If You Absolutely Must Own Retail, Look For Debt-Free Dividend Payers

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Includes: AMZN, ANF, FINL, FL, JCP, M, PIR
by: Orange Peel Investments

Summary

Retailers don't look especially strong heading into this summer, where rates could rise, causing a slowdown in lending and discretionary spending.

When discretionary spending falls off, we expect retail business to fall off with it.

The sector is flying too high. If you absolutely must own retail stocks, look at dividend payers that are debt-free.

By Parke Shall

We have been critical of retail as a sector for months, and we still think that retail is going to be the first of a few sectors that's going to pull back heading into rate hikes. When the market finally corrects, whether it's due to rate hikes or not, we're also expecting biotech to contract significantly.

Coming off of the 2008 crisis, retail has been unstoppable. As lenders continue to dole out credit to the country, discretionary spending has risen, helping bolster retail companies. The Dow 30 Retail Titans Index has continued to show strength over the last 12-month period. One could argue this chart remains in the middle of a longer-term breakout.

^DJTRET Chart

^DJTRET data by YCharts

We're less confident as we move into the second quarter of 2015.

Some will argue that a rise in rates signals strength and borrowers will be better suited to pay back debts. We take the more cautious end of this argument. Not to be never-ending pessimists, but at some point, lenders will start to curb their lending and borrowers are going to realize that they want to make good on some debts before the cost of capital continues to rise, as would happen during a rate hike. We've made it clear how we feel since the beginning of 2015, writing two articles looking at monthly retail numbers. You can read those articles here:

We're wary of retail not only because rate hikes will probably mark a slowdown in discretionary spending, but also because many retailers face challenges within their specific businesses. Companies like J.C. Penney (NYSE:JCP) continue to spin their wheels and try and find an identity that works. Clothing seller The Wet Seal and electronics retailer RadioShack have found themselves in bankruptcy. Other companies like Abercrombie (NYSE:ANF) are struggling still with the decrease in mall traffic. Many other brick and mortar-based companies are spending cash looking to create a hybrid online/in-store model to try and compete with behemoths like Amazon (NASDAQ:AMZN) and appeal to younger shoppers who do more shopping online.

One look at companies like Pier 1 (NYSE:PIR), which finally impressed the street last week after a couple quarters of misses and guide downs, and it's clear that the retail climate is not nearly as strongly positioned as it needs to be heading into rate hikes.

Companies like Foot Locker (NYSE:FL) and Finish Line (NASDAQ:FINL) have beat earnings as a result of buybacks and cutting expenses.

On top of this, you have the ongoing mess at the country's West Coast ports, which is a result of the International Longshore and Warehouse Union and the Pacific Maritime Association. This conflict continues to pressure smaller businesses and traditional retailers. PYMNTS.com expanded on this:

Truckers that normally haul five containers a day out of the Port are averaging less than one, China Ocean Shipping (Group) Co. said it will skip at least one Port and Maersk Line has canceled some sailings. One West Coast customs broker told The Wall Street Journal that her customers are being assessed as much as $300 a day for containers that are sitting at the Port waiting to be unloaded, despite the fact that her customers would like more than anything else to remove said containers and are being forcibly prevented from doing so.

Small business owners, that traditionally keep lower inventory supplies, have been hardest hit by the slowdown, but its effects on retail are slowly creeping up the chain.

"We're in trouble right now with some of our customers," said Softline President Jason Carr. "It's a major headache."

Bob Pisani at CNBC went through and highlighted some of the other struggles within the retail sector last week. According to CNBC:

  • Costco reported negative 2 percent comps, its first negative comp since Aug. 2009. Obviously the gas priced decline was an issue for the retailer, but even excluding the crude impact, the core same store sales number was only up 4 percent, below expectations.
  • Teen retailers are still struggling. Buckle had negative comps, while Zumiez posted a 5.5 percent comp -- not bad, but below expectations.
  • Overall, I'm a bit disappointed. We had a very early Easter, and when that happens, March is usually a bit loaded at the front end. Let's hope things turn around as the weather improves.

As we said in our last piece, if you absolutely must invest in retail, look at companies that don't have any debt exposure. In addition, if the company pays a dividend, that can help offset any declines that occur as a result of people moving out of the sector. Here's a list of 20 or so companies that pay a dividend without debt, as provided by Valueline:

Again, with the coming rise in rates, we think there's going to be a slowdown in discretionary spending, which should also help to slow retail spending. We don't recommend owning retail stocks here unless the company is online-based or has a fully implemented in-store/online hybrid model already in play. We haven't seen too many of these. Staple stocks like Macy's (NYSE:M) probably aren't a bad bet for the long haul, but we wouldn't want to be caught holding when the sector corrects. Also remember that the cost of capital is going to rise when rates do... bad news for companies that need to tap the capital markets regularly or are already carrying debt.

That's about as far as our optimism goes, however. We expect continued weakness for the sector moving into this summer.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.