Back-to-School Season Gets an `F'

So far, shoppers aren't fueling the second-half rebound that retailers need--and were counting on

Perhaps you've seen the television commercial for Staples Inc. (SPLS ) office-supply stores. A smiling father dances though the aisles, plunking pencils and notebooks in a shopping cart as he gleefully anticipates sending the brats back to school. His kids trail glumly behind him. The commercial's theme music: "It's the Most Wonderful Time of the Year."

Alas, if only it were so for the nation's retailers. Just a few months ago, many merchants were predicting a robust second half for 2002. But based on early results from the back-to-school season, the next six months could be more of a slog than a waltz. Excluding cars and gasoline, retail sales slipped 0.2% in July. And weekly surveys show that early August receipts are flagging as well--down as much as 1.6% from July. Federated Department Stores (FD ), the Gap (GPS ), and Sears Roebuck (S ) all say sales were worse than expected in the first two weeks of August. Even discount chains Target Corp. (TGT ) and Wal-Mart Stores Inc. (WMT ), which have been gaining market share from department and specialty stores, said sales gains were running at the low end of their forecasts.

If that were not enough, consumer confidence seems to be eroding. On Aug. 27, the Conference Board announced that its consumer confidence index was plumbing a nine-month low. The same day, Merrill Lynch & Co. analyst Daniel D. Barry downgraded the entire retail sector thanks to reduced expectations for the second half. The news sent retail stocks--which have been sinking since May--down across the board.

All of this could have serious implications for economic recovery. Consumer spending on goods besides cars--which are selling briskly thanks to 0% financing and other incentives--is projected to barely rise in the third and fourth quarters, after adjusting for inflation. That means other sectors of the economy, especially business spending on equipment and inventory building, will have to kick up a notch if the economy is to maintain the 3% annual rate of growth it has enjoyed in the past three quarters. "There hasn't been a recession or depression where the consumer hasn't cushioned the downside and restrained the upside," says Steven Wieting, senior U.S. economist at Salomon Smith Barney.

For retailers, a consumer pullback during the crucial back-to-school period could mean a very unmerry Christmas. Because stores order goods up to a year in advance, it's hard to switch gears if demand slows. In recent months, retailers have been rebuilding inventories based on earlier predictions of a robust second half. In fact, in July, store inventories, excluding cars, were up for the third month in a row--something that hasn't happened since mid-2000.

But if demand doesn't accelerate for apparel, personal computers, and compact disks, retailers may find themselves with overcrowded shelves during the holiday season. The result: profit-killing discounting and promotions. Marc Gerstein, director of investment research at earnings tracker Multex.com Inc., reports that in the past month, analysts have adjusted their third-quarter earnings estimates downward for retailers more than twice as often as they have raised them.

Already, stuff that would normally go on sale late in the fall is being deeply discounted. Sheila Harvey, a mother of three, took advantage of a buy-one-get-one-half-price deal at the Foot Locker Inc. (Z ) store in the Beverly Center mall in Los Angeles on a recent Monday night. "Everybody got two pairs," she said, pointing to her kids, who were carrying bags almost as big as they were. "We're done for back-to-school shoes." Jeans are also going for a song. The Gap has been offering $20 off selected styles--a discount of as much as 40%. Says Elana Cheeves, a mother of two, shopping recently at the Gap's Old Navy store in downtown San Francisco: "You never used to see $20 jeans at Old Navy."

For some retailers, the discounting won't be so painful. Abercrombie & Fitch (ANF ) and Limited Brands have promotions in which buyers pay full price for one item and get a second one at a discount. Such price-cutting minimizes the hit to the bottom line. But in the ultracompetitive--and fickle--teen apparel sector, retailers are turning to more unusual measures. Trendy chain Wet Seal Inc. (WTSLA ) is launching a promotion in September that gives shoppers buying a compact disk at Trans World Entertainment's F.Y.E. stores (TWMC ) a 15% off coupon for Wet Seal. "I get our brand in their 500 stores," says Wet Seal's director of marketing, Steven Strickland. "If it works, you'll see more of those."

