California Dreamin' a Retail Nightmare?

by: Wall Street Strategies

By Brian Sozzi

Enthusiasm is running high on the notion that the U.S. consumer spending recovery has kicked into fourth gear from neutral. I sense the enthusiasm on earnings conference calls by listening to the line of questioning from other analysts. Then I have seen that optimism translate into the earnings forecasts for the balance of 2010, and on into 2011 and 2012, along with some aggressive movements on ratings and price targets.

Performance is being chased in the retail sector, no doubt about it. To say the pushing up of earnings forecasts for the next two years on retailers is not without merit would be wrong. Overall retail sales from the government have in fact improved, monthly comparable store sales are soundly positive on top of strengthening results from the latter stages of 2009, and core operating expenses remain nicely controlled. Moreover, the international growth story, particularly emerging markets, is overshadowing the modest, but welcome, demand recovery here at home. The thinking at the moment is that once a retailer plants a store in China, sit on back and enjoy the earnings accretion as rural dwellers go urban and wages increase.

All of this is fine and good. We positioned clients in numerous names in retail earlier this year in the fundamental belief that the feeling of pent up demand on the part of consumers, coupled with their de-leveraged personal balance sheets, plus benign inflation and lean operating budgets would create a powerful concoction for the bottom lines of retailers. Now that I sense the optimism seemingly smacking me in the face with each corner turned, I think the environment is ripe for big, contrarian calls. Especially after a company such as Best Buy (NYSE:BBY) serves up a hugely disappointing quarter and forward outlook.

I am actively in search of potential black swan events in the retail sector as we transition into 2011. In a nutshell, a black swan event, a term put forth by Nassim Taleb, tries to understand and uncover the disproportionate role of high-impact, hard to predict, and rare events that are beyond the realm of normal expectations. It could be a positive or negative event. For purposes of this piece, my rationale is straightforward. With P/E multiples no longer cheap (forward and trailing) in the retail sector (see Lululemon) (NASDAQ:LULU) and earnings forecasts on an uptrend, where can disappointment arise externally that would shock the expectations of the masses? Follow me here, I promise it all ties together. My black swan event is California, where many retailers have north of 10% of their store base positioned. Costco (NASDAQ:COST) alone derives 26% of its annual sales from the state.

Since the middle of this year (approximately) California has been called out as the comeback kid of sorts by retailers. Target (NYSE:TGT), Costco, Zumiez (NASDAQ:ZUMZ), and Home Depot (NYSE:HD) have partaken in more fruitful sales numbers from the land ruled by a guy known as the Governator. I have found all of this rather interesting, considering:

  1. Unemployment rate has remained steady this year. At 12.4%, the unemployment rate is among the highest in the U.S., and nowhere near the 4.8% cycle low in December 2006. It must be the likes of the Housewives of Orange County on the coastal cities driving spending.
  2. Wage growth, what wage growth?
  3. Home values are still depressed.

Whether the improved sales trend in the state is a function of brutally easy comparisons or much less leverage on the balance sheets of many amid the mailing in of the keys to the McMansion, is open for debate. As we enter 2011, I think California should be a focus not only from political/bond market perspectives, but for retailers as we bump up against those aforementioned stronger earnings consensus estimates from analysts.

There is no dancing around the troubles facing California as Governor-Elect Jerry Brown assumes office in January. California is staring at a budget deficit of $28 billion in the next fiscal year beginning in June, up from a $19 billion gap this fiscal year. Mr. Brown has been quoted as saying he plans to "rip the band-aid off next year," referencing what must be done to sure up the state's finances. In other words, he may very well pull a Chris Christie, which is to slash spending. On top of spending cuts, taxes may head higher. Heck, Controller John Chiang was quoted saying that California may have to hand out IOUs and defer tax refunds. The projected budget deficit, while worrying in its own right, pales in comparison to California's unfunded liabilities. According to the Stanford Institute for Economic Research, California has unfunded liabilities of $500 billion in pensions alone.

So let's take stock of what we have here. First, we have oozing enthusiasm embedded in the consensus numbers, which is being reflecting in valuations on retailers. Second, we have a state that is quite instrumental to a retailer's annual sales and profits. Third, all signs point to a continuation of depressed wages, sentiment and employment, along with spending cuts and tax deferrals in California. These are all negatives to consumer spending. The interesting thing here is that a new budget will have to be constructed when the old one is up in June, with the holiday season coming into focus. Sure sounds like a potential black swan if you ask me.

Detailed below is the California store count as a percentage of their total (the total includes stores operated in Canada and Puerto Rico, but excludes international) from the retailers contained in my coverage universe. If the California story were to unfold like I have envisioned, apparel and furniture retailers will be hit first, followed by discounters. A deep discounter such as 99 Cents Only (NYSE:NDN) should thrive, provided California doesn't drastically cut bus service (store base caters to lower income customers, which rely on public transportation).

* Urban Outfitters: 23%
o Urban Outfitters brand: 24% of 138 in U.S. operation in California
o Anthropologie brand: 21% of 145 in U.S. operation in California
o Free People brand: 32.0% of 38 in U.S. operation in California
* Abercrombie & Fitch: 12.7%
o Abercrombie & Fitch brand: 12.8% of 318 in U.S. operation in California
o Hollister brand: 13.1% of 434 in U.S. operation in California
o Abercrombie kids brand: 11.5% of 200 in U.S. operation in California

* Aeropostale: 8.7%
* Guess: 16.9%
* Bebe: 27.7%
* Pacific Sunwear: 13.0%
* Gap: 3.19%
o Gap North America: 3.3% of 1,127 stores in U.S. operation in California
o Old Navy North America: 3.1% of 1,036 in U.S. operation in California
* American Eagle Outfitters: 8.21%
* Ann Taylor: 4.4%
o Ann Taylor brand: 5.4% of 368 stores (includes outlet) in U.S. operation in California
o Loft brand: 3.7% of 539 stores (includes outlet) in U.S. operation in California
* Hot Topic: 15.5%
o Hot Topic brand: 11.8% of 680 stores in U.S. operation in California
o Torrid brand: 32.% of 155 stores in U.S. operation in California
* Target: 14.0%
* Wal-Mart: 4.7%
o Wal-Mart (U.S.): 4.7% of 3,792 in U.S. operation in California
o Sam's Club: 5.4% of 608 stores in U.S. operation in California
* Costco: 23.5%
* La-Z-Boy: 1 store out of 305
* Ethan Allen: 11.3%
* 99 Cents Only: 74.2%
* Home Depot: 5.2%
* Lowe's: 6.4%