Retail Industry Stock Outlook: November 2013

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

As a leader in the retail business, the United States provides ample growth opportunities for all types of retail companies. The retail industry covers everything in its scope, ranging from internet catalog sales, auto dealers, convenience stores, vending machines and clothing -- thus dividing retailers into numerous categories. 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.

From a growth perspective, the retail industry is among the dominant U.S. industries, and employs an enormous workforce. Retail sales represent approximately 30% of consumer spending.

Correlation with the Economy

So far this year, the broader markets have showcased signs of a better pace of recovery and have thus infused hopes of a better economic scenario going forward. One could contest this economic outlook, but the stock market’s strong recent gains show clearly which way investors think the economy is headed. After strong gains this year, the S&P 500 and the Dow Jones Industrial Average are in record territory already and on the cusp of reaching milestone levels.

The stock market continues to soar given the Federal Reserve's stimulus program, wherein the central bank buys $85 million in bonds each month. Though the Fed Officials hinted to gradually roll back the program, however, the timing of the probable tapering of the program is still not certain.

Overall, most market participants expect the Fed to hold off on making any changes to its policy stance at least through April 2014.

An improved housing backdrop and gains on the labor market front have raised hopes of better times to come on consumer spending front. The recent rise in mortgage rates as a result of Fed taper fears has had some dampening effect on the housing sector, but overall activity level in the sector remains favorable. The last jobs report also indicated positive momentum in the labor market, though the data may not have been entirely reliable given effects from government shutdown.

However, consumer confidence appears to have taken a hit as a result of the fiscal discord in Washington DC.

The Conference Board’s Consumer Confidence Index fell drastically to 71.2 in Oct 2013 following a small dip to 80.2 in September. The University of Michigan Consumer Sentiment survey shows similar weakness.

Key Metrics

The key data in retail industry analysis is comparable-store sales (comps), as it excludes sales at newly opened and closed stores. An improving job market, lower gas prices and favorable weather boosted sales data.

Apart from this, the reopening of government offices boosted customer traffic to stores for buy-now and wear-now apparel. These positives aided retailers to generate healthy sales for the month of October with consumer spending gaining some pace. As a result, the key metric data for most retailers reflected growth for the month of October.

Among the retailers, clothing chain L Brands Inc. (LTD), a specialty retailer of women’s intimate and other apparel, beauty and personal care
products, led the pack with an 8% rise comparable-store sales and an 11.4% increase in net sales. This was followed by drugstore operator Walgreen Co. (WAG), which posted a 5.8% rise in comps and a 6.1% increase in total sales.

Off-price retailer of apparels, footwear and accessories Stein Mart Inc. (SMRT) was also on the list of best performers. The company registered a
5.4% rise in October comps, while total sales increased 6.9%. The Gap Inc. (GPS) posted a 4% rise in comps and a 5.7% increase in net sales to $1.29 billion for the month of October.

Apparel and accessories retailer, Cato Corporation (CATO) reported a 3% rise in comps with a 4% improvement in net sales. Costco Wholesale Corporation (COST), the warehouse retailer, also delivered comps growth of 3%. Meanwhile, net sales for October rose 6% to $8.15 billion from $7.66 billion in the year-ago period.

The Buckle Inc. (BKE), a retailer of casual apparels, footwear and accessories for men and women, witnessed a 2.6% rise in comps when compared with Oct 2012 results. Net sales increased 2.8% to $86.6 million from $84.2 million in the prior-year period.

Drugstore chain retailer Rite Aid Corp. (RAD) reported a 2.1% growth in comparable-store sales for Oct 2013, primarily driven by improved comps results at its pharmacy stores. Total drugstore sales climbed 2.2% to $1.961 billion for the month.

However, some retailers showcased soft performance. Washington-based retailer of sports-related teen apparel Zumiez Inc. (ZUMZ) reported a 1.2% increase in comps, while net sales notched 10% higher to $46.3 million. Discount store operator Fred's, Inc. (FRED) witnessed marginal growth with only a 0.8% rise in comps, up from a 0.8% decrease witnessed in Oct 2012. Net sales for October increased 2% to $143.4 million.

However, the U.S. retail and food services sales data for Sep 2013 were disappointing. According to the U.S. Census Bureau, the retail and food services sales fell 1% sequentially but improved 3.2% year-over-year to $425.9 billion.

Retailing - New Game, New Rules

The retail industry is rapidly evolving with a dramatic change in consumer buying habits. Satisfying customers and enriching buying experience require new strategies from retailers today. Modern retailing, interestingly enough, is a new game with new rules.

