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4 retail stocks still on a roll
Despite some gloomy predictions, consumers haven't snapped their wallets shut just yet. Retailers that should rock on include Guitar Center, Nordstrom, Chico's and Jo-Ann Stores.
By Michael Brush
Anyone whos doubted the strength of U.S. consumers in the face of doldrums and disaster in the past five years -- whether it's been a sinking stock market or terrorist attacks on U.S. soil -- has been sorely wrong.
Through it all, consumers have kept their wallets open.
Despite that impressive resiliency, a fresh crop of pundits is again questioning the stamina of the U.S. consumer. Heres a taste of what the gloom-and-doom crowd has to say: - JPMorgan Chase (JPM, news, msgs) global equity strategist Abhijit Chakrabortti now counts retail as one of five sectors with the greatest risk of earnings disappointments. He argues theres little room for improvement in consumer spending because of weak job growth, high debt levels and declining savings.
- Morgan Stanley (MWD, news, msgs) chief economist Stephen Roach worries that household debt now stands at a record level: 90% of gross domestic product, up 20 percentage points over the past five years.
- Analysts at Bridgewater Associates recently cautioned that a U.S. consumption bubble will end badly and hurt the markets at some point in the next 18 months.
Since consumer spending accounts for two thirds of the gross domestic product in the U.S., alarmist warnings like these are cause for concern.
But should we really worry about the consumer?
Related news and commentary on MSN Money
Three errant arguments on consumer spending
No, says Oak Associates economist Ed Yardeni. Basically, Yardeni says, the skeptics rely on three key arguments in predicting the demise of the consumer. Heres why each argument is wrong.
No. 1: Too much debt
This is a favorite among consumer-bashers. But while debt is up, there are several compelling reasons to think this wont be a problem. First, the consumers ability to pay off debt -- the real issue -- hasnt changed much, says Yardeni. To see why, look at the Federal Reserve Boards household debt service ratio, an estimate of the ratio of debt payments to disposable personal income.
It stood at 13.4% in the first quarter. True, that is the highest level since 1980. But it has bounced around above 13% since 2001 without incident. And it has been above 10.59% since 1980, so it is not dramatically higher today. Its up, but it is not particularly worrisome, Yardeni says.
Next, people are actually getting better at paying off much of their debt, not worse. Personal-loan delinquency rates are down to their lowest levels in decades. Credit-card delinquency rates have fallen for nine months in a row, as of March. Theyre lower than they have been in two years, according to the American Bankers Association. Thats hardly a sign of a consumer burdened by debt.
Finally, while overall debt is up -- to $10.7 trillion, by one Fed measure -- assets are up as well, at $59.2 trillion by the end of first quarter. That means net worth is at $48.5 trillion -- a record level. Whats more, assets are reasonably diversified across real estate, cash, equities, pension funds and private business ownership, says Yardeni.
No. 2: The high price of gas
Its common to think that gasoline prices well over $2 a gallon will soon take a bite out of consumers' budgets. Not so. Incomes are rising fast enough to offset that, says Yardeni. As of May, personal income adjusted for inflation was up 4% compared to the year before. Thats higher than the average gains during each of the past three decades.
Yardeni calculates that energy was taking only 5.3% of disposable income by May. True, that's up from about 4% in 2001. But it is well below the 8% level in the early 1980s and about the same as before the first oil shock of 1973.
No. 3: Unemployment
Job growth hasnt been on fire, but jobs are coming back. Unemployment has fallen steadily to 5% in June from above 6% in 2003. And people are finally noticing. For the first time since October 2001, the University of Michigan Consumer Sentiment Index recently found that people no longer have a pessimistic view on the labor market, on the whole. That helps explain why the Conference Boards measure of consumer confidence rose to a three-year high in June -- even though gasoline prices went up so much. Yardeni thinks that the healthy increase in personal income -- combined with job growth -- means the country is adding higher-paid jobs. Thats good for the economy.
Dont worry, go shopping
Americans were born to shop," says Yardeni, "When we are happy we spend money. When we are depressed, we try to spend even more.
Indeed, June retail sales were surprisingly strong -- one reason the brokerage A.G. Edwards & Sons last week (on July 7) upgraded its overall rating on retail stocks to overweight from equal weight. Analysts expect follow-through strength during the back-to-school shopping season.
