FOOD AND BEVERAGE STORES
The Retail Sector comprises business engaged in Grocery Stores
retailing merchandise, generally without Specialty Food Stores
transformation, and rendering services related to Beer, Wine, and Liquor Stores
the sale of merchandise. Retailing is the final step
in the distribution of goods to consumers. In General Merchandise Stores
addition to retailing merchandise, some types of Department Stores
retailers engage in the provision of after-sales Other General Merchandise Stores
services, such as repair and installation.
Miscellaneous Retail Stores
MAJOR THEMES Office Supplies, Stationery, and Gift Stores
Used Merchandise Stores
CYCLICAL (CYCLE: GLOBAL ECONOMIC RECOVERY) Other Miscellaneous Store Retailers
Health and Personal Care Stores
A number of analysts have revised GDP growth
for 2011 upward near 3.5% from 2.8% since the Sporting Goods, Hobby, Book and Music Stores
announcement of the new Obama-GOP tax deal Sporting Goods and Musical Instrument Stores
which, in addition to extending the Bush tax cuts Book, Periodical, and Music Stores
for all income brackets, will allow businesses to
Furniture and Home Furnishing Stores
expense 100% of the cost of assets put in use in
2011. The sluggish growth in mid-2010 that Home Furnishings Stores
followed the 5% annualized growth rate in Electronics and Appliance Stores
FY09Q4 and 3.7% annualized growth rate in
FY10Q1 had elevated concerns of a double dip, MOTOR VEHICLES AND RELATED
though that seems less likely now with the tax Automobile Dealers
deal in place. Other Motor Vehicle Dealers
Auto Parts, Accessories, and Tire Stores
That deal, announced in early December, extends Gasoline Stations
unemployment benefits, cuts payroll taxes and
BUILDING MATERIAL, EQUIPMENT AND SUPPLIES DEALERS
adds some inducements for companies to buy
Building Material and Supplies Dealers
new equipment, reinforcing growth fueled by Lawn and Garden Equipment and Supplies Stores
consumer spending and business investment. As
they strive for efficiency and cutting costs, CLOTHING ACCESSORIES STORES
companies are increasing their purchases of Clothing Stores
equipment—up 16.8% on an annualized basis in Shoe Stores
Jewelry, Luggage, and Leather Goods Stores
the third quarter. Expenditures on new plants or
other facilities, however, declined 5.7% (annualized) last quarter. Meanwhile, consumer spending rose
at a 2.8% yearly pace, the highest since the end of 2006. Consumer spending is estimated to increase at
a modest rate of about 2.5% next year, which implies positive earnings for retailers across the spectrum.
But despite the tax deal, growth expectations, and a strong holiday season for retailers, the realities of
high unemployment and a still shaky housing market may continue to limit consumers’ ability and desire
to buy in early 2011. Higher commodities and materials input prices may also bump up prices of some
goods, further dampening demand. It seems reasonable for the sector as a whole to exhibit moderate
growth in 2011, near 3%, but lower than 2010’s 3.5% growth rate.
CREDIT MARKETS AND INTEREST RATES
The Federal Reserve is expected to keep its benchmark short-term interest rate near zero through 2011.
With inflation at a low of around 1% and unemployment high at 9.8%, the central bank's greatest
concern is warding off deflation and a recurrence of recession.
The goal of the Fed’s recent bond buying program, QE2, is to pump more dollars into the credit markets,
giving the economy more time to strengthen via downward pressure on short-term rates. If short-term
rates fall, that could induce consumer spending. Interestingly, the Fed’s second round of buying bonds
point has coincided with a general rise in long-term interests. The 10-year Treasury’s yield has risen a
half percentage point to 3.3% in just the past month, although changes in long-term rates are less
indicative of changes in consumer spending.
By early next year, the FOMC will develop an "exit strategy" to reduce its Treasury holdings. That will be
a form of gradual credit tightening, though the current prime rate of 3.25% can probably be expected
The Consumer Price Index (CPI) rose just 0.1% in November, leaving inflation over the past 12 months at
1.1%. By year-end, the 12-month inflation rate is expected to end up near 1.3%, a modest, unsubstantial
Core inflation, which strips out energy and food prices, will rise even more slowly. The core CPI
increased 0.1% in November and just 0.8% over the past 12 months.
But the economy is gradually absorbing the sum of the excess resources. The number of jobs in the
private sector, for example, is increasing, albeit slowly, suggesting that inflation will increase mildly in
the coming year and reinforces the unlikelihood of a deflationary spiral. As employment rises, we should
expect consumers to spend more, especially if confidence improves among consumers about the
general economic outlook.
Growth in employment rates is particularly important for retail sales. High unemployment over the past
two years has dampened consumers’ abilities to spend. The tax package working its way through
Congress is sure to boost employment along with adding to GDP growth. Although productivity gains
continue, it will be difficult for business to squeeze margins further, so employers will find it harder to
delay hiring workers as economic conditions improve.
