By and  on January 30, 2006

NEW YORK — As the mergers and acquisitions market keeps up its dizzy pace, retailers face challenges that go beyond the impact of consolidation.

Higher energy costs and a softer housing market could make this year difficult to navigate for retailers across all channels, even the robust luxury goods segment. But consumers' propensity to spend is a powerful force, and shoppers may surprise the more bearish economists. For retailers, the effort this year will be focused on maintaining a solid financial footing while growing their top line. So the industry can expect to see more concepts and formats open this year as well as more daring merchandise initiatives. And with consolidation trends freeing up valuable space, the retail real estate market surely will be stirred.

Mass With Class

Expect new lifestyle formats, pricier and more stylish apparel and "store-of-the-community" customization to continue to upgrade the mass retail channel this year.

In October, Wal-Mart vice chairman John Menzer touted the retailer's new "masstige" aesthetic to a group of Wall Street analysts. Target executives, speaking at their analyst conference in October, bragged their $10 billion-a-year apparel business is "a money machine" with gross margins "hundreds" of basis points higher than typical department stores, wrote Sanford Bernstein analyst Emme Kozloff in a research report.

But this drive for affordable luxury doesn't mean Target and Wal-Mart are abandoning millions of customers needing Tide detergent and cheap socks.

Rather, each retailer made strides last year in profiling who is most important to them and what opportunities each micromarket holds. Wal-Mart, for example, is becoming expert at serving the nation's growing and diverse Latino population. Target rearranged stores to suit its favored guests, such as mom-and-baby shoppers, with departments tailored to their frequent purchases.

In their desire to penetrate cities and older, dense suburbs, both retailers have been innovative in drafting stores for small sites, or redeveloping existing buildings. Witness Wal-Mart's planned conversion of a former Helene Curtis shampoo factory in Chicago, or the funky, steel exoskeleton of Target's Albany, Calif., store, designed to fit into its industrial neighborhood.

"Mass is an old idea. The idea of being able to reach for a ‘mass' target is pretty much gone," observed Jeff Smith, managing partner for Accenture's Global Retail Practice. "There will be format, price, shopping experience and assortment variations by market as each player tries to carve out audiences. Those [retailers] with the competence to fine-tune the dials will be successful. The others will be marginalized."Competitors have become wily at finding opportunities inadvertently created by the discount giants. Drugstore chain Walgreens, for example, has been selling a growing array of toys and household goods in addition to traditional drugstore wares. It's not inconceivable they might test apparel such as socks, basic T-shirts and baby outfits. The drug chain perceives a competitive advantage in its relatively small stores that are less onerous to navigate than a 100,000-plus-square-foot big box.

All this still leaves plenty of room for Wal-Mart and Target to grow, particularly at a cost to traditional apparel players. Department stores are at greatest risk, but even some specialty retailers may find sales poached if they don't offer differentiated value.

Tierney Remick, global managing partner with executive search firm Korn/Ferry Inter­national, said Target, which had a stellar year in 2005, already is "drawing [shoppers] away from the department stores and having a huge impact on consumer electronics."

Accenture's Smith speculated Wal-Mart might test a lifestyle store this year that would emulate some of Target's best practices in soft goods. The Bentonville, Ark., retailer operates a soft goods-only concept in the U.K. called ASDA Living, which focuses on apparel, home decor and housewares.

As one of her top-five predictions for this year, Citigroup analyst Deborah Weinswig forecasts Target will move into mall vacancies freed up by the Federated-May consolidation. Only 7 percent of Target's current stores are in malls, but those stores perform as well as, and potentially better than, stand-alone stores, Weinswig wrote. The mall scenario would put Target into head-to-head competition with department stores in many markets.

Specialty Concepts

If 2005 was the year for specialty retailers to announce or launch new retail concepts, then 2006 will be the year for follow-through. The specialists will continue identifying future growth prospects among both existing and new concept stores in order to drive incremental and comp-store sales.

Meanwhile, ongoing challenges facing the group will be driving consumer spending, which is inescapably linked to — but not altogether dependent on — markdown management, as well as grabbing market share by effectively leading fashion newness in the ever-competitive landscape.

While Abercrombie & Fitch Co. continues to tweak its year-old Ruehl brand, Chico's FAS Inc., Aéropostale Inc. and Gap Inc. are testing Soma by Chico's, Jimmy'Z and Forth & Towne, respectively. Guess Inc. is continuing to roll out Marciano stores as well as stand-alone Guess accessories stores, and Victoria's Secret is testing its Pink innerwear format. American Eagle Outfitters Inc., which is not planning to roll out its new Martin + Osa sportswear brand until the fall, recently said it is working on another new concept while also testing an intimates subbrand.And ultrahot retailer Urban Outfitters Inc. is reportedly on the path to identifying a couple of new formats. Analysts think the company, which already operates Urban Outfitters-, Anthropologie- and Free People-branded stores, could be considering a new lingerie concept or a new one that would target upper-middle-class consumers.

