Department Stores: Fewer and Tougher

Consolidation will continue to winnow the weak, leaving survivors better off. S&P's top choice: Sears

By Sam Stovall

One of the most recent industries to register on the list of those with top Standard & Poor's is department stores. Investors, anticipating an economic recovery, have marked up the stocks. Year-to-date through Mar. 15, the S&P Department Stores Index rose 4.8%, while the S&P 1,500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) gained 2%.

Despite investors' more upbeat stance, S&P analyst Karen Sack points out that the industry faces a number of challenges. Department stores did not fare well in 2001. Same-store sales were hurt by weak apparel demand and highly competitive pricing. In addition, the slowing economy and higher unemployment left consumers with less money to spend on discretionary items. Soft sales should continue in the first half of 2002, says Sack.

RETAIL WOES.

  Midpriced department-store chains have been losing market share to discount and specialty stores. As a result, notes Sack, cost-cutting will continue to be a priority for most chains. Keeping a tight rein on inventories has also become increasingly important as companies attempt to control margin-eroding markdowns, as well as offer shoppers the desired merchandise.

In addition, more store closings are looming. Companies have been rationalizing their assets by closing underperforming stores and changing their mix to higher-margin products. The upshot of the rampant industry consolidation, says Sack, is fewer -- but stronger -- players.

Still, it won't be easy for retailers. One obstacle: Demographic shifts in the U.S. population. An older consumer is less interested in fashion, according to the analyst, and spending priorities change with age. With price an overriding issue, combined with the multitude of retail outlets from which to choose, buyers are in the driver's seat, she notes. S&P projects consumer spending to increase only 1.6% in 2002, consisting of a 0.4% rise in consumer durables (sturdy goods like appliances), a 1.1% advance in consumer nondurables (items like clothing), and a 2.1% gain in consumer services.

Which companies will fare the best in this environment? Sack says the industry's consolidation over the past decade enhances the market position of the strongest department-store chains. They have lowered their operating expenses by merging divisions, eliminating back-office staff, and streamlining operations. The greater use of technology to manage inventory more carefully helped retailers ring up moderate earnings gains in 2001. In addition, companies have developed Web sites to attract new customers and boost sales to existing ones.

Sack's top pick in the group right now is Sears (S ), which is ranked 5 STARS, or buy. Although the company posted a 3.1% drop in February same-store sales, she believes that it will be successful in lowering its overall cost structure through better inventory management.

S&P Relative Strength Rankings

These industries carry six-month relative strength rankings of "5" as of Mar. 15, 2002 -- meaning that they're in the top 10% of the 115 industries in the S&P Super 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600) based on prior six-month price performance.

Industry/Sector Largest Company (Market Cap.) S&P STARS* Rank
Air Freight & Couriers/Industrials FedEx (FDX) 5 STARS
Commodity Chemicals/Materials Lyondell Chemical (LYO) 3 STARS
Computer & Electronics Retail/Consumer Discretionary Best Buy (BBY) 4 STARS
Department Stores/Consumer Discretionary Sears (S) 5 STARS
Fertilizers & Agricultural Chemical/Materials IMC Global (IGL) 5 STARS
General Merchandise Stores/Consumer Discretionary Costco (COST) 5 STARS
Home Furnishings/Consumer Discretionary Leggett & Platt (LEG) 5 STARS
Homebuilding/Consumer Discretionary KB Home (KBH) 5 STARS
Internet Software & Services/Information Tech. Yahoo (YHOO) 3 STARS
Semiconductor Equipment/Information Technology FEI Co. (FEIC) 5 STARS
Specialty Stores/Consumer Discretionary Barnes & Noble (BKS) 5 STARS

*S&P's ranking system for the appreciation potential of stocks over a 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).

Stovall is chief sector strategist for Standard & Poor's

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