Retail Stocks: Picking 2010's Winners and Losers

Retailers are ending 2009 with few guideposts to indicate what's ahead. For those trying to gauge the mood of the U.S. consumer, the 2009 holiday season has given no strong signal. Sales results seem to be meeting most predictions that this year would show little change from 2008's dismal sales and traffic numbers. With less than two weeks remaining before Christmas, "I don't think we're going to be finishing holiday season with a bang," says Doug Hart, a partner in the retail and consumer products practice at consulting and accounting firm BDO Seidman. Although economic numbers have improved in the second half of 2009, there are few signs of sustainable job growth. Measures of consumers' mood have stabilized but haven't bounced back, as the stock market did in 2009. "Retailers are not really getting good signals. They're not seeing a trend," says Georgetown University marketing professor Prashant Malaviya. Planning for the future is important for retail businesses that run on inventory. So the lack of a clear trend is probably alarming retailers, he says. retailers strain to offer discountsThe past year or two has favored discount retail chains, such as Wal-Mart (WMT) and Target (TGT), over their pricier rivals. Recent sales figures at Gap (GAP) demonstrate the trend. The company's bargain chain Old Navy saw same-store sales rise 6% from a year ago in November, but its more expensive chains, Banana Republic and Gap, saw same-store sales drop 4% in North America. Consumers' frugality has caused retailers to shift strategies, using more discounts and promotions to get them in the door. However, nondiscount chains know that they can't simply morph into TJX Companies (TJX), the owner of T.J. Maxx and Marshalls, which saw same-store sales jump 8% last month. "It's hard to reposition your chain or brand as a whole," Hart says. If chains slash prices or offer lower-quality goods, they hurt their brand prestige. But if they don't cut prices, consumers go to discounters. In 2009 and into 2010, retail chains will be seeking creative solutions to this conundrum. For example, Macy's (M) and other retailers have held special sales days, rather than cut prices across the board. If done right, it may be a way to "do promotions in a way that doesn't create a sense of entitlement in the consumers' mind," Malaviya says. Despite sluggish sales, retail chains have found ways to improve their businesses over the past year, industry experts say. current promotions are less desperateFor example, inventories are lean—down 10% to 15% to their lowest levels in years, says Jennifer Herber, a retail-focused investment banker with Stephens. Retailers have negotiated better deals with manufacturers, renegotiated rents, and designed products specially made to be offered at lower price points, she adds. Stores are offering discounts and promotions this holiday season. But unlike a year ago, these promotions were planned in advance and not merely designed to sell off lots of extra merchandise. The result of all this cost-cutting and planning is positive for earnings, if not for revenue figures. "Even if sales aren't up a lot, retailers should be noticeably more profitable than last year," Herber says. Investors, she notes, can also cheer the signs that bankruptcies and store closings have reduced competitive pressure on the chains that survived the downturn. As the economy recovers and sales inch higher, retailers may be able to capitalize on their wider profit margins. If the economy improves faster than expected in 2010, retailers will need to react quickly, says Randy Allen, an associate dean at Cornell University's Johnson Graduate School of Management and a former Kmart executive. "As the economy starts to improve, you'll see the movement back up the value chain," she says. how long can cost-cutting pay off?Luxury retailers, however, might be slow to see benefits from a better economy, she adds. The problem is that spending at chains such as Neiman Marcus, Saks (SKS) and Tiffany & Co. (TIF) are often driven more by bonuses, which could be slow to return to prerecession levels. For other consumers, key metrics include the jobless rate and gas prices, experts said. Cost-cutting at retailers, combined with a modest uptick in sales, could boost profits substantially in 2010. But there are reasons to believe the long-term outlook for the retail sector could be disappointing for investors. That's the view of Laton Spahr, a portfolio manager at RiverSource Investments. The U.S. is moving away from a consumer-focused economy, he says, as American consumers pay off heavy debts, the labor market stays weak, and home prices fail to rebound strongly. "Both revenues and profits for retailers are not going to be inspiring for the next three years," Spahr says. If the U.S. is in for several more years of "frugal consumption," discount retailers like Wal-Mart will continue to gain market share, he says. RiverSource owns Wal-Mart shares, which Spahr says are priced very reasonably. Retailers in 2009 found ways to make profits in a recession. But in 2010 and beyond, the challenge may be to continue to boost sales and profits in an environment in which consumers are still very reluctant to open their wallets.

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