About 8.5 million jobs were lost in 2008 and 2009. Since the recovery began in June 2009, when GDP
turned upward, only about 1 million jobs have been restored. Gains in employment have lagged—the
economy lost an additional 1 million jobs in the first six months of the recovery. Moreover, economic
growth, at 2.5% in the third quarter, is barely enough to meet job growth from newcomers to the labor
force. Greater growth is needed, and that might be in the works. Optimistic estimates have the current
9.8% unemployment rate falling below 9% over the course of 2011, and that seems more realistic given
the tax agreement. GDP growth will need to continue at 3.5% or more in 2012 to bring the rate
Confidence among U.S. consumers unexpectedly fell in December, restrained by concern that jobs will
remain scarce in 2011.
The Conference Board’s confidence index unexpectedly fell to 52.5, lower than the most pessimistic
forecast of economists. Another report showed home values dropped more than economists projected.
The loss of confidence is at odds with a report from the University of Michigan that showed sentiment
improved to a six- month high in December, and with data showing holiday spending posted the biggest
gain in five years. Federal Reserve policy makers this month said “depressed” housing and high
unemployment remained constraints on consumer spending, supporting their plans to expand record
monetary stimulus. Consumers remain very cautious and very nervous about where the labor market is
headed.” The median forecast for confidence, based on a survey of 61 economists, projected confidence
would increase to 56.3. The Conference Board revised the November figure to 54.3 from a previous
estimate of 54.1. Projections ranged from 53 to 60.
Meanwhile, the S&P/Case-Shiller index of property values fell 0.8 percent in October from the same
month in 2009. The decrease exceeded the 0.2 percent drop projected by the median forecast of
economists surveyed. Property values are generally a contributing factor in households’ consumption
Despite the Conference Board’s data, 2010 holiday retail sales jumped 5.5 percent for the best
performance since 2005, compared with a 4.1 percent gain during the 2009 holiday season.
ONLINE SHOPPING AND HOLIDAYS
U.S. consumers spent 5.5% more in the 2010 holiday season than they did a year earlier, bumping up
apparel sales as well as high-end jewelry and luxury goods. Online sales were strong, up more than 15%
for the period.
Perhaps the most exciting retail trend developing this holiday season is online and mobile shopping.
Retail outlets have rushed to offer mobile sales platforms.
Consumers, for their part, are increasingly using mobile devices as part of their shopping activities.
While 38.5% of consumers stated they don’t have a smartphone, over a quarter of consumers said they
definitely planned to use their smartphone to research or make holiday purchases, according to the
National Retail Federation.
NYC COTTON CV1
Rising cotton prices will impose significant costs on the retail sector—especially apparel stores and
department stores (ARO, AEO, ANF, M, JNF)—going into 2011. The question remains as to whether or
not that cost will be suffered by suppliers, retail outlets, or consumers. Given factors limiting consumers’
income such as high unemployment and lower home values, it is unlikely that retailers will be able to
pass those costs onto consumers and it is reasonable to expect lower operating margins next year. This
trend is critical and suggests that we should be cautious regarding investments in apparel-centric
companies until cotton prices stabilize.
RETAIL VS. THE MARKET
S&P RETAIL (^RLX) VS. S&P 500 (^GSPC)
------- = S&P Retail Index (^RLX)
------- = S&P 500 (^GSPC)
After two years of the retail sector posting underwhelming end-of-year gains relative to the market (in
2007 and 2008) and last year’s sluggish rates, retail sales accelerated dramatically at the end of 2010. It
remains uncertain whether or not those gains will carry over into 2011. Sustained improvement in retail
sales will primarily depend on improvement in the labor market. Retail sales in November were up 6.8
percent compared with the same month last year, with apparel stores leading the sector. Although
retailers typically do well during the holidays, the extent to which U.S. consumers hit the stores relative
to prior seasons may hint at consumers expectations of rising income in the future.
S&P RETAIL (^RLX) VS. EURO/USD EXCHANGE RATE (EURO/USD = X)
------- = S&P Retail Index (^RLX)
------- = EURO/USD
EURO/USD ForEx market developments appear to have had negligible impact on retail sales. The fall in U.S. retail
stocks during 2008 coincided with a modest depreciation of the dollar, contrary to expectations, though the
trend corrected itself throughout 2009 with U.S. retail sales touching a three-year high at the worst of the Greek
sovereign debt crisis in early 2010. In the second half of 2010, U.S. retail stocks resurged amidst relative ForEx
volatility surrounding QE2 and concerns about Irish banks. The retail fervor of the 2010 holiday season was, in
some part, due to cross-border online sales between European consumers and U.S. high-end retailers for luxury
goods, with companies like Tiffany & Co. (TIF) showing remarkable strength. U.S. retail stocks may have been
assisted by moderate appreciation in the Yuan in the second half of 2010, although the trend can only account
for a fraction of U.S. cross-border retail sales.
