'Frugal Fatigue' Spurs Specialty Apparel Retailers

It's been a great spring so far for specialty apparel retailers, which are enjoying higher sales and wider margins, but April sales could temper investor enthusiasm.

Until the stock market took a giant step backward on May 4, shares of Gap (GPS) were up 34 percent from Feb. 1, the start of the retailers' fiscal first quarter, with Abercrombie & Fitch (ANF) up 39 percent, J. Crew Group (JCG) up 23 percent, and Urban Outfitters (URBN) up 18 percent. American Eagle Outfitters (AEO) was the laggard with a gain of nearly 6 percent.

For all the worries about a jobless recovery and unemployment remaining above 9 percent for an extended period of time, consumer spending has rebounded more strongly than expected, with retail sales rising 1.6 percent in March. Marshal Cohen, a fashion industry analyst at research firm NPD Group in Port Washington, N.Y., attributes the bounce to something he calls "frugal fatigue."

"[Consumers] are starting to get tired of having to only shop at the lowest-priced retail outlets, particularly in apparel, which arguably had the worst performance during the recession," he says. They are now searching out retailers that offer good value. And consumers' concept of value has expanded beyond just price to quality and durability, as well as comfort and service, he says. They are also doing their homework, researching products and prices online before walking into stores.

Nimble Stores

Specialty retailers are in the sweet spot right now because they're more nimble than department stores, which have less control over the flow of merchandise into their stores due to their dependence on outside manufacturers, he says.

"It's more about having the right product at the right time and at fair value," he says. That's easier for specialty retailers since they own and control their merchandise from start to finish.

Although specialty retailers are still offering promotions to attract customers, they discounted less of their merchandise in the first quarter than in prior quarters, say analysts. Their confidence stems from better management of inventory, consumers' greater willingness to spend, and the stimulating effect that new products have had on customers, says Cohen. He expects first-quarter U.S. retail sales to be down 3 percent from a year earlier and believes the decline will narrow to 1.5 percent-to-2 percent in the second quarter.

Even Abercrombie, a high-end retailer long known for its resistance to markdowns, is learning some new tricks, including the meaning of twofers, says Laura Champine, an analyst at Cowen & Co. "They're realizing with their Hollister and kids' stores that they haven't been competitive enough in the past," she says.

Champine sees retailers continuing their momentum from March, whose sales strength she attributes to more than just an earlier Easter. While the timing of Easter will hurt April retail sales, she expects all the specialty retailers except Abercrombie to have positive same-store sales in April vs. a year earlier, with the group overall estimated to be up 2 percent. For the first quarter, she expects comparable-store sales to be at least 4 percent or 5 percent higher, while earnings will likely be up at least 10 percent across the group, mainly on easy comparisons with a year earlier.

Underlying Trends

But Richard Jaffe, an analyst at Stifel Nicolaus (SF), expects April retail sales to be much weaker than in March, when early warm weather motivated consumers to buy spring fashions. He predicts apparel retailers' same-store sales in April will be unchanged from a year earlier, vs. a 10 percent jump in March. But he advises investors to look beyond the monthly data and focus instead on the underlying trend for the quarter. The real question, he says, should be whether consumers' willingness to spend will drop off as the government's economic stimulus programs wind down and if the employment picture doesn't improve quickly enough.

In a May 3 research note, Wedbush Capital Markets said that despite its expectations for more muted sales in the second half of April, it believes lean inventory levels and easy comparisons bode well for higher earnings for all of the specialty retailers, driven by gross margin gains.

Analyst Samantha Panella at Raymond James (RJF) said in a May 4 note that she isn't sure consumers' hesitation to spend has completely passed, but she was encouraged by what she saw on recent visits to shopping malls. Retailers' focus is shifting this year to revenue growth and market share gains from cost-cutting and inventory management in 2009, she said.

Operating margins for many of the specialty apparel companies have been at or near record highs due to sharp cuts in selling, general, and administrative costs, cheaper product sourcing, and historically cheap transportation and warehousing costs in recent years, Deutsche Bank Securities said in an Apr. 25 report. But these expenses are rising, especially sourcing, and will probably weigh on retailers' profits as early as the second half of this year, which investors aren't fully anticipating, the report warned.

Eye on Urban Outfitters

Deutsche Bank said it expects Urban Outfitters to lead the sector with compounded annual sales growth of 14.8 percent from 2009 to 2012, compared with 10 percent for Abercrombie and 1.7 percent for Gap. Deutsche Bank calls Urban Outfitters "one of the premier growth stories in all of retail," with its Internet business ramping up across all brands, improving profit margins in its foreign business, and plans to expand into Asia and introduce new product lines such as bridal wear.

In a May 3 research note, Robert W. Baird & Co. projected a 4 percent increase in Abercrombie's same-store sales for the first quarter, a stark improvement from a 13 percent decline in the fourth quarter. But Baird remains concerned about the company's average revenue per retail unit, which fell 14 percent in March and is expected to be down substantially again in April. The firm maintained its neutral rating on the stock but expects Abercrombie to post a net loss of 20¢ a share for the first quarter, worse than the consensus forecast of a 13¢ loss, according to Bloomberg data.

There's usually a lull in sales between April and July, when back-to-school buying returns. This year, Cowen's Champine expects year-over-year sales growth to slow to the mid-single digits in May and June.

While consumer confidence appears robust, it has been hindered by lack of progress on unemployment, according to Tom Porcelli, U.S. market economist at RBC Capital Markets. The University of Michigan Consumer Sentiment index was 72 in April, vs. a cycle low of 55 and a longer-term average above 90. "We've clawed our way back, but there's quite a lot of room for improvement on the confidence front," he says. It's hard for consumer confidence to strengthen on stock market gains alone, and if there's a major correction in equity prices, Porcelli warns, that would drive confidence down quickly.

Appealing Merchandise

For Cohen, the real issue for specialty retailers is who will be progressive enough to bring in exciting merchandise to engage consumers at a deeper level. He thinks Aeropostale (ARO) has the best chance to do that, based on its price value and style.

Whichever company takes the lead, it will need to be family-friendly, he says, since parents are doing more of the buying now that kids have less disposable income than they once did. The retailers that come closest are Old Navy, owned by Gap, and American Eagle. By family-friendly, Cohen means no blasting music or sexy posters, and no sofas nestled in dark corners of the store.

"If Mom comes in and sees that, she says, 'I'm not letting my kid come in here,' " says Cohen.

Before it's here, it's on the Bloomberg Terminal.