No Grinch Expected for Retailers

S&P foresees healthy holiday sales thanks to the drop in gasoline prices and low unemployment. Among the stock picks: Coach and PetSmart

Don't underestimate consumers' willingness and ability to spend this holiday season, despite a year of grappling with historically high oil prices and a weakening housing market. Standard & Poor's holiday retail sales outlook is fairly positive for 2006, with an estimated 4.5% increase in holiday retail sales for the traditional November to December period. Gift card redemptions and after-Christmas sales activity will likely add an additional 0.5% growth to our estimate. S&P's Chief Economist David Wyss sees general merchandise, apparel, and other store (GAFO) sales rising 5% in the fourth quarter of 2006.

In comparison, the National Retail Federation (NRF) is projecting a 5% rise in holiday retail sales, which is below the 6.1% increase reported in 2005. The International Council of Shopping Centers (ISCS) is expecting a 5.7% gain for the November to January holiday shopping season.

In its Annual Holiday Survey, published in October, market research firm The NPD Group found that consumers expect to spend about $728 on holiday purchases in 2006, vs. $681 in 2005 and $655 in 2004. S&P believes this may be a conservative projection, as consumers often underestimate their actual holiday spending. The NPD survey also indicated that consumers plan to spend more money this holiday season on clothing, toys, books, music, and fragrances, and less on electronics. Also, survey participants are expected to shop primarily at discount/mass merchant retail outlets this year.

Good Tidings

Moreover, given the promotional splash Wal-Mart (WMT; ranked 4 STARS, buy) initiated in October with toys and in November with consumer electronics, we expect attractive pricing to lure even the most reticent shopper.

We believe there are several positive influences that could drive holiday spending in 2006. One is extra shopping days. There are 31 shopping days this year, the longest span since 2000, when sales rose 4% as the U.S. economy entered a recession. Hanukkah is falling much earlier this holiday season (beginning at sundown on Dec. 16), and this should increase demand during the period.

Another driver is lower unemployment. The unemployment rate dropped 0.2 percentage points, to 4.4%, in October from September, while average hourly earnings were up 0.4 percentage points. This means that people could have more money to shop.

Also helping is the drop in gasoline prices. As of Nov. 6, average regular unleaded was selling for $2.20 per gallon, a 7.4% decline over year-ago prices. The recent price is also nearly 28% lower than this summer's peak gas price of $3.04. Facing less sticker shock at the gas pump compared to only a few months ago, we think consumers will have more dollars to spend at retail.

Fashion Flow

Also, consumer confidence is holding up. The Conference Board Consumer Confidence Index stood at 105.4, down modestly from September's 105.9 reading but up from 100.2 in August, its lowest level in 2006.

Another positive influence is the fact that gift cards remain a key driver of sales. According to the National Retail Federation's 2006 Holiday Consumer Intentions & Actions Survey, 56% of shoppers plan to give gift cards or gift certificates this year. Gift cards, which aren't counted as part of a retailer's sales until they're redeemed, accounted for 13.1% of 2005's holiday spending, according to the ICSC. Typically, about 60% of gift cards are redeemed through January.

The last factor is fashion trends. A steady flow of new styles and fashion brands is supporting apparel and accessories demand at department and specialty stores.

We think it would be unwise not to caution investors about the negative influences that could pressure holiday spending, particularly as many major retailers have already announced plans for more aggressive promotions in 2006. The first one is declining home prices. The slowdown in the housing market, combined with higher interest rates, continue to weigh on consumer spending, as homeowners have less increase in home equity to borrow against.

Bargain Hunters

S&P expects home prices to decline 5% in 2006. With consumers no longer using their home equity as an ATM, David Wyss expects to see attenuated growth in consumer spending as 2007 progresses, although not necessarily impacting the gift giving season.

A second risk is the negative savings rate. On a quarterly basis, the household saving rate has been negative for six consecutive quarters, after falling below zero in the second quarter of 2005 for the first time in the history of the data. Combined with higher interest rates and rising heating costs, consumer spending could lose steam.

Lastly, promotional activity could accelerate. Given the long shopping season, shoppers may postpone purchases to wait for a lower price. The only winners in pricing wars are consumers and price leaders. Therefore, given expected lean inventory levels and the deleterious effect that slashing prices has on profits, we expect sane behavior on the part of most retailers.

The following are our 5-STARS (strong buy) Holiday Picks.

Abercrombie & Fitch (ANF) With four specialty apparel brands in various stages of growth/maturity and a fifth in the incubator, we see Abercrombie & Fitch's diversification resulting in a doubling of sales while mitigating risk (see, 10/30/06, "Abercrombie & Fitch: Power Shopper"). International expansion provides an additional growth vehicle while enhancing the aspirational positioning of the brands. Our $88 target price represents potential upside of approximately 19% from the current price.

Risks to our recommendation and target price include negative same-store sales trends, and fashion and inventory risk. In terms of corporate governance, we are concerned about the presence of affiliated outsiders on the board.

Coach (COH) We continue to see ample opportunities for Coach as it further penetrates the estimated $4.8 billion U.S. market for luxury handbags and small leather goods, with an emphasis on frequent new product flow and new usage occasions. This season Coach will launch a new jewelry line, and will offer cashmere sweaters and fur trimmed puffer jackets to elevate the brand. Our target price is $48, for potential upside of approximately 22%.

Risks to our recommendation and target price include changes in consumer-spending patterns, and access to sourcing, fashion, and inventory risk.

PetSmart (PETM) We believe PetSmart has a strong opportunity to gain market share this holiday season in the pet-products industry, which is estimated to reach $38.4 billion in 2006, due to the transition of main rival PETCO Animal Supplies to private ownership. We think the company has a good chance to further distance itself from the competition with a broad holiday product selection. Our target price is $34, for potential upside of approximately 12%.

Risks to our recommendation and target price include a potential slowdown in consumer spending; the inability to find attractive locations for new stores; and the failure of PetSmart's service offerings to gain wide appeal.

Standard & Poor's Equity Research analysts Joseph Agnese, Jason Asaeda, Mark Basham, and Michael Souers contributed to this article