"All the top specialty retailers that you and I know are constantly on the lookout for new ways to grow their business because growth is the name of the game. But it's getting increasingly difficult," said Martin Brill, founder and president of retail consultancy Sweetwater Consulting. "There are only so many voids in the market. A lot of the voids have been filled and the competition is getting tougher. To me, the key to the new concepts is a combination of product and retail innovation in terms of retail presentation."

So where are the voids in the specialty retail sector? Brill cited active athletic apparel, specifically yoga-driven, concepts. That's partially because retailers stand to capitalize not just on apparel for yoga, but also yoga-related accessories, for example.

Tim Shimotakahara, associate at investment banking firm D.A. Davidson & Co., agrees with Brill that active lifestyle retailers who cater to low-impact athletics, such as yoga, will be hot this year because the activity spans age groups and demographics.

"Action sports [retailers], board sports, lifestyle companies — we're going to see continued growth through '06 from the strength of '05 driven by the general taste demand in the market," said Shimotakahara, who thinks the action/board/lifestyle sports market was legitimized this year in part by Quiksilver Inc. buying Rossignol and by Volcom Inc. successfully going public.

Better Economics

Peter Hooper, managing director and chief U.S. economist at Deutsche Bank Securities, speaking at a New York Society of Security Analysts meeting earlier this month, believes the "consumer will hold up" this year. He told attendees that, despite what may be a slowing in the housing market, one should expect "moderate consumer growth, not a sharp drop-off."

This is good news for the high-end retailers and the department stores. Consumer spending in these segments has been strong, but has softened slightly, leaving analysts to wonder how 2006 will play out.Weinswig said in a recent research note that retailers among her broadlines coverage universe face more difficult comparisons in the first half of 2006, at 4.3 percent, with comps easing a bit in the second half of the year to 3.2 percent. The department stores face an average comp of 3.8 percent in the first half of the year, and 2.4 percent in the balance of 2006.

Her top pick is Federated De­partment Stores, whose merger with May Department Stores makes it the "most dominant department store player in the world." Upcoming asset sales — credit card portfolios, store locations and the Lord & Taylor business — will help the company pay down debt.

Another ongoing trend in the department store sector is mergers and acquisitions. Last year saw Neiman Marcus Group and Goody's Family Clothing get taken private through acquisitions by private equity firms. This year, barely a month old, already saw The Sports Authority announce it would be taken private by a financial sponsor. Then there's talk on the Street that Saks Fifth Avenue could see a similar fate. Saks' Parisian business is currently up for sale as well as Federated's Lord & Taylor business.

The fallout, as stores merge, are acquired or consolidate, includes store closures, which can free up a lot of key retail space. Robert Drbul, equity analyst at Lehman Brothers, wrote to investors, "We believe it is important to closely monitor the valuations on any upcoming real estate transactions, as they will likely prove or disprove the theory that investors should consider certain retail stocks on the basis of their real estate alone."

Other Variables

Factors, firms who handle a company's accounts receivables for a fee and who assess the creditworthiness of retailers, are optimistic in their overall outlooks for 2006. But it is peppered with some caution.

The market is strong enough to weather any potential storms that might arise this year, said Stanley Officina, president of Ultimate Financial Solutions LLC. The current climate will force retailers to focus internally, but that won't negatively impact credit, he predicted.

"There is some fat out there in the retail community that has to be trimmed," Officina said. "We're seeing the tip of the iceberg right now with some of the announcements that are coming out."From a creditor's view, recent market consolidation isn't having much of an impact. "Even with all the consolidation with Neiman Marcus and Federated and the changes going on at Saks, I don't see that from a credit standpoint there's going to be any significant weakening in that end of the market," said Gary Wassner, president and principal of Hilldun Corp.

In fact, the consolidation trend of the last few years will drive retailers to focus more closely on their operations as they face the challenges of a survival-of-the-fittest contest, factors said.

"There has been a trend toward consolidation, resulting in financially stressed retailers being merged into stronger, better-managed companies," said Thomas DiMaio, senior vice president and regional manager of Hana Financial. That trend should continue into this year, he said.

The consolidation within the industry will strengthen the retail base by winnowing out stores that aren't doing well, Officina said. "We're overinventoried with retailers as it is," he said.

"What we'll see spilling into 2006 is that some of the weaker players that are very leveraged may be challenged," said J. Michael Stanley, executive vice president of Rosenthal & Rosenthal Inc. With most of the retailers who have been sold or leveraged recently, the lack of strong, committed financial partners has had an impact, but overall, those credit issues are localized, Stanley said.

"Overall, most major retailers are in good shape. It would take a deep recession to cause concerns and there are no signs of that happening," said John La Lota, president of Sterling Factors Corp.

A cooling of the real estate market potentially could impact expectations for the credit industry this year, sources said, but most think it is unlikely to have a negative effect.

"If there is a housing market downturn, it could dampen consumer spending, credit quality and job creation. Home equity extraction has offset the negative effect of a doubling of oil prices in the last two years, but won't continue. However, interest rates should level off this year with the overall result having a neutral effect on the creditworthiness of the consumer-reliant customer base," said Thomas V. Pizzo, president and chief executive officer of Wells Fargo Century.With contributions from Vicki M. Young, Amy S. Choi and Liza Casabona

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