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August 18, 2005

Is Retailing Starting to Falter?
by Chad Hudson

UNEDITED

Several retailers reported second quarter results over the past week. Overall, results have been strong, but investors have been jittery. Since March 2003, retail stocks, as measured by the Morgan Stanley Retail Index have doubled. While some of the increase has been from multiple expansion, most of the gain has come from spectacular earnings growth. Earnings for the aforementioned index have increased by 57% since the summer of 2003. Retail stocks have also outperformed the overall market this year. While the S&P 500 has advanced less than 1%, the Morgan Stanley Retail Index has increased 10%.

Nordstrom reported that its second quarter revenue increased 7.8% and same store sales climbed 6.2%. Earnings per share jumped 43% to $0.53 per share, a nickel more than Wall Street forecasted. Operating margins expanded by almost 240 basis points to 9.8%, the highest since at least 2000. Interestingly, Citigroup raised its full year EPS estimate, but lowered its target multiple and reduced its price target from $40 to $35. Citigroup expects the multiple to contract due to greater competition from the Federated / May Department Stores merger.

On the other end of the spectrum, Wal-Mart reported that second quarter earnings increased 8.1% from a year ago. Revenue increased 10% with same store sales advancing only 3.5%. This was the smallest increase in earnings since the quarter that ended October 2001. Furthermore, the retailing giant said full year earnings will be $2.63 to $2.70 per share. In May, the company said earnings per share could be as much as $2.74. CEO H. Lee Scott said that he does "feel good about the economy...But I worry about the effect of higher oil prices. So I anticipate that we will face challenges as the year progresses." Wal-Mart also disclosed that higher energy prices cost the company $130 million during the quarter, $100 million in higher utility expenses and $30 million due to higher freight costs.

Target has been able to attract higher income customers than Wal-Mart and has not suffered as lower income customers have reduced discretionary spending as energy prices have escalated. During the second quarter Target's revenues increased 13.6%, driven in part by an increase of 6.7% in same store sales. Earnings per share jumped 37.2% helped by a 110 basis point gain in gross margin.

Home Depot reported that its sales increased 11.7%. New stores accounted for 7.7% of total revenue growth, and same store sales increased 4%. Same store sales were driven by a 5.5% increase in average ticket and were negatively impacted by a 1.5% drop in traffic. The company said that cannibalization negatively impacted same store sales by 140 basis points and has cannibalized 17% of its store base. The company raised the low end of its EPS growth guidance, which now stands at 14%-17%. Gross margins declined by 15 basis points.

Lowe's continued to outpace Home Depot during the second quarter. Lowe's reported that second quarter sales increased 17% helped by a 6.5% increase in same store sales. Most of this increase was driven by an increase of the average ticket by 5.6% and transactions increased 1.7%. Earnings grew 21%. Gross margins increased 52 basis points to 33.8%. The company did say the sales through the first half of August were on the low end of is plan, 4%-6% same stores sales increase, but expects sales and margins to improve.

The teen apparel retailers have historically been at the mercy of the latest fashion trend. When the fashion trend aligns with a retailer's merchandise, sales can soar. But when the trend changes, it can be disastrous. Hot Topic was a high-flyer up until last year. Its sales went from $23.6 million in 1996 to $572 million for the year ending January 2004. Income soared from $440,000 to $47 million over those eight years. The stock went from under $5 to over $30. Sales continued to climb last year, but in March 2004 same store sales slowed and then started to decline during the second quarter. The stock fell to $15 during the middle of the year and has traded between $15 and $23 since then. It appears this range will be breached. On Wednesday, the company announced that earnings for the next two quarters will be below analysts' estimates. The stock traded as low as $12.75 in after-hours trading.

American Eagle Outfitters has been one of the most popular teen retailers over the past two years. American Eagle reported earnings of $0.37 per share, a penny better than Wall Street forecasts, however, a lower tax rate added two pennies to second quarter earnings. Analysts are worried about denim. When the company reported July same store sales, it said that "denim comped positively." Prudential analyst, Stacy Pak, noted it was interesting that considering same store sales were up 21%, the company didn't say that "denim comped double digits" or "denim was very strong." Pak also questioned how management was unable to leverage strong comparable store sales. SG&A as a percent of sales dropped only 2 basis points.

Abercrombie & Fitch reported that sales increased 42% driven by a 30% increase in comparable store sales. Earnings per share increased 43% to $0.63 per share. As strong as these results were, analysts were expecting more. Analysts expected the company to earn $0.69 per share. The company also guided down earnings estimates for the year. The company said it expects to earn $3.10 to $3.30 this year, while the consensus estimate was $3.38. Gross margin fell and SG&A expenses fell. Inventories increased 72%. This was the first time since 1999 that the teen retailer experienced year-over-year growth in inventory per square foot. The company said it was due to a "significant" increase in denim inventory. The company "made a big investment to own this business...There's no markdown risk to our basic merchandise. I expect the denim business to continue to be strong."

These results clearly disappointed investors. Its stock price dropped almost 4% on Wednesday, and traded as much as 7.5% lower. It appears that investors had just grown too optimistic. The company raised its full year EPS guidance to $3.10 - $3.30 from $2.80 - $3.00. But Wall Street consensus estimate for the year fell to $3.30. Credit Suisse lowered its EPS estimate by $0.23 to $3.40, still a dime more than the company expects to earn.

Retailers have kept inventory levels in line with sales. This has been more due to strong consumer demand than better inventory management. Without excess inventories, retailers have not had to discount merchandise and have enjoyed higher gross margins. The impressive results over the past two years got the attention of investors. If growth starts to slow, retailers could be in a pinch. Inventories will grow, putting pressure on gross margins, plus stores will not be able to leverage SG&A. This is what happened in late 2002, which caused the group to lose about one-third of its value.

Chad Hudson
Mid-Week Analysis
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