Can retail stocks keep up their torrid pace?

This story first appeared in the November 17, 2003 issue of WWD. Subscribe Today.

The next few months will tell us, but there’s no doubt that they have been sizzling hot. Buoyed by a confluence of improving economic indicators and events, the major market indices have seen their strongest gains in years, and retail stocks, supported by expectations of a pickup in consumer spending, are leading the pack.

Since bottoming out eight months ago, the Standard & Poor’s Retail Index has shot up by more than half, or 50.3 percent, since the end of February. That performance more than doubled the gains seen in the Dow Jones Industrial Average, which rose 24.2 percent over the same period.

With the National Retail Federation projecting holiday sales growth of 5.7 percent, an extra shopping day versus the prior-year period and easy comparisons to last season when retail sales rose only 2.2 percent — the worst performance in 10 years — retail stocks would seem poised to add to their already impressive gains.

“This year’s sales comparison is the easiest since 1990, when sales were flat with those of the prior year,” wrote Lehman Brothers analyst Robert Drbul in a research report. “Holiday sales are expected to be more robust than they were last year because of the combination of low interest rates, low inflation, improving equity markets, the surge in mortgage refinancings and higher disposable income from the withholding tax cut and child tax credits. We believe retailers’ strong performance during the back-to-school period bodes well for the upcoming holiday selling season.”

Of course, it almost goes without saying that there are complications in predicting the future movements of share prices, an activity many analysts liken more to an art than a science, despite the wealth of data they plug into their elaborate and arcane forecasting models.

Among the more salient — and unknowable — factors muddying analysts’ and investors’ predictions are the movement of gas prices, future employment trends, consumer confidence and, critically, how much the bullish holiday expectations are already reflected in share values. And with some stocks having doubled and even tripled this year already, there is the question of just how much higher can they go.

But even after taking all that into account, industry observers for the most part are very upbeat regarding the holidays.

“If you look at the retail group as a whole, I don’t think valuation is an issue. By and large I think it’s fairly valued,” said Robert Buchanan, an analyst with A.G. Edwards & Sons, which is expecting a 3.4 percent comparable-store sales increase for the holidays. “But valuation is just one consideration. It’s such an art picking stocks.”

Buchanan stressed that the members of the retail group must be evaluated on an individual basis. Moreover, he pointed out that the retail group’s remarkable gains must be put in context with the larger market and economy in general.

“I think consumer trends tend to lead the broad economy,” Buchanan said.

As the rest of the economy and industrial averages pick up, the gap between the retail sector and the other indices will narrow, he said. However, that doesn’t mean retail values have no place to grow.

“It’s true that some retail stocks have seen a big run-up,” Buchanan noted, “but that is coming from depressed levels. Aeropostale, if anything, is undervalued. Too Inc. and Dillard’s are overvalued. At Too Inc., it’s just not happening in their core business. I just don’t see a 10-year-old girl making a bee-line to a Too in the strip mall. In the case of Dillard’s, I think they’re late on taking their markdowns.”

Aeropostale led WWD’s sample of retail stock performance for Feb. 28 to Oct. 31, soaring 211.3 percent to $30.85 from $9.91. That beat the S&P Retail Index over the same period by 161 percent, and the Dow by 187.1 percent. Dillard’s and Too, for their parts, underperformed both averages, growing just 16.9 percent and 8.2 percent, respectively.

Other hot stocks include Christopher & Banks, which advanced 207.7 percent over the eight-month period to $29.20 from $9.49; Retail Ventures, formerly Value City, with a 205.9 percent gain to $5.66 from $1.85; and Sears, whose shares have traded up 144.8 percent to $52.63 from $21.50.

Smith Barney analyst Deborah Weinswig is also bullish for the holidays and said some strong stocks still have plenty of life in them.

“We’re expecting sales to increase 4 to 6 percent,” she said. “I think the stars are in alignment right now. Economically, we have lower tax withholding rates, a reduction in gas prices and consumer spending is up. Mall traffic is picking up and the high-end consumer is definitely back. And retailers have been very conservative with their inventories, so there is potential for gross margin improvement and selling, general and administrative expense leverage.”

For the holiday season, Weinswig wrote in a research note that Federated Department Stores “continues to be our top pick. It is one of the most leveraged companies [going into] the holiday within our broadlines coverage universe, with approximately 55 to 65 percent of annual earnings per share generated in the fourth-quarter alone.”

Based on that and other factors, last week Weinswig upgraded Federated to “buy” with medium risk from “hold” with medium risk. Over the eight months covered, Federated’s stock expanded 87.6 percent to $47.55 from $25.34, easily outperforming the S&P Retail Index and Dow by 37.3 percent and 63.4 percent, respectively.

At the high end, Neiman Marcus Group, Saks Fifth Avenue parent Saks Inc. and Nordstrom have seen their shares advance 75.6 percent, 80.8 percent and 80.9 percent, respectively, and there is good reason to think they’ll continue to grow through the fourth quarter as the evidence continues to mount that the sector has rebounded.

But before investors get too irrationally exuberant, bear in mind that there is, as always, a more cautious view. Some fear that investors and analysts may be oversold on the correlation between back-to-school and holiday sales increases, which, according to Lehman Brothers, have mirrored each other by 89 percent since 1993.

Elizabeth Pierce, an analyst with Sanders Morris Harris, for example, said she was concerned there could be some stock give-back in the coming weeks leading up to Christmas as the battle between two consumer spending theories plays out. Pierce said while she expects consumers to embrace the holidays, she said the recent runup in stocks reflect the strong back-to-school sales and the expectation that holiday sales will follow suit. However, as most consumers have become procrastinators, she said stocks could be weakened as investors may not see the desired comp trends in November.

So investors, of course, must pick wisely. Whether they get capital gains or lumps of coal in their Christmas stockings, only time will tell.

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