I dont think the consumer is going to roll over here for at least another year or more, says Chris Serra, a Thrivent Small Cap Stock fund (AASMX) portfolio manager who follows retail stocks. While job growth isnt fantastic, it is getting better, and interest rates are low. There is a lot of money in the system. People still have a lot of money in their pockets and they are going to spend it.
Like most analysts, Serra thinks its important to find the right niche stocks when investing in the retail sector. In that spirit, here are several specialty retail plays and two broad-based retailers with room for more upside, despite big gains so far this year. Just keep in mind these are now momentum plays that, for the most part, are not cheap. That means they can reverse sharply if anything changes. So, as usual, dont take concentrated positions.
A portfolio's guitar hero
Whether its baby boomers looking to emulate their '60s musical heroes or kids hoping to be the next Green Day, were buying more guitars, amps, keyboards and drum kits as a nation -- if the sales results of Guitar Center (GTRC, news, msgs) are any indication.
The music-and-instruments chain expects to chalk up same store sales in the 5% to 7% range in the next two quarters. And its been growing by rolling out new stores for years. Guitar Center takes business from small mom-and-pop operators by offering lower prices and superior service -- like friendlier in-store help and better return policies.
Its a fragmented industry, and they are consolidating it, says Serra. They have 150 stores now, and they can easily go to 300 or more. Guitar Center stumbled recently when it got ahead of its supply lines. A strong fourth quarter -- especially for guitars -- drained inventory more than expected. That ate into the supply for the first quarter.
The inventory hiccup sparked panic selling in March through April, and thats when Serra bought. Since then, management has said its fixed the supply-chain problem, and the shares have recovered. But Serra isnt selling. He thinks aggressive store openings and an advance in operating margins to 9% from 6.7% last year could push the stock over $90 in the next one to three years.
Two upscale retailers
Arun Daniel, a consumer-sector analyst with ING Investment Management, isnt convinced the higher price of gasoline wont hurt low-end consumers at least just a little. He points out that upscale retailers did well in June, but low-end retailers like TJX Companies (TJX, news, msgs) and Dollar Tree Stores (DLTR, news, msgs) missed expectations for sales growth. Thats why he prefers to go with high-end retailers. Two examples: Nordstrom (JWN, news, msgs) and Chico's FAS (CHS, news, msgs).
Nordstrom is a department store that thinks like a specialty outlet. The company traces its roots to retail footwear sales, so it puts special emphasis on having the right selection of whatever it sells, says Legg Mason analyst Richard Jaffe. Nordstrom has its buyers operate regionally, making them better able to jump on local fashion trends quickly.
Nordstrom also dedicates far less floor space to name-brand vendors. This allows Nordstrom to quickly dedicate floor space to emerging fashion trends, says Jaffe.
Nordstroms knack for keeping on top of fashion trends may be one reason both teens and their parents like to shop there, says Serra, who believes the stock can trade into the $50s in a year or more. The stock recently sold for $35.
Upscale clothing retailer Chico's FAS caters to women over 35. It has a store called White House | Black Market for younger women, and the company has launched a chain called Soma, which sells intimate apparel. Chico's is clearly hitting the trends right. It posted June same-store sales of 18.8%, or double expectations -- one reason its a favorite pick at Value Line, says Steve Sanbourn, director of stock research.
Bigger is better for Jo-Ann
Jo-Ann Stores (JAS, news, msgs) is the nations largest retailer of fabrics and sewing products. Its also a retailer in transition. The company is closing down smaller stores and opening superstores that sell a mix of sewing goods and arts and crafts products. The transition is painful, as opening costs weigh on profits. That makes Jo-Ann Stores a value play, trading at just 13.1 times 2006 earnings. Jo-Ann Stores also appears cheap because it has already started expensing stock options, unlike many retailers.
The bigger stores, however, will ultimately make the company much more profitable, says Robert Rodriguez, a value manager at First Pacific Advisors who has a knack for spotting under-valued names. Rodriguez has huge cash positions in his funds because he doesnt like market valuations overall. But he was recently adding to his Jo-Ann Stores position near current levels.
Jo-Ann Stores, which sells for around $28.40, has 717 Jo-Ann Fabrics stores, and 131 superstores. It plans to add 40 superstores this year, 60 next year and 75 the following year. Rodriguez believes that will help lift operating margins to 8% from recent levels of around 5.5% -- part of a transformation that could push the stock into the $45 range in three years.
Stock picks
With this column, I'll add Chico's, Jo-Ann and Guitar Center to my Company Focus portfolio for tracking, and we'll see how they do from here.
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