(BBY) U.S. Retail Industry Stock Outlook – August 2012 – Industry Outlook

Retailers procure goods in large quantities directly from manufacturers or wholesalers and sell them in small quantities to customers through a retail outlet or online. As consumer spending is the key to the viability of any economy, the health of retail industry is an important economic indicator.

As a pioneer in the retail business, the United States provides ample growth opportunities for all types of retail companies. Retailers of all sizes, including individual direct marketers or direct sellers, small- to medium-sized franchise unit owners, and large “big-box” store operators, compete in the U.S., fostering increased growth opportunities.

From a growth perspective, the retail industry ranks second among all the U.S. industries, and provides enormous employment opportunities. Annual sales turnover of the retail industry is more than 12% of total trade volume of all the U.S.-based businesses. Additionally, it accounts for over 11% of total employment in the country.

Recent Industry Trends

Despite beginning the year on a strong note, sales slowed down during the calendar second quarter (for the period ended June 30, 2012), reflecting a drop in consumer spending. The June sales results for most U.S. retailers were impacted by unsteady demand. Gains around Father’s Day were offset by weakening sales as bad weather hit later in the month.

Following the disappointing June sales, retailers seemed to be doing well with consumers initiating the key back-to-school shopping season in early July instead of August. Looking at this encouraging start, we expect the back-to-school season to hold good for retailers in August and September. The National Retail Federation projects ‘back to school’ and ‘back to college’ spending to grow compared to last year.

The key data in retail industry analysis is comparable store sales (comps), as it excludes sales at newly opened stores. July comps remained solid for most retailers as hot weather and significant promotions led the role-play for summer clearance sales. Comps results for apparel retailers like Limited Brands (LTD) (up 12%), The Gap Inc. (GPS) (up 10%), Ross Stores Inc. (ROST) (up 7%) and TJX Co. (TJX) (up 7%) outperformed expectations. Additionally, discount store operators such as Costco Wholesale Corp. (COST) and Target Corp. (TGT) came in strong, posting a 7% and 3.1% increase in July comps, respectively.

On the other hand, department store chains like Macy’s Inc. (M), Kohl’s Corp. (KSS), Nordstrom Inc. (JWN) and Saks Inc. (SKS) continued to show promise with 4.1%, 1.7%, 0.9% and 3.5% rise, respectively. However, results at the drugstore chains were not so good with Walgreen Co. (WAG) posting a 7% decline in July comps, and Rite Aid Corp. (RAD) managed to grow only 0.5%.

Major underperformers in July included, teen apparel retailer Wet Seal Inc. (WTSLA) (down 15.6%), Cato Corp. (CATO) (down 2%), and The Buckle Inc. (BKE) (down 0.1%).

Backdrop Still Weak

Uncertain and sluggish economic conditions continue to weigh upon the retailers, indicating a grim outlook in terms of profitability and consequent growth. However, continuous efforts on their part to offer innovative products and value pricing have been paying off in an economy which is still in the doldrums. It is still a tough time for retailers, who are using their entire arsenal to combat the sluggishness.

According to the U.S. Census Bureau, the U.S. retail and food services sales declined 0.5% from the prior month sales to $401.5 billion in June. The latest domestic retail sales data points to a third straight month of decline, reminding the days of financial turmoil in 2008.

Moreover, the Conference Board came out with its reading of the Consumer Confidence Index — a barometer of U.S. consumer health — which fell to 62.0 in June from 64.4 in May.

In addition to the U.S., economic readings have been bleak in Europe as well as in China, the second largest economy. Consumers in these regions are gradually becoming more rational about their spending patterns as well. In addition, dismal unemployment conditions are also weighing on their discretionary spending, affecting the growth and profitability of the retailers. The unemployment rate in the United States was reported at 8.2% in June.

Store Closings a Common Trend in 2012

The retail industry expansion trend that was witnessed in 2011 in terms of store openings seemed to fade in 2012 with the announcement of triple-digit store closing plans by leading retail chains like Sears Holdings Corporation (SHLD), The Gap Inc. (GPS) and Abercrombie & Fitch Co. (ANF). However, further analysis on the subject showed that the increased shuttering of stores was mainly due to shift in consumer preferences and change in retail shopping trends, while it had little to do with any alteration in the industry fundamentals.

A detailed information of store closures for 2012, as announced by retailers, is as follows: 100 to 120 Kmart and Sears full-line stores, 950 Gap North America stores (through fiscal 2013), 100 Pacific Sunwear of California Inc. (PSUN) stores (in 2012), 35 U.S. and about 1 to 2 Mexico stores of OfficeMax Inc. (OMX) (in fiscal 2012), 22 77kids stores of American Eagle Outfitters Inc. (AEO), 50 U.S. Best Buy Co. Inc. (BBY) big-box stores (through fiscal 2013) and many more.

