The Crazy World of Post-Christmas Retail

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Analysts are expecting an increase in holiday sales when the dust settles, but there's still a long road left to travel in the final days of 2012. Right now, sales are forecast to come in below their 2011 position, which would leave retailers in the lurch. But the day after Christmas is thought to be the third-busiest shopping day of the year, and consumers have lots of reasons to head back to stores to finish up their holiday season. Meanwhile, retailers are hoping to cash in on all of the gift cards they sold leading up to the holidays, and to minimize the damage from returns.

The current outlook
Coming into the end of the year, the National Retail Federation had estimated that sales would grow by 4.1%. That was a slowdown compared to 2011, when sales grew 5.6%, but it was a healthy dose of growth nonetheless. Now, analysts from MasterCard have said that holiday sales are only up 0.7% through the Dec. 24. That leaves a lot of ground to cover in the last few days. That shortfall is going to be exacerbated by the tidal wave of returns that threatens to wash over retailers.

Researchers estimate that somewhere between 10% and 15% of all holiday sales will come back through the doors. That's a huge setback for businesses if they're unable to convert those returns into new sales, or simply to staunch the bleeding by turning would-be returns into exchanges. But there is a bright spot that comes along with the darkness of returns: gift cards.

Companies like Target (NYSE: TGT  ) and Wal-Mart (NYSE: WMT  ) don't recognize gift card sales when they happen. Instead, companies add revenue when the cards are redeemed, and right after Christmas is one of the more popular times for redemption. That means that companies are going to be ready for gift card users, and are going to try to make the most of them as they walk through the door. Target is even highlighting gift cards on the front page of its mailer this week, in order to increase redemptions.

The reason that retailers don't claim the income from gift cards immediately is twofold. First, until the gift card is redeemed, it's a liability. Most gift cards no longer expire, and clearly the company has no idea what they'll be redeemed for. For instance, if a customer uses the card only on sale items, companies realize minimal margins. Second, thanks to a law in California, many large companies now cash out gift cards under $10 in value. If the company booked an entire $25 in revenue for a card, they might have to end up reversing close to 40% of that revenue if the card ends up being cashed out.

Who wins?
So with the back-and-forth of merchandise, how can investors play the end of the year? While The Motley Fool doesn't advocate timing the market, that doesn't mean we shouldn't take advantage of a slight downturn when it's presented. Right now, downbeat forecasts and fiscal cliff uncertainty are pushing some retail stocks down. Those companies are still excellent businesses, but market sentiment and overall outlook have helped move their stock prices.

In my opinion, two of the better businesses that have taken a hit today are Coach (NYSE: COH  ) and Gap (NYSE: GPS  ) . Gap issues a huge number of gift cards, and at the end of its past two years has had over $225 million worth of cards unredeemed. That's about half of what Target had outstanding at the same time, even though Gap only pulled in 20% of Target's revenue last year. That means that Gap has a lot riding on the holidays, and could record an excellent post-Christmas period.

Coach doesn't do any meaningful business through gift cards, but it's a company that thrives on getting people into the store. As Karen Talley wrote in The Wall Street Journal, "Returning merchandise gets customers in the store, where they can end up buying more or more-expensive items, especially as retailers hold after-Christmas sales." That's Coach's bread-and-butter, and getting, say, some small purses back is a great way to get customers to pick up bigger purses, which are on sale after the holidays.

2012 is finishing up and The Motley Fool is already fired up for next year. In fact, The Motley Fool's chief investment officer has selected his No. 1 stock for 2013. Find out which stock it is in our brand-new free report: "The Motley Fool's Top Stock for 2013." I invite you to take a copy, free for a limited time. Just click here to access the report and find out the name of this under-the-radar company.

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