Sector Spotlight: Retailers Encounter the Mall of Worry

Parents may be greeting back-to-school season with a sigh of relief, but investors in retail stocks are biting their nails, hoping sales will pick up after a nasty second quarter.

Spring and summer weren't particularly kind to retailers: A late Easter, weird weather swings, a consumer made reluctant by the seesawing stock market and higher interest rates combined to produce several months of disappointing sales. July sales released last week showed heavy markdowns at most stores to clear all that unsold stuff from the shelves. In theory, that means the decks are clear for fall merchandise; let the rebound begin!

Not so fast.

While there are some signs that the first of the fall merchandise is selling well, there are still plenty of concerns. For one, it's not clear to what extent higher interest rates and gas prices have cut into consumers' willingness to drop a wad at the mall. And with plenty of clothes in their closets from the last 112 months of economic expansion, people are picky. They're holding out for what analysts call "compelling fashion," i.e., something they simply can't live without. They're perfectly willing to turn up their noses at looks they don't like, as the summer's malaise has demonstrated.

"Is the consumer slowing, or is the fashion too extreme?" wonders one hedge fund manager who holds both long and short positions in retail stocks.

High Hopes

While the bulk of fall merchandise has yet to reach the stores, some retailers' results are providing early reads. On the plus side, there are Abercrombie & Fitch (ANF) and AnnTaylor (ANN).

Prepping Abercrombie in 2000

Abercrombie, which was white hot among teens and college students until it stumbled earlier this year, has shown some signs that it's getting its fashion act together. As TheStreet.com reported in a previous story, some investors think its preppier fall look and lower prices may help it rebound. And while July sales at stores -- that have been open for at least a year -- fell 2%, that was better than analysts had expected, helped by strong sales of new fall duds. Abercrombie said its second-quarter earnings, due out Aug. 8, will exceed the company's previous estimates of 16 cents to 18 cents a share. Its shares rose 19% to close at 19 on Thursday, their high since Feb. 15.

Taylor Made AnnTaylor in 2000

AnnTaylor, meantime, said July sales rose 1.6%. It, too, said second-quarter earnings should be higher than analysts had anticipated. And its shares rallied too, rising 14%. The company said transitional and fall goods were getting a good response so far. "They have it nailed down that the consumer spends 13 1/2 minutes in the dressing room," says Jennifer Black, an analyst with First Security Van Kasper, who thinks Ann still has huge appeal for working women. (She rates AnnTaylor shares a strong buy, and her firm hasn't done recent underwriting for the company.) With all the fashion bibles proclaiming the return of the suit for fall (the inevitable Casual Friday backlash), Ann seems set to profit -- as should Talbots (TLB), which also raised earnings guidance on Thursday.

Consolidating at Lower Levels

More Trouble Gap this year

On the down side, there's specialty store bellwether Gap (GPS), which warned that its second-quarter earnings won't meet the Street's already lowered expectations due to problems at the once-rosy Old Navy unit. While the Gap stores themselves did well during July, Lazard Freres analyst Todd Slater isn't so sure the fall lineup will maintain that momentum. "My issue with their leather is that it's $300 for a jacket and $200 for pants," he says. And the bright, more fashion-forward colors "may not be appropriate for the mass consumer," he says. (Slater rates Gap shares a hold and his firm hasn't done recent underwriting for the company.)

Limping Nordstrom this year

And most department and some general merchandise stores are still ailing: Kmart (KM) is closing stores. Meantime, Nordstrom(JWN), which is shifting its merchandise mix in an attempt to make itself more modern, is still suffering growing pains: It said late last month that second-quarter earnings would likely fall short of the First Call consensus of 55 cents a share. Nordstrom said sales during the first week of its anniversary sale -- which features fall merchandise -- were "below planned levels." That is likely a company-specific issue more than a mallwide disdain for fall goods, but that view still didn't ease retail investors' fears.

While one hedge fund manager likes the prospects of some companies like AnnTaylor, he doesn't think the retail sector is out of the woods yet. It's difficult to extrapolate broad consumer demand from the results from individual companies, he says. And as for some of the optimism about the fall? "Forecasting demand is tricky," he says. The Fed, the markets and the effect of the election; all that is still in the future.

As long as consumers look like they might be picky with their back-to-school shopping, investors will likely do the same with retail stocks.

>To order reprints of this article, click here: Reprints