Additionally, Abercrombie & Fitch is currently in a remodeling phase as it plans to close its underperforming U.S. chain stores over the next few years, while simultaneously speeding up growth at its Abercrombie Kids and Hollister store concepts. The company intends to increase its international presence by opening five Abercrombie & Fitch stores in Hamburg, Hong Kong, Munich, Dublin and Amsterdam as well as an Abercrombie Kids store in London in fiscal 2012. In addition, the company plans to open about 40 international Hollister stores in fiscal 2012.

Another reason behind these increased store closure plans by retailers is the growing demand for new shopping modes, namely thr Internet and mobile phones. Consumers today prefer to use their laptops or smart phones to compare prices of things they want to buy and place orders online, instead of driving to the company’s stores. This growing trend has guided major U.S. retail chains to downsize their physical retail operations, and in turn, develop their e-commerce and m-commerce sites to attract customers.

Overall, we believe such store closing announcements will continue to rise through the end of 2012.

The “Re” is Back in Retailing

‘Transformation’ is the new mantra among the retailers. Despite rapid technological advancements which are influencing consumer behavior, the retail industry continues to reinvent, redesign and revitalize its physical store formats to maintain their dominance.

Of late, retail giants including Best Buy Co. Inc., Target Corp., J.C. Penney Co. Inc. (JCP) and Build-A-Bear Workshop Inc. (BBW) are focused on revisiting and re-evaluating conventionality and traditional business traits, while also envisioning its brick-and-mortar store merchandise offerings. Additionally, these companies continue to actively re-engineer and re-tool various systems and processes.

Moreover, the retail groups are coming up with strategic initiatives to boost operating efficiencies, drive growth and enhance shareholder’s value. Most of the retailers are focusing on abridging costs drastically to ensure competent operating channels. We believe that such measures are necessary to gain competitive advantage over peers. However, focus on improving the top line should be prioritized to gear long-term growth.

Above mentioned traits are made clear seeking the example of J. C. Penney, which has left no stone unturned to bring the company back on the growth trajectory. Management has taken up everything from implementation of new pricing strategy, fresh logo and strategic merchandise and cost reduction initiatives, while enhancing the shopping experience of customers. The company targets expenses to be 27% of sales by the end of the transformation process.

Moreover, the leading specialty retailer of consumer electronic products — Best Buy will shutter some stores which are not contributing to its growth, while modifications of others are also in the cards. The company plans to transform its big-box format to a big profit center by redesigning its prototype stores to mimic Apple Inc’s (AAPL) retail store format. Best Buy is not the first one to resort to such mimicry as Microsoft Corp. (MSFT), Walt Disney Co. (DIS), Tesla Motors Inc. (TSLA) and AT&T Inc. (T) has already opened stores copying the Apple format.

Target Corp. is another retail chain that has resorted to a major redesign by developing the “City Target” format, which aims at tapping the urban markets, where real estate remains a constraint. These stores are designed to fit in urban locations, both in terms of size and store design aesthetic. Recently, the company opened its first City Target stores in Chicago, Los Angeles and Seattle with 80,000 square feet, a lustrous urban background, no lawn and garden department and smaller back rooms.

In a similar move, Cabela’s Inc. (CAB) — one of the leading specialty retailers of hunting, fishing, camping and related outdoor merchandise — unveiled its new ‘Outpost’ store format. The relatively smaller-size store will provide shoppers with Cabela’s retail experience and will facilitate the company to capitalize on the under-penetrated markets.

Challenges and Some Remedial Measures

The retail industry is highly competitive and has significant challenges. Although the U.S. economy has started witnessing a recovery, we still believe that 2012 will not fully mark the return of the retail market. Consumers are slowly regaining confidence and cautiously increasing their spending.

Moreover, consumers remain sensitive to macro-economic factors including interest rate hikes, increase in fuel and energy costs, credit availability, unemployment levels and high household debt levels, which may negatively impact their discretionary spending, and in turn, adversely affect the growth and profitability of retail companies.

Macroeconomic Conditions: Retail is no different from other U.S. industries, which remain affected by the slow economic recovery. While the unemployment rate has decreased considerably over time, consumers are now beginning to draw out their savings to spend, hoping for some economic recovery. Though this is a positive sign, there has been a considerable rise in prices of commodities, which is making it difficult for consumers to make ends meet. On the other hand, the retailers are struggling as they are unable to pass these increased costs to consumers and their employees, given the already shrinking income levels.

Changes in Consumer Needs, Attitudes and Behavior: The growth of modern retail is linked to consumer needs, attitudes and behavior. Adapting to the sluggish economic environment prevalent over the last few years, consumer behavior has shifted to being more conservative. This has now become the normal behavior of consumers as they remain budget conscious, seeking more and more value. In the process, buyers are swiftly switching to the less expensive brands and consolidating shopping trips.

Moreover, people today prefer to cook and eat at home against their prior habits of eating out. This shift in the consumer behavior is inducing retailers to adopt various strategies to stay in competition. Retailers are offering trend-right and well-designed assortments at compelling prices, without compromising on quality, in order to drive traffic.

