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Industry Outlook

As consumer spending is the key to the viability of any economy, the health of the retail industry is an important economic indicator. According to the National Retail Federation, retail accounts for about $2.5 trillion of annual U.S. GDP and acts as a barometer for measuring the health of the nation’s economy.

The United States provides ample growth opportunities for all types of retail companies. Retailers of all sizes -- individual direct marketers or direct sellers, small- to medium-sized franchise unit owners, and large “big-box” store operators -- compete in the U.S., fostering increased growth opportunities.

The retail industry provides enormous employment opportunities, accounting for nearly 42 million jobs. Annual sales turnover of the retail industry is more than 12% of total trade volume of all the U.S.-based businesses.

Recent Industry Trends

Retailers had a robust 'back to school' and 'back to college' season with most companies posting positive comparable store sales (a key metric in retail industry analysis as it excludes sales at newly opened and closed stores) in the months of July, August and September. The back to school season had an encouraging start as consumers began shopping early July instead of August. Further, the spending appetite of shoppers also scaled up.

October comps for most retailers escalated as the U.S. unemployment rate declined in September, while property values improved, boosting consumer confidence and ultimately driving consumer spending levels to grow. Additionally, cool weather, strong store traffic and Columbus Day promotions helped sales growth in the beginning of the month.

The Conference Board’s reading of the Consumer Confidence Index -- a barometer of U.S. consumer health -- rose to 72.2 in October from 68.4 in September, marking the second consecutive improvement after a long time. The unemployment rate in the United States, reported by the US Bureau of Labor Statistics, remained static at 7.9% in October, following a decline in September.

Comps results for apparel retailers like Limited Brands up 3%, The Gap Inc. (GPS - Analyst Report) up 4%, Ross Stores Inc. (ROST - Analyst Report) up 4% and TJX Co. (TJX) up 7% remained positive. Additionally, discount store operators such as Costco Wholesale Corp. (COST - Analyst Report) and Target Corp. (TGT - Analyst Report) came in strong, posting a 7% and 2.4% increase in October comps, respectively.

On the other hand, department store chains like Macy’s Inc. (M - Analyst Report), Kohl’s Corp. (KSS - Analyst Report), Nordstrom Inc. (JWN - Analyst Report) and Stage Stores Inc. (SSI) continued to exhibit potential with 4.1%, 3.3%, 9.8%, and 6.5% increase in comps, respectively. However, results at the drugstore chains were disappointing, with Walgreen Co. (WAG) posting a 5.9% decline in October comps, and Rite Aid Corp. (RAD) dipping 1.1%.

October comps for the teen apparel retailers remained mixed with The Buckle Inc. (BKE) and Zumiez Inc. (ZUMZ) posting increases of 3.8% and 0.6%, respectively; while comps for Wet Seal Inc. (WTSLA) were down 7.6% and Cato Corp. (CATO) remained flat.

The upcoming holiday sales season is expected to be rewarding for retailers as the consumer sentiments remain positive, improving unemployment rates and soaring home prices. The National Retail Federation expects holiday sales this year to rise 4.1% to $586.1 billion, above the 10-year average holiday sales increase of 3.5%, still remaining lower than the 5.6% growth recoded in the 2011 holiday season.

Optimism for the holiday season remains intact as retail promotions are expected to hit the right chord with holiday shoppers. Retailers have pulled up their socks to make the most of the busiest shopping season of the year from offering lucrative discounts to flexibility of shopping through smartphones and tablets to free shipping and 24-hour shopping.

Certain retailers including Target Corp., Wal-Mart Stores Inc. (WMT) and Sears Holdings Corporation (SHLD) have announced their plans to kick start the holiday season by opening their showrooms to public earlier at night on Thanksgiving Day, instead of the usual practice of opening at midnight.

The latest trend this holiday season is the policy of matching prices being offered by online retail giants in order to be a part of the competition. Discount retail chain, Target Corporation and beleaguered consumer electronics retailer, Best Buy Co. Inc. (BBY - Analyst Report), announced that they will offer their patrons the facility to match the prices being offered by Amazon.com Inc. (AMZN), Wal-Mart Stores Inc.’s Walmart.com and ToysRus.com.

Further, to better serve the shoppers, the retailers are ramping up their hiring plans. Retail giants such as Macy’s, Target Corp., Wal-Mart Stores, Kohl’s Corp. and Toys “R” Us have announced their hiring plans for the upcoming holiday season.

However, the consumer spending plans this holiday season may be affected to some extent as macro challenges remain prevalent in the U.S. economy and the consumers have adapted a budget-conscious method of spending, which has become the population's ‘New Normal.’

Hurricane Sandy’s Impact on Retailers

Hurricane Sandy, which hit the U.S. East Coast on October 28, led to a two-day shut down of the U.S. stock trading, marking the first back-to-back shutdown owing to weather related adversities since 1888. The storm, which is estimated to have caused more than $20 billion of economic damage, had both a positive and negative impact on the October sales data of retailers.

