NEW YORK — Tight expense controls might bail out fourth-quarter retail profits despite weak holiday sales, but analysts fear that the stores have squeezed about as much out of prices and costs as they can.

In the year ahead, they said, margin maintenance and enhancement, and the resumption of top-line growth, will come down to better retailing fundamentals: products, presentation and service.

Citing leaner inventories, tighter expenses, easier margin comparisons and better sourcing from foreign manufacturers, a broad spectrum of retailers — including Federated Department Stores, J.C. Penney Co., Target, Gap Inc., Abercrombie & Fitch and Ann Taylor — said last week that, despite sales that barely rose above the freezing point in December, they experienced higher gross margins than expected, leading many to maintain or even raise earnings expectations for the current fourth quarter.

December comp increases averaged about 1 percent as specialty stores straddled that figure, discount and off-price stores were generally above it and department stores somewhat below. With the long wait for critical December comps now over, the focus shifts to the end of retailers’ fiscal year and the reporting of their fourth-quarter profits next month.

Shari Schwartzman Eberts, a broadline analyst with J.P. Morgan Securities Inc., said: "The greater-than-expected margin improvement will offset the top-line shortfall, so profits will be in line with expectations."

For example, she said, Federated missed sales — comps were off 2.6 percent, but the department store company had better inventory and expense controls in place, leading to better margins than planned. As a result, it didn’t cut into its fourth-quarter outlook.

And there are other examples to be gleaned from company reports. Abercrombie & Fitch, too, said that although transactions per average store were down 11 percent last month versus last year, the average transaction value was up 10 percent, a reflection of its nonpromotional strategy, resulting in a solid margin performance. The teen retailer said it was now expecting to record higher earnings for the fourth quarter than anticipated and raised its profit guidance to a range of 86 to 88 cents from the 79 cents originally forecast.

Gap, too, cited better margins, although the San Francisco-based company did not give earnings guidance. "Total company merchandise margins exceeded expectations with improvements year-over-year across all divisions, driven by better markdown margins," Heidi Kunz, Gap’s chief financial officer, said last Thursday on a prerecorded conference call detailing the company’s monthly results.But how long can retail companies rely on margin expansion to save the bottom line with little or no sales growth?

While retail executives could breathe a sigh of relief when the season was not quite as gloomy as some had feared, retail watchdogs warn that the margin expansion most enjoyed throughout 2002 will not be present in 2003 and said retailers need to find a way to drive top-line growth if they want to see profit growth this year.

Retailers have managed to stay above the fray by selling products with planned promotions, but much of what they are selling is not unique, retail analysts said. With a significant overcapacity of stores in the marketplace, many selling commodity products, marking down prices is perhaps the only way to drive sales.

Eberts warned: "It is getting harder and harder for department stores to offset sales weakness with margin improvements as they start to recycle inventory reductions. The fourth quarter will come in OK, but the gains are not as strong as they were in the first half of the year."

Continued profitability will rest not on a balancing act between cutting inventories and cutting prices, Eberts said, but on a reaffirmation of the ideas that have always distinguished fashion retailers — exciting fashion and efficient customer service.

She outlined a vicious price circle. "Retailers need to take some margin risk and none of them are leaning in that direction right now," Eberts said. "They are trying to conserve cash and make their numbers. It has become easier to make numbers with less markdown risk, but they’re now in a position of greater markdown risk because they’re selling commodity goods, and that’s all about price."

Her specialty store counterpart at J.P. Morgan, Brian Tunick, said: "Consumers are just chasing the lowest price. That’s the big problem retailers are going to have this year. It’s tough to get excited about a lot of the industry right now with this environment of mall traffic being negative for 21 months in a row and consumer confidence levels at a nine-year low and continued apparel deflation."

Stores that have made the effort to distinguish themselves are realizing both improved sales and higher profits, he noted: "The industry needs to step out and be differentiated, like Hot Topic, Pacific Sunwear and Chico’s — who are not participating in the price wars and are still reporting higher sales — or they are going to fall victim to the consumer only buying on sale. That’s OK for the discounters, but not for the rest of the industry."Tunick selected a trio of companies that last month registered double-digit comp gains, a rarity among the December filers. Hot Topic, PacSun and Chico’s had same-store sales increases of 10.6, 16.1 and 12.6 percent, respectively, despite the harsh economic climate and differences in customer base.

Jennifer Black, an analyst at Wells Fargo Van Kasper put it simply: "What has to happen is the product has to be really great. If the merchandise is right, the product sells, but when it isn’t, people are not going to buy it."

She cited Wet Seal as a retailer that missed the fashion mark and paid dearly in its numbers: a 19.4 percent decline in December comps.

On the other hand, Black said Ann Taylor’s 14.6 percent drop for the month, at first glance, might make it seem the women’s apparel specialty store was in trouble. But, J. Patrick Spainhour, AT’s chairman, said in a statement that the company experienced continued margin gains in December, roughly 300 basis points, enabling it to reiterate current quarterly guidance.

However, it’s becoming more difficult to generate margin improvement despite top-line depletion, as the benefits of alternative sourcing, lower expenses and improved efficiency approach their peak. Discounts, markdowns and even planned promotions may be close to the point where they can no longer be benign.

"Retailers cannot get away with discounting indefinitely," Steve Skinner, a partner in the retail industry group at Accenture, said. "The only way to get ahead in the long run is to put something new into the store. That is what is missing."

Why not get back to merchandising? Skinner said he expects to see retailers return their focus on product innovation and service this year to lure their customers back into the stores, drive margins and put more price stability back into the marketplace.

Russell Jones, a retail consultant at Cap Gemini Ernst & Young, said: "Retailers should look back on the holiday season and say, ‘I did not do the right things.’ Retailers got themselves trapped into thinking that the only way consumers would buy was through promotions, and I believe that was not appealing all season long to all shoppers."Jones asserted that the way the industry has worked over the past few years has convinced price-sensitive shoppers to shop either the weekend after Thanksgiving or the weekend before Christmas, when promotions are most intense. Yet on the other hand, they are missing out on customers who are after something more than a penny or a few dollars saved.

"For the rest of the season, retailers are trying to convince those who do not buy promotions to buy based on promotions," Jones continued. "That is not working because they cannot find anything interesting. Only a few retailers like Wal-Mart can win when the game is all about price. Those other retailers who decide to get into the promotional game will lose because Wal-Mart is a better discount store."

He cited Nordstrom which, with its 3.4 percent comp increase last month, was among the few department stores to see its top line head in the right direction.

"Nordstrom breaking out of the pack might help some see the way," Jones said, noting that the Seattle-based specialty department store has returned to some of the principles, such as great customer service and unique merchandise, that had always made it different.

Expectations are guarded for the first half of the year, but Accenture’s Skinner believes that tax cuts and economic recovery will put consumers in a better state of mind to spend by mid-year. Economic stimuli and "a comeback in product and service innovations should drive more positive store revenues in the second half of the year," he said.

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