Sale Days Are Over for Retail Stocks

These days, it's been tough to keep track of Wall Street's sentiment for the retail sector. Since January, five analysts have upgraded stocks like Federated Department Stores (FD - commentary - Cramer's Take) (two as recently as last week), while another two firms simultaneously downgraded the entire sector.

What's an investor to do?

Consumer cyclicals such as retail, lodging and autos have helped pull this market out of its post-Sept. 11 plunge. Since I highlighted Federated last October at just under $33, the stock is up 30% to $43, outperforming both the Dow Jones Broadline Retailers index, which is up 19.6% in the same time frame, and the S&P 500, up 8.1%.

Federated's Price Tag Takes a Markup This retailer has seen a solid recovery since September

But the newest retail bulls are late to the game: The easy money has already been made here. I'm now siding with firms like Credit Suisse First Boston, which turned negative on the group this week. The good news is largely in these stocks, and more economically sensitive sectors like industrials will likely do better.

The Economic Backdrop

Although consumers saved the economy from total collapse after Sept. 11, their leadership role in future economic growth probably won't be as pronounced. One retail analyst says that the latest buzz is over an economic indicator that has a strong correlation to retail stock price performance: the difference between growth in consumer spending and industrial activity as measured by personal consumption expenditures (PCE) and industrial production.

When that number is very positive -- that is, the growth in PCE far surpasses the growth in industrial production -- retail stocks outperform. Right now, PCE growth is about 9 percentage points higher than industrial production, the widest difference in 19 years.

But once that spread stabilizes and starts to narrow, the environment for retail stock performance will turn negative. Investors will flock to better growth in industrial sectors, which they've already begun doing. The latest data -- better-than-expected numbers from the industrial sector and a steady 3% PCE -- suggest that the gap will close soon.

No one would care much if retail stocks were still really cheap, but they're not anymore. For example, even though Federated still trades at a price-to-earnings ratio of just 12.4, not far from its historical average of 13.5, that's a big jump from its 9.7 multiple when I highlighted the stock.

Federated's earnings growth has been nonexistent since 1999, and I don't have much faith in this year's management guidance of around $3.40 a share. After all, the company's same-store sales have been lagging behind its competitors': In the fourth quarter ended in January, Federated's same-store sales slipped 6% vs. a 2.6% industry decline. In February, its same-store sales fell 2.8%, compared with a 0.7% industry gain.

Plus, while the company's EBITDA margins -- a good measure of operating profit performance -- of about 13% are above the industry average of about 9% to 10%, they've been dropping, off their 1998 peak of 14.4%.

These trends will probably reverse as the year progresses. The Sept. 11 terrorist attacks hit Federated very hard because of its high concentration of stores in the New York metropolitan area, which make up 24% of its sales. Its two Manhattan stores alone contribute 5% of the company's sales. Any improvement, though, is largely reflected in the stock's recent sharp rise.

The Fingerhut Factor

Of course, we can't forget Fingerhut, the disastrous catalog retailer acquired by Federated in 1999. Most analysts are cheering Federated's decision to try cutting its losses by selling Fingerhut, but this blemish could mean that Federated will always sell at a lower P/E than some of its peers, like May Department Stores (MAY - commentary - Cramer's Take), which trades at a P/E of 14.5.

Federated has reportedly received a nonbinding letter of intent from Business Development Group Acquisitions to acquire Fingerhut. In the meantime, Federated says it has already accounted for the cost of winding down the catalog business, which is now being classified as a discontinued operation. One can only hope that its estimates for the cost of dumping Fingerhut are correct.

There's a lot to like about Federated: great brand-name department stores like Bloomingdale's and Macy's, strong free cash flow ($757 million last year) and the potential for earnings recovery this year (12% growth to $3.40 a share from $3.03 in 2001). In fact, at $33 a share, I loved it -- but these positives are largely in the stock now. It could trade up to the high $40s, but another earnings miss or more problems at Fingerhut could just as easily send it back down to the $30s.

In fact, good news on the overall retail front is already reflected in many of the sector's stocks. CSFB's analysis, for example, shows that the P/E ratios of seven major department store retailers have expanded an average of 68% since the beginning of 2001. Right now may be a good time to take profits from that outperformance as the group enters its seasonally weakest time of year.

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Odette Galli writes regularly for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to Odette Galli.