By now, earnings season has wound down for the second quarter of 2009. As always, there were positive surprises, disappointments and investor reactions of both the anticipated and counterintuitive variety.

Going into the season, uncertainty was greatest for the retail sector. As retailers reported their earnings, it became increasingly apparent that the industry was experiencing a wide dispersion of results, ranging from failure to success.

In this week's installment of The Finance Professor, I am going to take a more detailed look at some of the critical factors that determined success or failure in the retail industry and point out a few examples of good, bad and ugly quarterly earnings. I've divided my analysis into three sections, representing the three factors most responsible for separating the winners from the losers in the retail industry this past quarter. Following that, I go into a specific example, using

Home Depot

(HD) - Get Report

and

Lowe's

(LOW) - Get Report

.

Inventories

Capacity utilization, the ratio of actual output to the installed base of potential output, has decreased tremendously. Whether with automobiles, clothing, washing machines, furniture or even some prepared foods, there has been a common trend in this recession: inventory reduction. We are making and buying fewer things than we used to. Lower demand has been met with decreased supply. The challenge for retailers was to shrink inventories in order to monetize their balance sheets while still having product to sell to customers.

Just several months ago, retailers' shelves and showrooms were flush with inventory. Now you can walk into a

Wal-Mart

(WMT) - Get Report

or a

Sears

(SHLD)

or a

Best Buy

(BBY) - Get Report

and find empty spaces on shelves. Simply put, retailers were content to sell off merchandise and were in no rush to replenish their inventories. If a retailer was caught with too much inventory and had to mark down products to empty the shelves, then these actions adversely impacted gross margins and earnings.

Abercrombie & Fitch

(ANF) - Get Report

was one such example of a retailer who got it all wrong. Once a darling of teen and tween shoppers, Abercrombie has lately experienced declining sales and an earnings spiral. Gross margins fell 360 basis points, and same-store sales fell 30%. Abercrombie's performance was just plain ugly.

On the other hand,

Gap

(GPS) - Get Report

controlled its inventory and improved productivity. In the process, it yielded higher margins and better-than-expected results. And outside of retail, the homebuilders have dramatically cut back on the inventory of unsold homes and are finally beginning to turn the corner on the home-sales drought of the past well over two years.

Merchandising and Selection

Controlling inventory is defensive. Having the right inventory is smart merchandising.

Denim

, for example, was out of favor for several years before making its comeback. Despite trafficking in high-priced products,

True Religion Apparel

(TRLG)

has done quite well the last few quarters. The more moderately priced

American Eagle Outfitters

(AEO) - Get Report

had a challenging quarter but was spared from disaster as a result of getting denim merchandising right.

Remember the hubbub about hybrid cars a year or so ago when crude oil was around $150 a barrel? There were waiting lists for the

Toyota

(TM) - Get Report

Prius hybrid, and you had to pay a premium price to buy one. The price of crude oil has since declined dramatically, and the demand for hybrid cars fell with it. And with drivers shunning new cars with hybrid and conventional engines alike, demand for used cars has soared. New-car dealers ordered fewer new cars, and selling used cars has turned out to be more profitable. It took the Cash for Clunkers program to reverse that phenomenon.

Curbing Expansion/Managing Contraction

Since 2003, retail and restaurant companies were expanding rapidly within the U.S. As more houses were built, more strip and shopping malls sprang up. These malls were filled with retailers and eateries. Furthermore, retailers catering to home renovation repair and remodeling

Simply put, we were saturated with retailers in this country. The economy was not big enough for Best Buy

and

Circuit City

, or

Bed Bath and Beyond

(BBBY) - Get Report

and

Linens 'n' Things

, or

Dick's Sporting Goods

(DKS) - Get Report

and

some small regional competitors.

In restaurants,

McDonald's

(MCD) - Get Report

and

Yum! Brands

(YUM) - Get Report

focused on overseas expansion.

Ruby Tuesday

(RT)

managed its way back from trouble by eliminating expensive leases and underperforming units over the course of the recession. Home improvement retailer Lowe's the home improvement retailer continued to expand in an already saturated market, while Home Depot focused on building up its distribution network rather than its installed store base.

Lowe's vs. Home Depot

I just mentioned how Lowe's and Home Depot took different approaches to managing the recession. Home Depot appears to have succeeded, while Lowe's is stumbling. On

RealMoney Silver

, I compared several metrics for these two companies per their second-quarter earnings reports and conference calls.

As you can see, while both companies had some difficulties operating in the challenging environment, if you go down the list, metric by metric, Home Depot stands head and shoulders above Lowe's.

What accounts for these discrepancies? Here are three factors that come to mind:

    Home Depot is focusing on international expansion and domestic rationalization, while Lowe's is still focused on domestic expansion in a contracting home-remodeling market.

    Lowe's has always been seen as better from the perspective of appearance and its appeal to women. That also gave Lowe's the perception of being more upscale than Home Depot. In this economy, upscale just does not work. Home Depot could be a trade-down beneficiary.

    Lowe's got stuck with too much inventory. Home Depot can better manage its inventory and is investing in a better distribution network.

    At the time of publication, