Retail Markdown (Fool On the Hill) August 31, 1999

An Investment Opinion

Retail Markdown

By Warren Gump (TMF Gump)

This year hasn't been too rosy for the stocks of retailers. Despite a buoyant economy, many companies have suffered from missteps or changes in market dynamics. Neiman Marcus (NYSE: NMG) released Q4 earnings of $0.06 per share, compared to $0.33 last year. Office Depot (NYSE: ODP) warned last night that second-half profits would fall shy of analyst projections because of weak sales and margin pressures. Last week, The Wet Seal (Nasdaq: WTSLA) announced earnings that were below the level achieved one year earlier. Two weeks ago, Saks Inc. (NYSE: SKS) warned that it would not achieve expected yearly earnings. All of these companies have seen their stocks turn south as their estimates tumbled.

What's more interesting than the "isolated" weakness of these companies is the malaise surrounding retail stocks in general. Stocks in retail companies that are meeting and beating estimates are sitting out of most of this year's stock market gains. Retail King Wal-Mart (NYSE: WMT) is up only 9% for the year. Warehouse store behemoth Costco Wholesale Corp. (Nasdaq: COST) has risen 4%. Abercrombie & Fitch (NYSE: ANF), the successful outfitter to the college crowd and its wannabes, is flat. In comparison, the Dow Jones Industrial Average is up 18% and the Nasdaq Composite Index is up 25%. Why aren't these stocks doing better during a period of record economic activity?

Part of the reason for this underperformance is the benchmarks that I chose to compare the retailers to. While the Dow and Nasdaq Composite have surged double-digit percents so far this year, the broader-based Standard & Poor's 500 index has risen only 7%. An index for smaller stocks, the Russell 2000, is up only 1% for the year. Many retailers are smaller companies, making this a more appropriate benchmark. However, even using these more comparable indexes, the performance of most retailing stocks looks bad.

Home improvement and building supply chains Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) are down 1% and 11%, respectively, for the year. As Sears (NYSE: S) has seen 10% of its market value evaporate, JCPenney (NYSE: JCP) has suffered a 20% decline in its stock price. May Department Stores' (NYSE: MAY) year-to-date price decline is 1%, and Federated Department Stores (NYSE: FD) has only been able to achieve a 6% gain.

These lackluster year-to-date price changes have come despite excellent profit news and forecasts from some of these companies. Home Depot, for example, is expected to see earnings leap 36% this year to $1.45 per share. Analysts expect Federated's earnings to jump up 13% for the year and Wal-Mart's earnings should grow 24%. The published estimates for Costco project a 19% earnings-per-share improvement for the year.

Merrill Lynch's retail analyst, Dan Barry, lowered his ratings on several stocks based on concerns about e-commerce. While Mr. Barry doesn't think that the financial impact of the Web retailers will be noticeable this year (most analysts say it will remain less than 1% of general merchandise sales), he believes investors will perceive the issue to be much more substantial. Of course, investors with plans to hold onto their stocks for longer than a year would be crazy if they didn't incorporate changes caused by e-commerce and shifting distribution channels into their evaluation of a company.

The market has actually done a pretty good job predicting the success of the retail sector over the past couple of years, assuming you think the market is discounting results six months to one year hence. During 1997 and 1998, retailing was one of the better sectors in which to be invested. The Standard and Poor's retailing index beat the S&P 500 by 12 percentage points in 1997 and by (gulp!) 33 percentage points in 1998. This market success preceded the actual financial success still being enjoyed by many retailers.

Fundamentally speaking, this year's rising interest rates suggest that the torrid growth in consumer spending might slow down. A key driver to consumer spending is home sales, which are currently near peak levels. If higher rates slow housing turnover, sales of home improvement items, furniture, and decorating knickknacks will likely subsequently fall. In addition, higher interest rates reduce the number of people that can benefit from refinancing their mortgage, which usually provides extra disposable income though loan increases and/or reduced monthly payments.

The question I'm grappling with is whether this year's downturn in retail stocks is an indicator that sector growth has hit a peak or if it is typical market noise. My gut tells me that the market is probably right in suggesting that earnings growth for most retailers has topped out. After such a long period of massive consumer consumption, it's hard for me to envision how the sector overall can continue to achieve double-digit earnings growth, particularly in an environment where interest rates have a flat-to-upward bias.

If overall consumer spending growth has peaked, investors considering the sector will have a headwind gusting against them as investors focused on short-term results flee most of the stocks. In such an environment, evaluating the merits of each company's growth prospects and ability to adapt to changing competitive positions becomes more important than ever. If you shop regularly, you know that you can occasionally find some items that quickly sell out at a slight discount. Then again, much of that same merchandise is marked down an additional 10% - 50% during a clearance sale a few months later.