Why It's Time to Buy Retail Stocks

Many retail stocks are off their recent 2009 highs after weak June sales were reported and some economic data has suggested that we are in for a slow economic recovery. However, even assuming only a modest recovery in the economy into 2010, the outlook for retail earnings is better than it has been for several quarters. Sales declines appear to be bottoming just as cost cuts are starting to show up in full. Additionally, many retailers have the potential for significant upside to gross margins this year.

Sales appear to be bottoming: Per US Advanced Retail Sales data, seasonally adjusted retail sales appear to have bottomed in March with a 12.1% year-over-year decline. June’s 10.0% decline was the best showing since last November as the declines started to accelerate into this recession. Last year’s fiscal stimulus remains as a near term challenge for retail comparisons.

However, as we enter the fall, easing comparisons should start to improve reported sales. This, of course, assumes no significant drop off in demand from the current sales trend.

Admittedly, this is the biggest risk to retail, but one that appears at least partially discounted already in analyst earnings estimates and the valuation of retail stocks.

Gross margins are improving and should be substantially higher by 4Q. Inventories are expected to be well under control now as predicted by many retailers as 1Q results were reported.

Confirmation of this can be seen in the recent Commerce Department report for May showing a 1.6% drop in retail inventories and the Inventory/Sales ratio falling to 1.42 from 1.54 in April and 1.38 last year. With inventory under control, heavy discounting should abate. This should mean substantial upside to gross margins from reduced discounting for 4Q of this year.

Other factors that will improve margins near term include reduced transportation costs starting in 2Q (after oil spike last year) and reduced product costs from reduced labor, material and energy expense largely starting in 3Q.

Retailers have now had enough time to reduce “fixed” costs. Cost cutting began in 4Q, but for many retailers 2Q will be the first time earnings receive the full impact of reductions. Cost cuts have ranged from simply downsizing corporate headquarters and headcounts to, in select cases, rent reductions.

Additionally, many retailers canceled remodeling and other upgrades and trimmed or eliminated store growth this year. The bulk of these types expenses occur in 2Q and 3Q, suggesting the sharpest SG&A reductions are likely occurring in the next couple of quarters.