Retail: There Goes The Gravy Train

-- Rising interest rates and inflation will probably leave consumers with less to spend -- Deep discounters such as Wal-Mart will keep the price pressure on rivals

After packing their closets with new clothes, supersizing their TVs, and fueling their SUVs with costly gas for the past year, Joe and Jane Consumer are getting tapped out. "The real question," says Standard & Poor's (MHP ) Chief Economist David A. Wyss, "is can consumers keep it up, given that they're already spending all they have?"

The answer: not the way they have been. In the new year, total U.S. sales will grow, but far more slowly than last year, as consumers rein in their spending in the face of rising interest rates and nascent inflation. Retailers will sell $1.06 trillion worth of general merchandise, apparel, furniture, and other products (excluding cars and food). That's 3.8% more than last year, predicts S&P, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ). Not bad, but it's well short of last year's 6.2% increase over 2003.

Rising interest rates are already beginning to bite into spending. The percentage of disposable income that U.S. households pay out to service mortgage and consumer debt crept to 13.32%, near its all-time high, at the end of the third quarter. With the benchmark federal-funds rate expected to climb from today's 2.25% to 4% by yearend, consumers' variable-rate credit-card balances and mortgages will track upward, too, eating up more cash. At the same time, higher rates will slow home-mortgage refinancings and home-equity loans, pinching off a source of spending that in recent years has fueled countless renovations -- and growth for the likes of Home Depot Inc. (HD ) and Lowe's Cos. (LOW ).

Impending inflation, led by energy prices, may also dampen spending. The 20% increase in gas prices in 2004 left drivers with less to spend. And while energy prices are expected to moderate in the new year, problems in the Mideast, or a demand spike, could send prices skyward. Each 10% increase in the year-over-year gasoline price knocks about a third of a percentage point from chain stores' sales growth, according to the International Council of Shopping Centers. That's a big hit when many chains struggle for just 2% to 3% growth.

As retailers adjust to this new consumer reality, they face a familiar foe in the form of Wal-Mart Stores Inc. (WMT ). The giant continues to push prices relentlessly downward, affecting retailers in other markets. "Even the Neiman Marcus shopper occasionally buys socks or sweatpants from Wal-Mart," says S&P retail analyst Marie Driscoll. With 295 new or expanded Wal-Mart stores and Supercenters scheduled to open in 2005, the Bentonville (Ark.) giant will further extend its reach through the year.


Among the few able to outflank Wal-Mart have been "dollar stores" such as Dollar General Corp. (DG ) and Dollar Tree Stores Inc. (DLTR ), which have managed to undersell the juggernaut by stocking huge amounts of cheap goods, including discontinued merchandise, often sold for $1 or even less. When Wal-Mart fails to slash prices enough on fast-moving merchandise such as DVD players, sales suffer -- as they did in the past holiday season.

At the high end of the retail market, luxury retailers such as Coach Inc. (COH ) and Neiman Marcus Group Inc. (NMG ), which prospered in 2004, will find this year less robust. Middle-income consumers who might have splurged in recent years will be less likely to do so now. These stores' wealthy customers face falling stock returns as interest rates rise.

In the middle market, the outlook is mixed. In the first part of the year, specialty apparel chains such as Gap Inc. (GPS ) face tough comparisons with the first quarter of 2004. Then, the early arrival of spring weather fueled full-price clothing purchasing, says Wells Fargo Securities (WFC ) retail analyst Mark Montagna.

Meanwhile, retailers of all stripes are pushing forward with cost-cutting strategies, and coming up with new ways to stock distinctive merchandise. Many stores are rolling out higher-quality private-label lines, notably in the crucial women's apparel segment. With private-label goods, stores can undercut national name brands yet still make a healthy profit. As health-care and energy costs inch upwards, retailers will work to cut inventories to prevent margin-eating markdowns and continue to find savings in areas such as payroll costs by using part-time workers.

For those who can't master these tricks, bankruptcy looms. Financially troubled chains ranging from teen retailer Gadzooks Inc. to Kmart Corp. (KMRT ) will continue to close stores. But that won't necessarily lessen the unrelenting competition in the industry, both online and offline, from new and fledgling retail concepts. "There's constant segmenting with new stores," says Montagna. Abercrombie & Fitch Co. (ANF ), for one, recently launched Ruehl, a clothing chain aimed at women in their twenties.


Online sales growth will continue to outpace traditional retailers, but by less than in recent years. JupiterResearch (JUPM ), in Darien, Conn., estimates that e-commerce sales, excluding autos and travel-related transactions, will rise 19%, to nearly $80 billion, in 2005 -- about 4% of all retail sales. That's a healthy increase, but it's lower than 2004's 25% rise, in part because the number of customers new to the Web is shrinking. Sales at the market-leading e-tailer, for example, are forecast to grow by 19%, to $8.1 billion, in 2005, down from a 30% rise in 2004.

E-tailers are confronting many of the same challenges as their traditional competitors. In the past, they could count on picking off customers from bricks-and-mortar stores. No longer novel, Web retailers attract fewer defectors these days and instead increasingly "compete with one another for existing customers," says Jupiter analyst Patti Freeman Evans. That's partly because the quality of the shopping experience is improving at bricks-and-mortar retailers. As the the bar rises, e-tailers and real-world stores alike will be chasing choosier shoppers with fewer dollars.

By Louise Lee in San Mateo

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