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Retailers: Back-to-School Outlook

S&P analysts expect to see more trading down and focus on value. Favored stocks include Wal-Mart and Best Buy

From Standard & Poor's Equity ResearchIn many parts of the U.S., Labor Day marks the start of the school year—and sometimes the last-minute dash to buy pencils, backpacks, and other necessary supplies.

For this year's back-to-school outlook for retailers, the macro-economic backdrop leaves much to be desired. Consumer sentiment is near its 25-year low, reflecting inflationary pressures, weakening employment trends, and volatile financial markets. Despite a recent 22% ($32) drop in the price of oil to $113 per barrel since its July high, it remains a whopping 58% above the year-ago level and has cut into discretionary spending, most explicitly due to the average price of gas hovering at $3.81 per gallon, up 37% year-over-year. Higher energy costs have also led most consumer products companies to raise prices due to cost pressure on raw materials or distribution.

Although 2008 is working out to be a year of necessities, not frivolities, we believe there's a silver lining: Most back-to-school purchases are necessities. This year we expect to see more trading down and a focus on value as consumers come to terms with reduced spending power. The implications for holiday spending are not good, by our analysis, and in fact, we see domestic per capita spending declining during 2008's holiday season (November to January), offset in part by international shoppers at flagship locations boosting the aggregate spending.

However, for now we focus our attention on the back-to-school season. With the National Retail Federation (NRF) projecting $51.4 billion (up 2.4%) in back-to-school/back-to-college (BTS/BTC) purchases this year, the following are S&P Equity Research's stock picks and pans for the 2008 season.

Our picks are:

Abercrombie & Fitch (ANF): ranked strong buy

American Eagle Outfitters (AEO): ranked strong buy

Best Buy (BBY): ranked strong buy

Deckers Outdoor (DECK): ranked buy

J.C. Penney (JCP): ranked buy

Nike (NKE): ranked buy

Under Armour (UA): ranked strong buy

Urban Outfitters (URBN): ranked buy

VF Corp. (VFC): ranked buy

Wal-Mart (WMT): ranked buy

Our pans, which are all ranked sell, are:

Dillard's (DDS)

Sears Holdings (SHLD)

Timberland (TBL)

Each of these companies has been selected based on its exposure to favorable (and unfavorable in the case of the three sell recommendations) trends the S&P Consumer Discretionary Retail group expects this fall. For example, strong consumer electronics demand underpins our Best Buy recommendation, while contracting disposable income supports our positive stance on Wal-Mart.

We see VF Corp. benefiting from its leading backpack and denim market positioning and J.C. Penney from being a leading BTS shopping destination in the mall, while downtown, Urban Outfitters clothes the college-bound with the latest "must-have" fashions. Under Armour is the leading supplier of team sports apparel and is growing its product lines and consumer base.

The Big Picture

In our view, the major negative for the economy is that home sales and prices continue to slide. S&P believes we are more than halfway through the downturn in home sales, but prices are not expected to bottom out until late 2009. Lower housing values have restricted the ability of households to withdraw home equity through cash-out refis or home equity loans, curtailing consumer spending.

Other negative trends include lower payrolls, lackluster consumer confidence, food and energy inflation, and high gasoline prices. With housing values and investment portfolios down, consumers are less "wealthy" than in the recent past.

In sum, although the current data are still mixed, we believe that it sure feels like a recession. S&P economists estimate the likelihood of a recession over the next 12 months at 80%.

On the positive side, school enrollment trends support an increase in BTS spending. The NCES sees total public primary and secondary school (grades pre-K through 12) enrollment reaching a record 49.812 million in 2008. According to the NRF, many parents plan to spend some of this year's economic stimulus rebate checks (up to $1,800 per family of four) on household electronics (computers and cell phones). Digital phones, including Apple's (AAPL) new iPhone, cameras, and MP3 players are likely to augment traditional BTS/BTC PC demand and should drive double-digit category growth, by our analysis. And in 2008, 13 states and the District of Columbia are providing a temporary reduction in state (and sometimes local) sales taxes for retailers for BTS shopping.

Psychological Relief

The wild card is energy costs. If current trends continue, gasoline and heating costs could decline, as well as prices of petroleum-based products, which could provide psychological relief and perhaps translate into higher consumer spending.

Retail analysts and investors watch the BTS selling season closely to gauge consumers' willingness and ability to spend. The strength of the season's sales has historically been a good leading indicator for the biggest spending holidays, Christmas and Hanukkah, when approximately 25% of retail sales occur.

This season is artificially supported by the tax rebates, and S&P anticipates the benefit of that $106 billion injection will be largely complete by the onset of holiday shopping this November. In fact, we anticipate the reduced per capita spending we are projecting for this BTS season will be even more visible in three months when consumers shift to more discretionary holiday purchases. We believe the willingness to spend in the current environment is waning; moreover, willingness is not enough, as the requisite purchasing power is attenuated.