Despite the gradual rise in consumer discretionary purchases, the sluggish U.S. economy and continued weak in Europe cannot be ignored. Burdened with the lackluster scenario, retailers have largely concentrated on buyers’ needs and lured them with innovative products, attractive discounts, free shipping and the ease of shopping through smartphones and tablets. However, these strategies only helped in generating modest revenues.

Thus, retailers essentially need to come up with brilliant strategies, while incorporating technological advancements and utilizing their real estate portfolio to the optimum level. In short, they need to Experiment, Differentiate, Optimize and Transform. In doing so, most retailers today are adopting an “omnichannel” approach, utilizing all possible mediums to engage consumers, including brick and mortar stores, online, and mobile.

Banking on this new mantra, Staples Inc. (SPLS), the world’s largest retailer of office products and services and second largest online retailer, launched its first omnichannel stores, what it refers to as "the future of retail."

Simply put, through this omnichannel strategy, Staples hopes to integrate its retail network with enhanced digital capabilities. The company stated that stores will incorporate its .com and mobile assets. Alongside, the stores will feature Staples.com kiosks.

This new era store concept, with all its attractions could well prove to be a game changer in the long run for Staples. Providing shoppers the ease of shopping on their own terms and enriching their in-store shopping experience could be a crucial point of differentiation among other retailers.

In harmony with the evolving retail industry, department store operator Macy's Inc. (M) also adopted an omnichannel strategy. Despite macroeconomic challenges and cautious consumer spending, Macy’s continues to post healthy results. Management largely attributes the credit to its omnichannel strategy aimed at enhancing customers’ shopping experience.

Other notable retailers who are dancing to the tune of the omnichannel strategy include Nordstrom Inc. (JWN) and Chico’s FAS Inc. (CHS).

Trends to Rule Going Forward

Some of the trends that are expected to rule the retail sector going forward include employing more technological solutions, incorporating customer feedback and targeting additional audiences with products and services.

With the growth of the .com era, shoppers have largely adopted new purchasing modes, using the Internet, mobile phones and tablets. Consumers today prefer to use their laptops or smartphones to compare prices of products they want to buy and place orders online, instead of visiting 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.

Other traits that are expected to affect the retail industry are the growth of self-service options for processes such as checking out and finding items in stores. These offerings provide greater convenience and faster transactions, and they satisfy shoppers who prefer to visit brick-and-mortar locations for immediately purchasing predetermined items.

Of late, the store-within-a-store concept has been making headlines, though it's nothing new to retailers. J. C. Penney Company Inc. (JCP) is one such retailer which has been focusing on this business strategy for quite some time. The recent one to join the league is consumer electronic retailer Best Buy Company Inc. (BBY), which has been facing stiff competition from industry bellwethers such as Wal-Mart Stores Inc. (WMT) and Amazon.com Inc. (AMZN) to increase its footfall, sales and profitability.

Best Buy is leaving no stone unturned to woo consumers and attain incremental revenue, and it was well evident from its strategic initiative of opening over 1,400 "Samsung Experience Shops" within its stores, announced in April. The model seems to be working for the retailer, which also has a dedicated floor area for Apple Inc.’s (AAPL) products.
Taking the initiatives further, Best Buy recently unveiled its partnership with Microsoft Corporation (MSFT) to roll out the “Windows Store” across its 500 outlets in the U.S. with an additional 100 in Canada. The electronics retailer come out with better-than-expected results for the October quarter, but warned about trends in its margins for the all-important holiday season quarter.

Further, retailers across the industry are identifying the need to know their customers better, to drive growth. In today’s retail world, where consumer is the king, companies are focusing on effectively using data and analytics to better understand consumers, as well as for branding, product management, and making better pricing decisions. Focused on leveraging large amounts of consumer-related data and providing personalized solutions to customers, retailers are adopting the technologies like Cloud Computing.

Challenges and Some Remedial Measures

The retail industry is highly competitive and encounters significant challenges. Although the U.S. economy has started witnessing a recovery, we still believe that 2013 will not fully mark the resurrection. Consumers are slowly regaining confidence and cautiously increasing their spending.

Moreover, consumers remain sensitive to macroeconomic 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 eventually adversely affect the growth and profitability of retail companies.

Macroeconomic Conditions: Retail is no different from other U.S. industries, which is highly dependent on the economy to prosper. Such heightened dependence on the economy and factors like job growth and interest rates indicate that a speedy recovery of the economy is vital for the health of the retail industry. While the unemployment rate has decreased considerably over time, consumers are now beginning to draw out their savings to spend, anticipating some economic recovery.

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 regular behavioral pattern of consumers as they remain budget conscious, seeking greater value. In the process, buyers are swiftly switching to the less expensive brands and consolidating shopping trips.

