Tough Year Ahead For Specialty Retailers

by: Howard Sun posted on: April 14, 2008 | about stocks: BBBY / BBI / BBY / BGP / BKS / CAB / CC / GME / HD / HIBB / JAS / LL / LOW / ODP / OMX / PETM / PIR / RSH / SHW / SPLS / TIF / TSCO    

Specialty retailers are a sub-segment of the $4 trillion retail industry in the United States. Specialty stores sell a single category of merchandise or carry a few closely related categories. Major categories of specialty retailing include electronics, home-related items, office supplies, shoes, books, toys, pet supplies, sporting goods, apparel, jewelry and others. Companies that fall into these categories include The Home Depot (HD), Best Buy (BBY), Staples (SPLS), Gap (GPS), Circuit City (CC), Bed Bath & Beyond (BBBY), Foot Locker (FL), Blockbuster (BBI), Radio Shack (RSH), PetSmart (PETM) and Tiffany & Co (TIF). In other words, these stores are different from the traditional mass, grocery and club retailer that carry a wide assortment of products and categories.

Specialty retailers are experiencing difficult times due to macroeconomic challenges. First, I will explore some of the industry trends; I will then talk about the major challenges retailers are facing; finally, I will discuss some useful strategies to employ when analyzing these companies.

Industry Trends

Retailers seeking growth overseas – As the US market becomes increasing saturated, retailers are looking to overseas markets for growth, especially in Asia. For example, in December 2006, Home Depot acquired 12 stores in China from the Chinese company Home Way; in May 2006, Best Buy acquired 75% stake in Jiangsu Five Star Appliance, the third largest electronics chain in China; other companies like Nike (NKE) and Staples are also aggressively entering the Chinese and Indian markets.

Retailers narrowing focus on the core business – Several struggling retailers have decided to sell off or shut down their noncore operations in an effort to streamline their businesses. For example, Pier 1 Imports (PIR) rationalized its store base by closing 36 stores including all of its Kids stores in 2007; Radio Shack closed 500 stores in 2006 and 21 additional stores in 2007.

Increased number of service offerings – Many specialty retailers are now selling services as a means to distinguish themselves from rivals. For example, Best Buy has had a lot of success with its Geek Squad offering repair, support and installation services at all stores; PetSmart, the largest US pet supplies retailer, is also the largest pet services provider for services like grooming, training and boarding facilities. Many retailers have found that since launching these services, they’ve seen a spike in both retail revenue as well as traffic to stores, which has boosted consumer loyalty.

Growth in store brand private label – Many retailers introduced their own store branded products to increase margins and draw increased awareness to the store brand versus third-party brands. For example, Staples offers over 2000 private label products including notebooks, office chairs and paper clips and plans to increase private label sales from 20% to 30% of revenues in the next few years.

Expanding e-commerce – Online sales growth have beaten traditional retail sales for many years and continue to do so. In 2007, the $35 billion e-commerce market now represents approximately 3.5% of total retail sales, up from 0.5% in 2000.

Challenges In 2008

Home sales in the US remains bleak – based on the most recent home sales figures from the National Association of Realtors, single family home sales in February 2008 were 23.8% below February 2007 levels. This means that home improvement and “do-it-yourself” retailers such as The Home Depot and Lowe’s are likely to continue to post soft sales results. Home furnishing retailers like Bed Bad & Beyond are also likely to post weaker sales.

Strong competition from discounters and online retailers – increased consumer preference for online retailing and discount stores is diluting specialty retailers’ profits and resulting in industry consolidation. For example, big-box retailers like Wal-Mart (WMT) and Costco (COST) have increased their focus on selling electronics at lower prices compared to electronics chains Circuit City and Best Buy. Big-box retailers offer consumers the convenience of buying everything they need under one store. In addition, today’s gas prices are forcing consumers to take overall fewer trips; this makes the Wal-Mart trip that much more important.

Consumer confidence remains low – the consumer confidence index is at its lowest levels in five years as consumers are becoming more concerned about the job market and the overall economy. Many economists believe the national savings rate will increase over the next few years; consequently this will likely cause consumers to spend less on everyday products.

High energy costs and raw materials – Rising energy costs is a double edged sword – consumers are making fewer trips because of the increased costs and retailers are experiencing reduced margins from manufacturing to supply chain and transportation. In bleak times like now, many companies are simply absorbing these increased costs versus passing them onto consumers. For specialty retailers, this means reduced revenues and profit margins.

What To Look For In Specialty Retailers

There are several factors that I look at when I analyze retail companies:

  • Retail category – In which segment does the retailer compete in? How does this retail category fit into the overall economy? What’s the level of competition within the category? What’s the growth potential?
  • Retailer strategies – Who does the retailer target? How does the retailer differentiate from competitors? Does the retailer have an international strategy? What types of products does the retailer carry? Do the retail locations fit the retailer’s strategies?
  • The income statement – Same-store sales growth; Profit margin growth (gross, operating, net); Sales per square foot growth; International expansion
  • The balance sheet – Low debt-to-equity ratio (a high debt load means higher interest payments which reduces investment capital); Inventory turnover in-line with category levels

Outlook For 2008

The specialty retail industry looks less than promising in 2008. Decreased consumer spending, increased margin pressures, undiversified retail categories and an overall recessionary economy put this industry at high risk. At this point in time, I do not recommend going long in any of these companies. I believe the recession is here to stay and will not likely turnaround anytime soon. However, there are several companies that I’m watching more closely than others. These include Ann Taylor (ANN), Best Buy (BBY), Lumber Liquidators (LL), Cabela’s (CAB) and Saks (SKS).

Disclosure: none

Howard Sun

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