Byline: Evan Clark

NEW YORK — Wall Street could be ready to fall out of love with retail — again.
Retail issues have outperformed the brightest of predictions in the six months since the financial markets reopened following Sept. 11, but their nature as early-cycle stocks may soon pull them down as interest rates turn northward.
While bottom-line strength tended to be concentrated among discounters and other value-oriented retailers, most stores finished the fourth quarter with results that far exceeded their worst fears for the season, even those based on results through mid-September. If hardly the makings of a boom, results being reported this year, combined with the brevity of the recession and the resilience of both consumer spending and consumer confidence, suggested a retail marketplace that was slightly down but hardly out.
But the figures emanating from Wall Street tell an even more upbeat story. The Standard & Poor’s retail index jumped 34.8 percent to 972.54 between its close of 721.42 on Sept. 17, the day trading resumed after being halted by the terrorist attacks, and their final position on March 18.
Since the markets reopened, the S&P 500 has risen a less robust 12.2 percent, while the Dow Jones Industrial Average increased 18.6 percent. The Dow plunged 7.1 percent on Sept. 17, the day from which these comparisons were drawn.
On Monday, the retail index slid 1.4 percent to 950.19, while the S&P 500 was off 1.5 percent to 1,131.70. The Dow Jones fell 1.4 percent to 10,281.67.
However, analysts and economists find it hard to believe the run-up will run on. “Many investors believe we’re in the ninth inning of retail stock outperformance and everybody’s trying to pick the time and place to get out,” said Shari Schwartzman Eberts, equity analyst at J.P. Morgan Securities.
The rally, she pointed out, “really started back in 2000 when everyone was concerned the economy was slowing down.”
Slowing economies produce lower interest rates that often benefit retailers with increased consumer spending and elevated stock prices. Retail stocks generally peak early in the economic up cycle and then start to drop, partially in anticipation of rising interest rates.
The Federal Reserve cut the short-term interest rate 11 times last year, finally dropping it in December to 1.75, its lowest level in 40 years.
“In the normal cycle before Sept. 11, clearly investors were looking to play an economic recovery with retail stocks,” said Eberts. The attacks were “a shock to the system and investors, but set up another early cycle play because they forced the worst.
“There was a lot of concern that consumer confidence would be shattered, travel would grind to a halt and the economy would go into a sharp recession. All of those things were expected to really curtail consumer spending, given that consumers were already worried about the economy,” said Eberts.
Although the most dire predictions didn’t materialize, there were certainly reasons in late September and October to expect the worst, including drastically reduced sales, a wave of profit warnings and ongoing uncertainty underscored by the anthrax attacks and military action in Afghanistan.
Retail watchers have also had to adjust to the bankruptcy of Kmart Corp., filed on Jan. 22, and the weakness of Gap Inc.’s earnings, comparable-store sales and, consequently, debt ratings.
Consumer confidence, widely measured through the Conference Board’s index, plummeted to its lowest level in seven years after the attacks, dropping to 84.9 in November from 97 in September after five straight months of declines. Although the next two months saw upward motion, the index settled a bit in February to stand at 94.1.
However, Lynn Franco, director of the Conference Board’s Consumer Research Center, asserted that the index still pointed to healthy consumer spending. “The consumer will continue to provide solid spending support as the economy moves into recovery,” she said in a statement earlier this month.
Based on historical performance, retail stocks had a good chance of outperforming the general market during the last six months. The retail index has bested the S&P 500 during the first quarter in 10 of the last 12 years. During the fourth quarter, the retail index has beaten the broader market eight times since 1990.
By contrast, the retail measure has been weaker than the S&P 500 eight of the last 12 years during the second and third quarters.
ABN AMRO retail analyst Christine Kilton-Augustine in a telephone interview last week warned that some of the seasonal strength in retail stocks “has become a self-fulfilling prophecy because investors expect the stocks to outperform.” (On Monday ABN AMRO said it would shutter its U.S. domestic cash equities business.)
The cycle overall, though, has been more hot than cold for retailers. Over the past eight years through March 18 — the earliest possible comparison — the S&P retail index is up 194 percent, beating the Dow Jones (up 171.5 percent) and the S&P 500 (up 147.4 percent).
J.P. Morgan economist James Glassman noted that retailers have also been helped over the last half-year by “a phenomenal period” of consumer spending.
“Instead of retrenching, consumer spending exploded. A lot of that was driven by autos, but still Christmas turned out a lot better than people thought,” he said.
