Wal-Mart's Report: A Red Flag for Retail Sector Investors

Includes: HD, LOW, PIR, TGT, WMT, XRT
by: Markos Kaminis

The day's news wire included two troubling bits of information you may have missed. Thanks to a flood of mostly positive news, an important message was smothered. Both the ICSC and Wal-Mart same-store sales data showed an important and intensified negative trend, but thanks to WMT's better than expected EPS report, the red flag provided to the retail sector Tuesday was missed by the popular press.

Wal-Mart (NYSE:WMT) reported street exceeding EPS of $0.97, besting the experts' view by a penny. The nation's top retailer did not stop there though. WalMart also raised its guidance range for the full year by five cents. As a result, the stock is up 2% at the hour of this scribbling.

The S&P Retail SPDR (NYSEARCA:XRT) is up nearly 2% too, since Wal-Mart is a dominant component of every retail index, except the ex-WalMart portfolios (assuming at least one exists; obviously it should). Here's why I think you should use this momentary pull up of retail stocks to sell, in case you missed that message here over the last few months. The rise of retail indices today is completely due to Wal-Mart's EPS beat and guidance hike, but within WalMart's report there is an important poison pill for the US retail sector to swallow. That same information came across again today in the ICSC Weekly Same-Store Sales Report, and it's a glaring red flag for retail sector investment.

Wal-Mart's Report Break-Down

You heard the good news already, but what you did not get is how WalMart averted industry obstacles presented by a weak US market. Basically, the company overcame an apparent major stumbling block via its growth overseas and tight operational management. It also employed a good deal of cash in share repurchases, which can lift a bottom line.

Net sales increased 2.8%, to $103 billion, but look closely. Eight-tenths of that growth came on currency exchange, and that hints at another key catalyst. Sixty percent of the company's square footage increase came from international growth in Q2. Wal-Mart leveraged operating expenses and expanded its ROI to 19%, versus 18.4% in last year's quarter. However, even as Wal-Mart impressively created value, its report warns of trouble for other less perfect retailers.

Wal-Mart's US operations saw stagnant sales year-to-year in Q2, while its International segment grew sales by 11%, including the currency gains. Sam's Club contributed a 2.2% increase on a smaller sales figure. While WMT's international growth benefited from robust activity in Mexico, Brazil and China, its US namesake division saw a 1.8% decrease in same-store sales. Take note, because this is a store that appeals to price-seekers. This is where poor people shop and where middle and formerly upper class Americans facing tough times trade down to. WalMart has been stealing market share from a broad spectrum of retailers over recent years, and especially during the recession; and now even it cannot grow them. That is saying something rather dire about American consumption. Do you know what else WalMart has been seeing an increase in? Food stamp usage. Now, the company said traffic trends improved toward the end of the 13 week's measured for Q2, but retail stock buyer beware nonetheless, because that is a very vague statement and can mean or not mean a lot.

ICSC Weekly Same-Store Sales Concur

Tuesday's International Council of Shopping Centers (ICSC) data covering the period ended August 14 concurred with WalMart's results and differed from its vague offsetting statement. So which do you want to base your investment decisions on then? Sales deteriorated further in the August 14 period, with the week-over-week comparison losing 1.3%. The yearly comparison still shows 3.3% growth, but that's down from last week's 3.7% change.

We also remind that last year's comparable economic activity was simply the worst in generations, and so easy to beat in comparison. Redbook showed a 2.7% increase in sales against the prior year, versus 3.0% last week (another sign of deceleration against normalizing comparables with time). The result? We have a stagnant state of consumption developing, if not a deteriorating state.

Arbitrage Opportunity

I think today's mixed message from Wal-Mart is providing noise to the real retail sector story. Disregarding valuation and stock specific characteristics that may surface a handful of winners, the general retail sector trend is being skewed today because Wal-Mart is such an important part of all retail indices. The company represents a major portion of the American retail sector, and is huge based on market capitalization; thus, it is weighted heavily in these indices.

So, as Wal-Mart goes, so go the industry indices. Given this skew, many retail players are likely benefiting today without reason. So I see this an opportunity to save a few dollars by reducing weight in the sector.

Take note that the sensitivity of the sector today to the positive news may also reflect a valuation test, as retail stocks have already seen some downgrades and share price drops since spring and again this month. Yes, stocks will also move ahead of economic data (and I mean recover eventually), but I believe we are still in a period of realization of a new economic paradigm I've been trying to lay out for you to see over recent weeks and months. This economy will not be the same again, at least not for a long while. Regulation and common sense have trimmed that negligent and even criminal lending that had Americans living beyond their means for years.

I realized that problem ten years ago, when my little sister without a college degree and with a mall job managed to buy a new car. I knew I couldn't afford one with an MBA, and so something was clearly wrong with the system. I talked about that here before the financial crisis; long-time readers will remember it. Money was too easy to get, clearly. We all knew it, but we blew it off.

There's no blowing it off anymore. New laws and new internal banking rules and reserve requirements are playing an important role in changing all that. 16.5% under-employment is playing a major role in keeping consumption tame as well. Panicked people living on unemployment while Congress debates cutting it off are getting a grip on it too. Welcome to the new economy, not like the old one. In this one, productivity brought on by technological advancement is not a good thing. In the past, it was noted for its role in allowing companies to expand margins. Now, it is also responsibile for keeping companies from hiring workers that are not really needed. It's amazing how a change in the labor market can affect views on unions, immigration and maybe even robotics... isn't it.

Over recent weeks, we have learned that Q2 GDP will get a shaving at its next revision, and it looks as if we might flirt with economic contraction in the second half of the year. Economists cannot imagine that, but the American economy is a consumer driven one. We don't export yet, and even if we did, Chinese domestic growth looks poised for a hurdle of an asset and real estate bubble burst sometime soon. So, can we really count on China and Europe (ex-Germany) to keep buying whatever we do sell? That's rhetorical...

So, my friends, I say take this rally and shove it. The Dow is up 1.0% at this hour (down from +2% earlier); I would sell it. The S&P Retail SPDR is up 1.5% (down from earlier as well); I would sell it! I think what we have here is an opportunity... to get out.

Disclosure: No Positions