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

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, where people like to spend their time. The idea behind this strategy is to make shopping interesting for consumers, so that they would want to walk into the stores, rather than shop online.

Zacks Industry Rank

Within the Zacks Industry classification, Retail/Wholesale (one of 16 Zacks sectors) is divided into two categories -- Nonfood Retail-Wholesale and Food/Drug- Retail/Wholesale under the Medium (M) Industry Group and further sub-divided into 14 industries at the expanded level -- Building Products-Retail/Wholesale, Internet Commerce, Retail/Wholesale Auto/Truck, Retail-Apparel/Shoe, Retail-Consumer Electronic, Retail-Discount, Retail-Drug Store, Retail-Jewelry, Retail-Miscellaneous/Diversified, Retail-Restaurants, Retail-RGN Department, Retail-Supermarket, Retail/Wholesale-Auto Parts and Retail/Wholesale CMP.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Retail-Drug Store #9, Internet Commerce #22, Retail/Wholesale-Auto Parts #31, Retail/Wholesale CMP #46, Retail-Consumer Electronic #72, Retail-Miscellaneous/Diversified #91, Retail-RGN Department #109, Retail-Discount #109, Retail-Supermarket #165, Building Products-Retail/Wholesale #175, Retail/Wholesale Auto/Truck #175, Retail-Restaurants #179, Retail-Apparel/Shoe #222 and Retail-Jewelry #233.

Analyzing the Zacks Industry Rank for the constituent industries in this space, it is apparent that the overall outlook for the Retail/Wholesale sector is Neutral.

Earnings Trends

The broader Retail/Wholesale sector portrays an impressive earnings trend. The third quarter 2013 results for the sector were disappointing in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

The earnings "beat ratio" was 52%, while the revenue "beat ratio" was 28%. Total earnings for this sector increased 6.2% year over year, reflecting an improvement over 7.3% growth registered in the second quarter of 2013. Total revenue grew 3.7% in the quarter versus 4.2% jump in the previous quarter.

Looking at the consensus earnings expectations for the rest of the year, the picture looks blurred with earnings expected to grow only 1.4% in the fourth quarter of 2013, registering full-year 2013 growth of 7.2%. Going into the next year, however, earnings expectations look slightly encouraging, with projected earnings growth of 10.8% in the first quarter and 13.5% in the second quarter of 2014. Additionally, full-year 2014 earnings are expected to grow 17.0%.

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 retailers are focusing on. Moreover, cost-containment efforts and merchandise initiatives to improve margins are top priorities.

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. 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. The stocks in our coverage with a Zacks Rank #1 (Strong Buy) include, Best Buy Companies Inc., Rite Aid Corp., Constellation Brands Inc. (STZ), Hanesbrands Inc. (HBI), Quicksilver Inc. (ZQK), Builders FirstSource Inc. (BLDR), TravelCenters of America LLC (TA), Netflix Inc. (NFLX), Nu Skin Enterprises Inc. (NUS) and Mohawk Industries Inc. (MHK).

Additionally, we prefer stocks with a Zacks Rank #2 (Buy), namely Ulta Salon, Cosmetics & Fragrance Inc. (ULTA), Marinemax Inc. (HZO), Tractor Supply Company (TSCO), Five Below Inc. (FIVE), Gildan Activewear Inc. (GIL), Big Lots Inc. (BIG), PriceSmart Inc. (PSMT), The TJX Companies Inc. (TJX - Analyst Report), Marks & Spencers Group Plc (MAKSY), Conns Inc. (CONN), GameStop Corp. (GME), DSW Inc. (DSW), Finish Line Inc. (FINL), Haverty Furniture Companies Inc. (HVT), Fortune Brands Home & Security Inc. (FBHS), The Kroger Company (KR) and Michael Kors Holdings Ltd (KORS).

On the other hand, there are stocks that don’t hold promise in the near term, and carry Zacks Rank #4 (Sell) and Zacks Rank #5 (Strong Sell). These include Barnes & Noble Inc. (BKS), Hibbett Sports Inc. (HIBB), Staples Inc., Costa Inc. (ATX), PVH Corp. (PVH), Coach Inc. (COH), Fred’s Inc., Family Dollar Stores Inc. (FDO), Crocs Inc. (CROX), Wholesale Foods Market Inc. (WFM), Aarons Inc. (AAN), RadioShack Corp. (RSH), Aeropostale Inc. (ARO), Zale Corp. (ZLC), Leggett & Platt Inc. (LEG), Lowe’s Companies Inc. (LOW), Abercrombie & Fitch Co. (ANF), Fastenal Company (FAST) and BJ’s Restaurants Inc. (BJRI).

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