Higher Fuel Prices: As a new trend noticed of late, shoppers are making fewer shopping trips. This has emerged from the rise in gas prices as well as the hectic lives of consumers, while incomes are squeezed. Looking ahead, we expect this trend to continue for the next few years.

Apart from cutting down on the number of trips, shoppers also chalk out their shopping mission before stepping out. Today, consumers look for multichannel retail outlets, which offer variety of goods, rather than making separate visits for paper goods, health and beauty items, grocery, etc. Thus, retailers now need to understand the consumers’ shopping missions and get the most out of their visits by broadening their assortments with the appropriate depth, breadth and freshness to appeal to their shoppers’ missions.

Staging Stores: The waning popularity of brick-and-mortar store formats has made it essential for retailers to adopt new techniques like ‘staging stores’ to woo customers. Staging basically refers to the act of making the company’s stores attractive destinations, where people like to spend their time. One example for this is Starbucks Corp. (SBUX). The idea behind this strategy is to make shopping interesting for consumers, so that they would want to walk-in the stores, rather than shop online.

Use of Internet and Mobiles in Shopping: With shoppers becoming more and more tech-savvy these days, a new era of shopping via internet, smartphones and tablets has taken over. Today, consumers are increasingly using the tech-media to make purchases, find coupons and search for the best deals.

The rate of electronic retail shopping is expected to increase significantly over the next four to five years. To take advantage of this growing trend, retailers need to identify the best possible means of benefiting from the use of technology in shopping while implementing relevant strategies. By integrating the digital mode into the shopping experience, retailers can earn rewards in the form of increased shopper demand and greater shopper loyalty.

Shrinking Margins Raise Concerns: In the current strained economy, retailers are struggling to grow and maintain decent profit margins due to the inflated input costs, rising inventory levels, market saturation, the rise of multichannel buying, an aging population, fewer prosperous shoppers, reduced customer loyalty and the rise of digital media to influence purchase decisions.

Further, fashion obsolescence remains the key concern for retailers as this may lower the comparable-store sales and deplete margins. Some retail chains which have been struggling with margins pressures, of late, include Nike Inc. (NKE), Big Lots Inc. (BIG), Deckers Outdoor Corporation (DECK), J. C. Penney, Best Buy and Family Dollar Stores Inc. (FDO).

In the fight against shrinking margins, retailers should work toward easing pricing pressures through reformulations, innovating product lines, redefining supply agreements, altering merchandise mix and boosting distribution channel tie-ups. Further, well-defined cost reduction programs along with proper implementation will help gain a competitive advantage and maintain profitable growth.

Conclusion

Retailers are trying to remain competitive primarily by shifting focus to the long-term horizon and finding innovative solutions to create value, reduce operating costs and mitigate risks throughout the enterprise.

Right sizing inventories, enhancing efficiency and competence and bringing in technological advancements are the key agendas that the retailers are focusing on. Moreover, cost containment efforts and merchandise initiatives to improve margins are also top priorities.

Further, retailers are largely concentrating on buyers’ needs, which in turn, will bring in huge potential for growth and is likely to augment sales in the long run. Additionally, exploring all possible opportunities to create premium as well as value products to suit the different income groups should help improve returns. Considering the current macro-economic environment, this strategy should be a smart move to better position companies to attract consumers.

Retail, owing to its huge spectrum, remains a lucrative investment avenue for investors. The sector reflects consumer spending trends, an important parameter to gauge the health of the economy (consumer spending accounts for approximately 2/3rd of the economy). Thus, identifying future winners from this sector would be a good investment decision.

We recommend few stocks in the sector at this point, as these companies are showing significant growth despite the secular headwinds. Adaptability to the buying habits of the consumers and strengthening the loyalty base helped these retailers to post strong results. The stocks in our coverage with a Zacks #1 Rank (Strong Buy) include Hot Topic Inc. (HOTT), Zumiez Inc. (ZUMZ), Petsmart Inc. (PETM), Lululemon Athletica Inc. (LULU) and Pacific Sunwear of California (PSUN).

Additionally, we like stocks with a Zacks #2 Rank (Buy), namely American Eagle Outfitters Inc. (AEO), Costco Wholesale Corp. (COST), Sears Holdings Corp. (SHLD), The Gap Inc. (GPS), Wal-mart Stores Inc. (WMT), Kroger Company (KR), Home Depot Inc. (HD), Ross Stores Inc. (ROST), Constellation Brands Inc. (STZ), Bed Bath & Beyond Inc. (BBBY) and Dick’s Sporting Goods Inc. (DKS).

On the other hand, retailers that we dislike with a Zacks #5 Rank (Strong Sell) include J. C. Penney (JCP), Nike Inc. (NKE) and SUPERVALU Inc. (SVU). Retailers on our Zacks #4 Rank (Sell) list include Ralph Lauren Corporation (RL), Abercrombie & Fitch Co. (ANF), Macy’s Inc. (M), Office Depot Inc. (ODP) and Avon Products Inc. (AVP).

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