American consumers opened their wallets a little wider in June as same-store sales chalked up an impressive 3.1% increase last month, according to a 28-company poll from Thomson Reuters. That's an improvement over May's bump of 2.5%. So are retail stocks prime for the picking? Wharton professor Stephen Hoch says not so fast. He doesn't think "the consumer is going to step up to the plate and spend us out of the economic doldrums." With that kind of conflicting information, what's an investor to do?
Don't worry. With a little more information, we can figure out what to do. Let's look at some additional data so we can make up our minds.
Why it's time to go long
Americans love to shop. There's no question about that. In fact, since bottoming out at the end of 2008, retail sales have shot back up, according to data from the St. Louis Federal Reserve. It may not be at the same level as when the economy was booming, but the other great American pastime remains intact.
If a retailer has the right product at the right price, customers will beat down its doors. Look at Aeropostale (NYSE: ARO ) , for example. The clothing retailer has taken the teen market by storm using the right balance of cool products and great deals. You don't follow up a 12% same-store sales increase in June 2009 with an 8% increase in June 2010 on just luck. Contrast Aeropostale's results with those from Gap (NYSE: GPS ) . Despite deep discounts, Gap's overall comps were flat, and comps at its flagship North American stores declined 3%.
Finally, as stock prices have fallen, retailer stocks are becoming more attractive. Wal-Mart (NYSE: WMT ) , a great barometer for the industry, currently trades at about 16 times free cash flow. In my opinion, the signs are beginning to point to attractive.
Find some shares to short
To boost sales, many retailers have resorted to discounting. As a result, margins have shrunk. American Eagle's (NYSE: AEO ) net margin peaked at 13.9% in 2007. Over the 12-month period ended in May 2010, sales are over 10% higher but net margins have shrunk to 5.2%. Ouch!
Consumer deleveraging continues to take its toll. According to the latest Federal Reserve data, consumer credit contracted at a seasonally adjusted rate of 4.5% in May. Those without credit concerns continue to loosen their purse strings, as evidenced by the 14.1% jump in same-store sales for high-end retailer Nordstrom (NYSE: JWN ) . But consumers with less credit are likely to make fewer purchases going forward.
Lower margins and fewer purchases lead to only one thing: lower returns. And investors do not like lower returns. During the good times, Abercrombie & Fitch (NYSE: ANF ) generated returns on invested capital (ROIC) north of 30%. That's an incredibly high number. Today, Abercrombie's ROIC is 5.7% and very likely below its cost of capital. Destroying economic value is not a recipe for higher stock prices.
My take
I'm short. The road ahead is, in my opinion, going to be very rough. Retailers will have to continue to work hard to generate sales growth and margins are likely to continue to suffer. The silver lining is that if performance doesn't meet expectations, investors are likely to sell and push stock prices down further. That's when I'd love to swoop in and buy up the great deals in the bargain bin.
I've given my opinion, but what do you think? Put your long or short vote in the comments box below. And don't forget to put your longs and shorts in CAPS.
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