In general, the October sales data of retailers remained largely unaffected by the storm as most retailers closed books for October sales on October 27. However, October sales for food, beverage and personal care stores seemed to have gained a little as consumers resorted to some stocking up of essentials before the storm.

Further, reports suggest that the overall impact of Sandy on retailers should be minimal as most of the damage occurred on a Monday and a Tuesday instead of the weekend, and it was well before Black Friday and the onset of holiday shopping. However, the real impact is expected to be reflected in the November sales, and will depend greatly on the timing of the recovery and opening up of the damaged stores. Delayed come back may cause retailers to lose on the sales in the upcoming holiday shopping season, substantially affecting their quarterly results.

As a common belief, storms are considered to be beneficial for food merchants before the occurrence of the calamity and for home improvement stores following the disaster, as people need to repair their homes. On the other hand, specialty-apparel chains and department stores get little chance to make up for their lost sales due to the storm.

Some of the department store chains that are believed to be hit hard by Hurricane Sandy are Macy’s and Saks Inc. (SKS). Macy’s houses about 30% of its stores in the states affected by the storm, while Saks has about 27% of its stores there. Further, drugstore retailers, Walgreen and Rite Aid, reported great damages to their stores. Walgreen, which owns the Duane Reade chain, pointed that about 750 of its 1,400 stores in the affected region remained closed during the storm.

Rite Aid reported that about 188 of its stores were either closed or operating without power as of October 31, down from about 790 stores that were closed during the storm. Other companies having high percentage of stores in storm affected areas include American Eagle Outfitters Inc. (AEO), Limited Brands Inc. and Urban Outfitters Inc. (URBN).

Backdrop Still Weak

Uncertain and sluggish economic conditions continue to weigh upon the retailers, indicating a grim outlook in terms of profitability and consequent growth. However, continuous efforts on their part to offer innovative products and value pricing have been paying off in an economy which is still in the doldrums. It is still a tough time for retailers, who are using all their resources in order to combat the sluggishness.

According to the U.S. Census Bureau, the U.S. retail and food services sales declined 0.3% from the prior month sales to $411.6 billion in October.

The "Re" is Back in Retailing

‘Transformation’ is the new mantra for the retailers. Despite rapid technological advancements, which are influencing consumer behavior, the retail industry continues to reinvent, redesign and revitalize its physical store formats to maintain their dominance.

Of late, retail giants including Best Buy Co. Inc., Target Corp., J. C. Penney Co. Inc. (JCP - Analyst Report) and Build-A-Bear Workshop Inc. (BBW) are focused on revisiting and re-evaluating conventionality and traditional business traits, while also envisioning its brick-and-mortar store merchandise offerings. Additionally, these companies continue to actively re-engineer and re-tool various systems and processes.

Moreover, the retail groups are coming up with strategic initiatives to boost operating efficiencies, drive growth and enhance shareholder’s value. Most retailers are focusing on abridging costs drastically to ensure competent operating channels. We believe that such measures are necessary to gain competitive advantage over peers. However, focus on improving the top line should be prioritized to accelerate long-term growth.

The above mentioned traits are evident from the efforts of J. C. Penney, which has left no stone unturned to bring the company back on the growth trajectory. Management has taken up everything from implementation of new pricing strategy, fresh logo and strategic merchandise and cost reduction initiatives, while enhancing the shopping experience of customers.

Moreover, the leading specialty retailer of consumer electronic products -- Best Buy intends to get rid of stores that are not contributing to its growth, while modifying others are also on the cards. The company plans to transform its big-box format to a big profit center by redesigning its prototype stores to mimic Apple Inc’s (AAPL) retail store format. Best Buy is not the first one to resort to such mimicry as Microsoft Corp. (MSFT), Walt Disney Co. (DIS), Tesla Motors Inc. (TSLA) and AT&T Inc. (T) have already opened stores emulating the Apple format.

Target Corp. is another retail chain that has resorted to a major redesign by developing the 'City Target' format, which aims at tapping the urban markets, where real estate remains a constraint. These stores are designed to fit in urban locations, both in terms of size and store design aesthetic. The has already company opened its first City Target stores in Chicago, Los Angeles and Seattle with 80,000 square feet, a lustrous urban background, no lawn and garden department and smaller back rooms.

In a similar move, Cabela’s Inc. (CAB - Analyst Report) -- one of the leading specialty retailers of hunting, fishing, camping and related outdoor merchandise – had unveiled its new ‘Outpost’ store format. The relatively smaller-size store will provide shoppers with Cabela's retail experience and will facilitate the company to capitalize on the under-penetrated markets.

Challenges and Some Remedial Measures

The retail industry is highly competitive and has significant challenges. Although the U.S. economy has started witnessing a soft recovery, we still believe that 2012 will not fully mark the return of the retail market, and 2013 may also have a somewhat similar story to tell, unless concrete steps are taken to bring the economy back on the growth trajectory. Consumers are slowly regaining confidence and cautiously increasing their spending.