S&P RETAIL (^RLX) VS. CBOE INTEREST RATE 10-YEAR TREASURY NOTE (^TNX)
------- = S&P Retail Index (^RLX)
------- = 10-Year Treasury (^TNX)
The rise in both U.S. retail stocks at interest-based T-note indices over the past quarter illustrates how investors
have reentered equities markets after a disheartening mid-2010. QE2 could hold down short-term interest
rates, but that would positively affect credit-based consumption and retail stocks through stronger earnings. In
either case—whether through stronger 2011 earnings are through the flight of investors away from safe UST
notes and back into equities—the environment for retail equities going into 2011, insofar as its relationship to
interest rates is concerned, appears favorable.
HOW TO PLAY THE SECTOR
FOOD AND BEVERAGE STORES
Overall, the adult beverage makers saw modest improvements in sales throughout 2010. The effects of the
global credit crisis seemed to undermine the belief in the inelasticity of demand for alcohol. Guest traffic at bars
and restaurants was significantly down, and this caused a shift in consumption to the lower-profit, at-home
channel. High unemployment and fragile spending caused many consumers to trade down away from premium
and super-premium spirits. However, with the economy showing signs of a rebound, distillers are seeing growth
across the board.
Spending on merchandise should favor high-end and luxury goods retailers like Tiffany (TIF) and Nieman Marcus
(NMG) above discount retailers like Wal-Mart (WMT) and Target (TGT).
Notice the difference with the last recovery, when spending initially grew faster at the discount retailers:
Real per capita spending on durable and nondurable goods is increasing, although real per capita spending on
services is still lagging. Sales at upscale retailers are bouncing back faster than in the previous recovery, while
sales at Target and Wal-Mart are expected to grow less than one percent in 2010.
MOTOR VEHICLES AND RELATED
For the automotive replacement parts industry and parts retailers the road has been much less bumpy than
most industries over the last couple of years. As consumers limited expenditures to necessary items, new car
purchased declined and dealerships suffered as expected; meanwhile, the average age of vehicles on the road
has continued to increase, as has the mileage driven. In addition, the automakers' troubles resulted in thousand
of dealership closings that has sent many drivers in need of repairs to independent garage services provided by
auto parts retailers.
These favorable trends have helped the replacement parts sector become one of the best performing
throughout the recession and in the slow recovery currently taking hold. The recent continuation of these trends
was confirmed last week by the country's largest aftermarket auto parts retailer, AutoZone (NYSE: AZO). Like its
top competitors O’Reilly Auto Parts (Nasdaq: ORLY) and Advanced Auto Parts (NYSE: AAP), AutoZone easily
topped analyst estimates in its most recent quarter. In fact, the company's first quarter was the eighth
consecutive quarter in which earnings per share grew by more than 20%, and the 17th straight quarter that saw
a greater-than-10% increase in EPS.
Another factor that has benefited the aftermarket parts sector has been the weather. Major auto parts dealers
are all acknowledging that the extreme weather of late 2010 has helped sales.
CLOTHING ACCESSORIES STORES
Based on better-than-expected 2010 holiday retail sales, specialty apparel retailers are poised for strength
heading into the first earnings season of 2011. Despite concerns about discretionary spending amid elevated
unemployment rates in the United States and economic uncertainty in a number of overseas markets, many
analysts believe that specialty apparel retailers are expecting continued sales and earnings momentum in early
There are two trends worth noting in relation to specialty apparel retailers in 2011. First, international and e-
commerce growth. A number of big names like Wal-Mart (WMT) and Sears Holdings (SHLD) have opened third-
party platforms and mature retailers with strong brand names have been expanding aggressively into Asia and
Europe, especially China. Inditex, the largest apparel company, is currently channeling more than 50% of its new
store investments into the region to capitalize on the growing middle class population. The population of
individuals earning between $15,000 and $20,000 annually in China has grown by more than 400% (22 million
people in raw numbers) over the past five years, and that number is expected to more than triple to 81 million
people by 2015.
Second, rising input costs. Over the past year, distribution expenses and commodity prices have increased
meaningfully, as manufacturing demand outpaced supply following a modest recovery in consumer spending
and as retailers restock inventory. According to the Journal of Commerce, the price of shipping a 40-foot dry
container from China to the U.S. averaged $2,200 in 2010, up 90% from $1,100 in the prior year. Additionally,
the price of cotton (which is a primary raw material for apparel manufacturing) increased approximately 30%-
50% earlier this year to $0.80-$0.90 per pound, as demand from apparel manufacturers picked up. The
supply/demand imbalance was further exacerbated by bad weather in the world's largest cotton producers,
including China, India, and Pakistan (which accounts for 30%, 20% and 8% of global production, respectively) in
recent months, which pushed cotton prices up another 70% to $1.55 per pound by November 2010. This is an
extremely dangerous trend for apparel and specialty retailers that will place downward pressure on dividends
growth and ward of investors in early 2011.
