Opportunities In The Retail Sector

Retailers have been one of the best performing groups in 2009. The S&P Retail Index [RLX] is up 19% year-to-date (through April 27). That is well above the S&P 500, which is down 5%.

It appears that investors believe that retailers bottomed out in the fourth quarter of 2008 and expect results to rebound in sometime in the second half of 2009. In our view, this enthusiasm for retail stocks is misplaced. While there have been some signs that conditions have stabilized from the freefall in the fourth quarter of 2008, there haven’t been any real signs of improvement for retailers.

The reality is that consumer spending will not rebound any time soon. We would continue to remain cautious with retail stocks.

That’s because consumer attitudes toward debt and spending have changed. Wealth destruction and reduced access to the credit markets have forced consumers to reduce discretionary spending, increase savings, and pay down debt. To stretch the dollars they do spend, consumers have become more frugal in their shopping habits.

The real risk for retailers is that consumers do not return to “normal” as defined by the last decade even after economic and credit conditions finally improve. To wit, many consumers took advantage of 0% financing to buy cars they couldn’t afford, option ARM mortgages to buy homes they couldn’t afford, and took out home equity loans to finance lifestyles beyond their means. How many of those same consumers would make those same choices today if given the chance?

We think the answer is not many, and that number is falling everyday. As more consumers shy away from the borrow-and-spend cycle, discretionary retail sales will come under additional pressure. We believe this will be a secular trend that lasts well beyond the current recession.

OPPORTUNITIES

Interestingly, the retailers that should do well no matter that how weak the overall economy is have underperformed the rest of the retail industry so far this year. Industry leaders Wal-Mart (WMT) and Costco (COST) are down 13.5% and 9.3%, respectively, since January 1.

In the last month, the under-performance was even more pronounced. There were numerous small retailers that were up more than 50% in the last month, while Wal-Mart was flat and Costco was up about 20%.

Many of those retailers that outperformed are highly leveraged and have stock prices in the single digits. We think it is unlikely that those smaller retailers will continue to outperform the industry leaders in this difficult economic environment.

Two stocks in our coverage that we rate as Buys are Kroger (KR) and Safeway (SWY). Kroger’s sales should remain relatively intact. Consumers will still need to shop for groceries even with in a weak economic environment.

We also like GameStop (GME). Its results have remained strong throughout this downturn, and its stock has been unfairly punished.

WEAKNESSES

We would avoid most names in retail. The stocks that are least attractive in this environment are those companies with levered balance sheets, marginal businesses, or those companies that do not generate enough cash flow to internally finance operations. Among our current Sell ratings are Cost Plus (CPWM), Overstock.com (OSTK) and Oxford Industries (OXM).

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