Moreover, consumers remain sensitive to macro-economic factors including interest rate hikes, increase in fuel and energy costs, credit availability, unemployment levels and high household debt levels, which may negatively impact their discretionary spending, and in turn, adversely affect the growth and profitability of retail companies.

Macroeconomic Conditions: Retail is no different from other U.S. industries, which remain affected by the slow economic recovery. While the unemployment rate has decreased considerably over time, consumers are now beginning to draw out their savings to spend, in the hope of some economic recovery.

Though this is a positive sign, there has been a considerable rise in prices of commodities, which is making it difficult for consumers to make ends meet. On the other hand, the retailers are struggling as they are unable to pass these increased costs to consumers and their employees, given the already shrinking income levels.

Changes in Consumer Needs, Attitudes and Behavior: The growth of modern retail is linked to consumer needs, attitudes and behavior. Adapting to the sluggish economic environment prevalent over the last few years, consumer behavior has shifted to being more conservative. This has now become the normal behavior of consumers as they remain budget conscious, seeking more and more value. In the process, buyers are swiftly switching to the less expensive brands and consolidating shopping trips.

Retailers are offering trend-right and well-designed assortments at compelling prices, without compromising on quality, in order to drive traffic.

Higher Fuel Prices: As a new trend, shoppers are making fewer shopping trips. This has emerged from the rise in gas prices as well as the hectic lives of consumers, while income remains constricted. Looking ahead, we expect this trend to continue for the next few years.

Apart from cutting down on the number of trips, shoppers also chalk out their shopping mission before stepping out. Today, consumers look for multichannel retail outlets, which offer variety of goods, rather than making separate visits for paper goods, health and beauty items, grocery, etc. Thus, retailers now need to understand the consumers’ shopping missions and get the most out of their visits by broadening their assortments with the appropriate depth, breadth and freshness to appeal to their customers’ requirements.

Staging Stores: The waning popularity of brick-and-mortar store formats has made it essential for retailers to adopt new techniques like ‘staging stores’ to woo customers. Staging basically refers to the act of making the company’s stores attractive destinations, where people like to spend their time. The idea behind this strategy is to make shopping interesting for consumers, so that they would want to walk into the stores, rather than shop online.

Use of Internet and Mobiles in Shopping: With shoppers becoming more and more tech-savvy these days, a new era of shopping via internet, smartphones and tablets has emerged. Today, consumers are increasingly using the tech-media to make purchases, find coupons and search for the best deals. This growing trend has guided major U.S. retail chains to downsize their physical retail operations, and in turn, develop their e-commerce and m-commerce sites to attract customers.

The rate of electronic retail shopping is expected to increase significantly over the next four to five years. To take advantage of this growing trend, retailers need to identify the best possible means of benefiting from the use of technology in shopping while implementing relevant strategies. By integrating the digital mode into the shopping experience, retailers can earn rewards in the form of increased shopper demand and greater shopper loyalty.

Conclusion

Retailers are trying to remain competitive primarily by shifting focus to the long-term horizon and finding innovative solutions to create value, reduce operating costs and mitigate risks throughout the enterprise.

Right-sizing inventories, enhancing efficiency and competence and bringing in technological advancements are the key agendas that the retailers are focusing on. Moreover, cost-containment efforts and merchandise initiatives to improve margins are top priorities.

Further, retailers are largely concentrating on buyers’ needs, which in turn, will usher in huge potential for growth and is likely to augment sales in the long run. Additionally, exploring all possible opportunities to create premium as well as value products to suit the different income groups should help improve returns. Considering the current macro-economic environment, this strategy should be a smart move to better position companies to attract consumers.

Retail, owing to its huge spectrum, remains a lucrative investment avenue for investors. The sector reflects consumer spending trends, an important parameter to gauge the health of the economy (consumer spending accounts for approximately 2/3rd of the economy). Thus, identifying future winners from this sector would be a good investment decision.

We recommend few stocks in the sector at this point, as these companies are showing significant growth despite the secular headwinds. Adaptability to the buying habits of the consumers and strengthening the loyalty base helped these retailers post strong results. The stocks in our coverage with a Zacks #1 Rank (Strong Buy) include Dillard’s Inc. (DDS), Aarons Inc. (AAN), Stage Stores, Conns Inc. (CONN), The Gap Inc. and ANN Inc. (ANN).

Additionally, we are also bullish on stocks with a Zacks #2 Rank (Buy), namely American Eagle Outfitters Inc., Petsmart Inc. (PETM), Macy's Inc., Home Depot Inc. (HD), Nike Inc. (NKE), Big 5 Sporting Goods Corp. (BGFV), Lululemon Athletica Inc. (LULU), Constellation Brands Inc. (STZ) and Dick’s Sporting Goods Inc. (DKS).

On the other hand, we are bearish on retailers with a Zacks #5 Rank (Strong Sell) and Zacks #4 Rank (Sell) including J. C. Penney, Deckers Outdoor Corp. (DECK), Cache Inc. (CACH), Spectrum Brands Holdings Inc. (SPB), Avon Products Inc. (AVP) and Best Buy.

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