The retail sector as a whole looks poised for moderate to strong growth through the beginning of 2011,
accelerating through the rest of the year as unemployment data improve and macroeconomic conditions
stabilize in Europe. My favorite companies right now are those with broad exposure to both high-end and
discount consumers, online (and/or mobile) sales platforms, and are positively correlated with market indices as
a whole. The following table lists four companies that meet these criteria and look particularly strong heading
into early 2011, Amazon, Nordstrom, Inc., Macy’s, and Home Depot. I have intentionally avoided specialty
apparel and footwear companies because of rising input costs (from rising commodity prices) that will inevitably
pinch margins and are likely to begin affecting those companies in the first quarter of 2011.
30 Dec. 2010
Company Amazon Macy's
Ticker AMZN JWN M HD
52.36 14.05 12.11 15.56
3.49 3.02 2.27 2.24
Fair Value 182.7364 42.431 27.4897 34.8544
182.75 42.44 25.24 34.86
Status Fair Value Fair Value Undervalued Fair Value
179 44.71 29.4 36.5
Beta 1.1 1.85 1.95 0.77
Div & Yield N/A 1.90% 0.80% 2.70%
2.71 1.45 1.56 1.28
MERRILL LYNCH & CO., INC RETAIL INDEX (RTH), TOP TEN HOLDINGS (12/28/2010)
Company Symbol Industry Recommendation
Wal-Mart Stores, Inc. Discount, Variety
WMT 192.63B Buy
Common St Stores
Home Depot, Inc. (The) Home Improvement
HD 57.18B Strong Buy
Common S Stores
Catalog & Mail Order
Amazon.com, Inc. AMZN 82.30B Strong Buy
Target Corporation Discount, Variety
TGT 42.41B Neutral
Common Stock Stores
WAG Drug Stores 36.71 Sell
Lowe’s Companies, Home Improvement
LOW 34.54B Neutral
Inc. Common S Stores
Costco Wholesale Discount, Variety
COST 31.56B Buy
TJX Companies, Inc.
TJX Department Stores 17.66B Neutral
CVS Drug Stores 47.42B Strong Buy
Best Buy Co., Inc.
BBY Electronics Stores 13.62B Strong Sell
KEY STATISTICS BY SELECTED INDUSTRY
As of 28 December 2010
Market Net Profit Total Dividend
P/E P/B P/FCF ROE
Industry Cap Margin Debt/Equity Yield
Grocery Stores 1,410B NM 3.8 -1.10% 41.5 0% 69.1 1.70%
Drug Stores 85B 17.8 7.6 2.40% 25.5 9% 25.2 1.40%
4377B 24.7 -7.7 15.30% 38 17% 55 0.90%
263B 18.8 12.2 11.70% 46.2 23% 44.7 2.50%
Wineries & 168B 11.8 -8.2 14.20% 25.6 27% 206.6 3.60%
349B 16.8 2.6 2.70% -27.5 11% 86.1 1.30%
Office Supplies 1B 15.3 -6 2.20% -22.9 17.40% 28.4 2.10%
Personal Care 3,001B 15.9 11.3 12.90% 184.2 24.30% 29.5 2.90%
2B 32.6 1.9 2.20% 26.3 5.30% 79.7 1.60%
Music & Video
9B 59 19.9 3.70% 1159.7 27.00% 122.2 0.00%
18B 20.6 2.8 5.60% 54.6 13.60% 3 1.20%
Appliances 13B 17.1 23.1 2.70% -66.9 9.80% 74.7 1.60%
Electronics Stores 20B 12.3 4.4 3.10% -40.3 19.00% 28.6 1.70%
22B 20.7 5.4 1.60% 43.9 8.90% 172.6 0.50%
14B 57.4 3.5 2.00% 12.1 5.40% 219.9 1.20%
Accessories, and 763B 26.5 5.3 2.70% 36.6 10.40% 125.9 1.20%
Materials 1B 25 7.9 1.20% -208.2 5.80% 205.4 0.00%
Apparel Stores 121B 15.5 3.5 5.40% 532.6 17.70% 566.2 2%
Jewelry Stores 163B 25 2.2 4% -50 8.70% 41.1 1.00%
Specialty Retail 349B 21.6 8.6 3.00% 149.4 12.90% 78.4 1.80%
362B 14.2 3.6 3.50% 130.7 21.10% 82.8 2.00%