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Still Riding the Bull: Retail Shares Expected To Outperform Market

After gaining 10 percent last year, shares of major stores continue to be strengthened by a positive economic outlook in the U.S., partly due to declining gas prices.

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Retail shares are still burning hot.

After gaining 10 percent last year, shares of major stores continue to be strengthened by a positive economic outlook in the U.S., partly due to declining gas prices. But valuations could get trumped during the first half by cooler weather, analysts said.

For now the retail sector is on a roll, outpacing other sectors, and equity analysts see Coach, Federated Department Stores, Target Corp. and Urban Outfitters as among the top picks for 2007.

In the luxury sector, a relatively weak dollar will likely continue to attract tourists from Europe to these shores, bolstering high-end retail sales, according to one analyst.

So far this year, the S&P Retail Index is up about 3.4 percent, while the Dow Jones Industrial is up just 0.7 percent. Buoying retail stocks are economic reports that point to low inflation, which bodes well for consumer spending.

Citigroup analyst Kimberly Green­berger said in a research note that “positive trends in wage growth and unemployment, along with continued energy price declines and the current steady interest-rate environment, point to a solid macroeconomic footing and a healthy consumer for 2007.”

Although some economists worry that the softness in the housing market could dampen consumer spending (see related story), Greenberger said the impact would not be significant. “We believe steady increases in wage growth are more highly correlated with consumer spending,” she said.

Still, there are some economists who see tempered spending this year. Last week, the National Retail Federation said it expected retail sales growth to slow to 4.8 percent this year, which compares with 6.3 percent in 2006. The estimate excludes automobiles, gas stations and restaurants.

What clearly will affect sales is the weather, as it has so far this winter, which has been relatively mild in the Northeast. Changes are ahead, however. “Projections for significantly cooler-than-last-year weather [throughout the U.S.] in January, February and April will likely yield significant comp and stock price volatility in early 2007,” Greenberger said.

In the specialty channel, the analyst’s top stock picks are Coach and Urban Outfitters. “We focus on Coach due to three new product line introductions and potential upside to consensus [earnings per share] estimates,” Greenberger said in her research note. “At Urban Outfitters, we expect continued merchandise improvements will lead to a return to positive comp sales and an operating margin recovery.”

This story first appeared in the January 22, 2007 issue of WWD.  Subscribe Today.

At a recent investment conference, Urban Outfitters revealed that it was getting ready to launch a fourth retail concept, yet unnamed. “As with Free People, there is likely to be just one store at first (or just a small handful) and it will take a few years before growth takes off,” said CIBC World Markets analyst Roxanne Meyer in a research note. Meyer also has Urban pegged as a top stock pick for 2007.

In the department store segment, Goldman Sachs analyst Adrianne Shapira said in a research note that “industry consolidation has clarified swim lanes across the sector.”

“Across fewer players, there is clearer distinction across good (J.C. Penney, Kohl’s), better (Federated), and best (Nordstrom, Saks) players,” the analyst said. “This has resonated with customers and, as a result, industry returns have improved. While we expect this positive trend to continue, the share reshuffling should moderate and, as a result, we are shifting our sector view to Neutral from Cautious.”

Shapira said across the department store sector, “Federated remains our Buy recommendation based on its compelling risk/reward profile.”

In a report from Craig Johnson, president of consultancy firm Customer Growth Partners, the analyst said he expected discounters and department stores to continue to do well. “The ‘Barbell Shopping’ pattern we’ve seen for the last couple of years intensified in Holiday 2006, as year-to-year sales rose 11.5 percent and 9.6 percent for our Luxury and Discount Indices [respectively] while declining 2.3 percent for the Mid-Tier Index.”

One of Johnson’s top trends for 2007 is for U.S. to continue to be a “shopping magnet” for the global luxury customer. “To an extent never before seen, America is becoming the world’s favorite shopping destination — at each end of the retail spectrum,” Johnson said. “At the high end, visiting ‘Euro-shoppers’ flooded luxury stores in New York and other gateway cities this Christmas, attracted by the weak dollar, trading at a discount of 11 percent to the euro and 14 percent to the British pound, from holiday 2005 levels, leading to double-digit growth of leading upmarket retailers.”

Johnson said at the discount end of the market, “both first-generation and newly arrived immigrants are concentrating their shopping in value formats such as Wal-Mart and the dollar stores, boosting otherwise mediocre sales. For many new arrivals, Wal-Mart has become today’s ‘Ellis Island,’ where immigrants first learn how to become part of American society, often get their first job (with America’s largest employer) — and, of course, learn how to shop.”

Shapira said Wal-Mart “poses less of a headwind to others” in the discounter space. She said the retailer “is taking a smaller incremental bite out of the retail landscape each year. Wal-Mart maintains pressure across retailers with its still robust 7.5 percent domestic square-footage growth. But its recent disappointing comp gains, despite continued turnaround efforts, means it is leaving sizable market-share crumbs behind for the rest of retail to feed off of.”

And, according to the Goldman Sachs analyst, Target will be the big winner. The Minneapolis discount chain is one of Shapira’s top stock picks for 2007.

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