According to the Bureau of Economic Analysis, broad consumer spending jumped 6 percent in real terms during the fourth quarter. Glassman said the measure looks to be a more moderate 2.5 to 3 percent increase for the first three months of 2002.
He attributed the unexpected strength to last summer’s tax cuts, confidence in the government, the so-far successful campaign in Afghanistan and the American consumer’s solidarity in the face of adversity. Consumers tend to “surprise you with how resilient they can be. If we didn’t see trouble last winter, I don’t know why it would happen in the future,” he noted.
Still the economist noted: “It will be a more challenging environment for retailers in the next several years compared with the last five years because we’ve never seen anything like” the bubble/boom times of the Nineties.
“It was the most amazing decade of prosperity that we’ve ever seen and the retailer was at the leading edge of it, but when you talk to retailers, they don’t remember it that way,” he observed. Despite the Nasdaq boom and the wealth effect among the paper and truly rich, retailers, he said, were pinched by an intensely competitive atmosphere, cheaper imports and the ever-moving target of fashion trends.
Going forward, Glassman said the prospects for economic improvement are good. However, “it’s not retailers who are going to benefit the most because it’s really the manufacturing industry that’s suffered the most over the last year.”
Although retail share prices have risen in accordance with historical trends, Steven Skinner, a partner in the retail industry group at Accenture, a management consulting firm, pointed out: “A rising stock price now indicates that Wall Street expects a better operating performance from the retailer in the future. So if we see a stock price going up we’re probably seeing enhanced gross margins, increased same-store sales and market share being taken away from a competitor.”
Investors, he said, “are seeing things like increased consumer confidence, stronger orders of durable goods, a lower unemployment rate, sustained low inflation and the economic stimulus package,” which will benefit retailers going forward.
Unemployment stood essentially unchanged in February at 5.5 percent.
“What we are seeing in general is that the stock market thinks the retail industry is on the mend,” he said, though it hasn’t yet worked through all of the negative effects of Sept. 11. Consumer confidence has yet to regain its pre-Sept. 11 levels and and same-store sales haven’t been consistent. However, inventories are very clean and supply chains are improved, he said.
“The turnaround is coming. It’s not completely here, but the basic infrastructure has been laid. There’s some uneven performance across the board in retail, but spring and summer will begin to see a better underlying operating performance,” he said.
Summer into fall, then, should be marked by further improvement for retailers, he said, and bring their stocks along for the ride. Stores also will benefit from being pitted against relatively soft sales comparisons from last year.
Better advertising and a more selective use of capital, in addition to very low inventories, are some fundamentals that Skinner noted would help drive retailers’ operations and stocks for the rest of the year.
“This downturn has injected a healthy dose of operational efficiency” into retailing, said Skinner. One example is more exacting inventory management, which helps the firms keep less capital tied up in its unsold merchandise and more of what the customer wants on the shelves. Retailers “are more efficient at serving the customer at a higher level and all of that bodes well for when we get a large return of the economy,” he noted.
Firms also have focused their microscopes on expenses to maintain profit margins — an action reflected in the oft repeated “we’re tightening our belts” and “we’re righting our ship” quotes in quarterly press releases.
Even though their stocks have generally risen, operationally, many retailers have simply tried to weather the storm in retailing, especially in already beleaguered sectors.
For instance, department stores in recent years have been fighting off their own inefficiencies and defending market share from encroaching discounters and specialty stores. Still, their stock valuations over the past six months have risen handsomely and, for the most part, outperformed the broader market.
In the past half-year, the shares of a slew of department stores left in the dust the retail index’s 34.8 percent increase. Among them was Federated Department Stores, whose shares rose 48.9 percent. The May Department Stores Co.’s shares were up a milder, yet respectable, 26.5 percent.
By contrast, these company’s earnings for the fourth quarter headed downward. Federated’s income from continuing operations and before charges retreated 22.5 percent to $310 million, while overall sales descended 8.4 percent to $5.13 billion. May Co.’s profits dropped 16.8 percent to $431 million, while its revenues slid 7.1 percent to $4.65 billion.
In a classic Wall Street/real world paradox, these and others retailers may improve their operations in the coming year, while their stocks could very well deflate.
Going forward, Kilton-Augustine noted: “The spring season is off to a decent start. Several retailers noted that men’s apparel may be stabilizing, which is an encouraging sign.
“We expect inventory levels to remain lean throughout 2002, and as a result, retailers should benefit from gross margin improvement,” she said.
With interest rates expected to rise, though, Kilton-Augustine noted: “It doesn’t mean you can’t make money, but you have to be more selective. You have to pick names where there’s a fundamental growth or a turnaround or a cost-cutting story.”

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