enthusiastic than the survey results. This reflects our view that interest rates gradually will rise next year, and that consumers are spending at already high levels, given the low savings rate and high consumer household-debt-service obligations. Consumers likely will keep spending. But without the benefit of a strong stock market, further rapid home-price appreciation, or the stimulant of special tax refunds, 2005 is likely to be a somewhat more challenging year for retailers.

What does that mean for the credit quality of U.S. retailers? The improved economic outlook and stronger sales performance to date generally should translate into improving underlying credit trends in the sector for 2004. Most S&P ratings outlooks in the department store sector have been revised to stable, from the strong negative bias of last year.

However, M&A activity and other discretionary decisions, such as for special dividends and share repurchases, could continue to have a negative impact on credit quality for certain retailers. Ratings recently were lowered on CVS (CVS) and May Department Stores (MAY) because of large acquisitions. Similarly, several restaurant ratings have been downgraded or placed on CreditWatch with negative implications because of debt-financed dividends to shareholders, or the proposed issuance of income deposit securities. Benassi is a senior features editor for Standard & Poor's Securities Services

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