Approximately 75% of BTS/BTC spending occurs in the four weeks leading up to the first day of school, or during August, though advertising campaigns start as early as the Fourth of July and many high school and college students wait until school is under way before making apparel purchases (to determine the cool silhouette/denim wash/graphic tee).

The Bright Spots

While 2008 is shaping up to be a challenging BTS/BTC season for all retailers, in our view, we expect Best Buy and Wal-Mart to post superior sales results as the leaders in their respective channels.

With consumers looking to stretch their disposable income, we believe Wal-Mart is poised to take market share across its major product categories with its everyday low pricing strategy and strong convenience factor. Moreover, despite our estimate of cost inflation in food and general merchandise, Wal-Mart has strategically lagged competitors in passing along cost increases, allowing for greater value to the consumer. Wal-Mart's new marketing slogan—"Save Money, Live Better"— should further enforce its low-priced image with consumers, in our opinion.

We believe Wal-Mart is well positioned to pick up a larger share of current customers' wallets while attracting new customers in the current economic environment. We see the company benefiting from a back-to-basics approach in apparel and increased branded product offerings in home and electronics.

Traffic trends to Wal-Mart turned positive this year as consumers opted for its low food and grocery prices (at least 15% below traditional food retailer competitors). Once in the store, customers tend to shop a wider variety of general merchandise categories to take advantage of the company's one-stop shopping convenience, to save on gas costs, and to benefit from Wal-Mart's value pricing.

Wal-Mart's Refocused Efforts

Wal-Mart is poised to gain market share in apparel in 2008, by our analysis. Average transaction growth is benefiting due in part to the company's refocused efforts on basics and away from its more fashion-forward offerings in late 2006. Having moved lower-priced (under $10) offerings back to aisle displays, we look for more consumers to be drawn into this category, reinvigorating sales.

In the home and electronics categories, Wal-Mart hopes to woo customers with an increased offering of national brands, such as Apple, Sony (SNE), Garmin (GRMN), and Dell (DELL) in electronics and Better Homes & Gardens, Dyson, Oneida, and Canopy in the home category. Wal-Mart has addressed the shopping experience as well, with improved displays and better lighting, while technology initiatives have led to shorter wait times during checkout.

As the leading consumer-electronics retailer in the world, Best Buy stands to benefit, in our view, from increasing demand, including significant strength in notebook computers; timely rebate checks; solid execution and differentiation leading to market share gains; and an advertising campaign geared to capture incremental spending.

Notebook Computer Boost

Consumer electronics is one of the few areas in retail that has been growing rapidly this year. In late July, the Consumer Electronics Association (CEA) increased its 2008 forecast for industry revenues to growth in excess of 7% from an earlier projection of 6.1%. In addition, while average selling prices (ASPs) continue to decline (as is the norm in electronics), unit sales growth for all major products is expected to increase. The CEA projects that notebook computers, the predominant electronics purchase for college students, will post unit growth of 28% in 2008. Other product categories that we expect to be strong during the BTS/BTC season include mobile phones, MP3 players, and video-game equipment.

However, not all forecasts are as rosy. The NRF has projected a 5% decline in total BTS/BTC spending on electronics, to an estimated $16.2 billion. This survey found that parents of children enrolled in kindergarten to 12th grade plan on spending 17% more on electronics purchases than they did last year, but due to a rise in students staying at home, per capita spending for college students is expected to decline 18%.

Although we tend to put more stock in the overall projected strength in consumer electronics this year (over a relatively small sample for weak BTS spending on electronics), we think execution remains paramount for retailers looking to drive positive sales results. So, despite the potential for weak sales of electronics in the BTS/BTC season, we remain confident that Best Buy will continue to capture market share from weakened competitors. While its primary competitors have struggled since consumer spending began slowing in 2007, Best Buy has thrived. It posted record sales and profits in fiscal year 2008 (ended February 2008) and is off to a strong start in fiscal year 2009 with a 4% same store sales gain in its most recent quarter (May).

Seasonal Stock Performers

Over the past 19 years, the S&P Retail Index tends to outperform the S&P 500 index in February, March, May, and November, with the greatest relative performance in March and November. We believe this pattern can be explained by forward-looking investors anticipating the holiday season, given the importance of November and December (approximately 20% to 25% of annual sales and about 30% to 35% of annual profits). In our view, the excess returns of February and March are likely a function of investors' response to the fiscal year (January) results and outlooks for the coming year.

Though we consider the BTS selling season to be important to retailers, we do not view it as critical to the financial success of the year, as investors typically become more interested in retail stocks leading up to the holiday season. We think this explains the relatively lackluster performance of retail stocks in July and August. (Note: Past performance is not necessarily indicative of future results.)

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