In an attempt to boost back-to-school sales, Best Buy Co. (BBY ) and Circuit City Stores Inc. (CC ) are waging a price war. At Best Buy recently, a 2-gigahertz Compaq computer bundled with a Hewlett-Packard printer cost $1,099. That's a $500 discount from two weeks ago, after in-store and manufacturer rebates. But the lower prices and weaker sales are hurting electronics sellers. Best Buy cut its earnings estimates twice this quarter, reducing its target by nearly a third on Aug. 8. RadioShack Corp. (RSH ) said that after a strong July, August sales have dropped dramatically, forcing the electronics retailer to lower its third-quarter earnings outlook by 30%. "We've seen 18 months of no-interest financing," says Stephen Baker, a consumer-electronics analyst at market researcher NPDTechworld. "We've seen rebate on rebate on top of rebate."

Not all retailers are suffering. Target Corp. (TGT ) says it's doing particularly well with a new line of colorful furnishings, such as lamps, wastebaskets, and sheets, created by designer Todd Oldham. They're especially popular in student dormitories, the company says. Other youth-friendly items flying off the shelves at apparel sellers include hooded sweatshirts, denim, and short-sleeve shirts. And while some youth-oriented outlets are hurting, others are hanging in there. "Some of these skateboard-oriented retailers like Pacific Sunwear of California Inc. and Quiksilver Inc. will do well," says Jeffrey P. Klinefelter, a research analyst at US Bancorp Piper Jaffray Inc.

But weaker sales spell trouble for much of the industry, which is still suffering from overcapacity after a store-building boom in the late 1990s. The total amount of U.S. retail store space has risen 75% in the past decade, to 5.6 billion square feet. The overcapacity is especially noticeable in teen and pre-teen apparel. Companies that expanded rapidly and are suffering include American Eagle Outfitters (AEOS ), Wet Seal, and Hot Topic (HOTT ).

For merchants that are already in trouble, this year could be the death knell. It's not an exaggeration to say that the rest of 2002 is critical for Kmart Corp. (KM ), which is now targeting Hispanic shoppers in the wake of its January bankruptcy-protection filing. The Gap, too, is struggling. In mid-August, the company was already projecting third-quarter results to be below last year's. Its back-to-basics approach--khakis, jeans, and white shirts--doesn't seem to be resonating. "Fashion is selling," says Emme P. Koz-loff, an analyst at Sanford C. Bernstein & Co. "But it will not be strong enough to offset extreme weakness in traditional basics."

So what will retailers do if demand does soften in the coming months? Salomon Smith Barney hedge fund manager and former retail analyst Richard Church says it's too early to expect retailers to start canceling orders. But he expects stores to keep inventory flat this year. "I never thought the second half would be good," says Henry Kaczmarek, a retail analyst at American Express Financial Advisors. "We're more bearish now." At the same time, retailers will likely continue what they've been doing for the past two years: cutting staff and learning to run their warehouses more efficiently.

Much will depend on the American consumer. For two years, shoppers have largely kept the economy going. But the combination of rising oil prices, surging personal debt, and growing fears that this will be a jobless recovery could finally convince consumers that it's prudent to pull back. And a host of other factors could also leave malls quieter this holiday season. Because states are cutting their budgets, Florida, for one, is not offering any sales-tax holidays this year, as it did in 2001. Even the calendar isn't helping: There are six fewer shopping days coming between Thanksgiving and Christmas this year than there were last year.

So with wary, bargain-hunting consumers willing to wait them out and with too much competition next door, retailers may be singing the blues well into the New Year.

By Christopher Palmeri in Los Angeles, with Robert Berner in Chicago, and bureau reports

— With assistance by Robert Berner

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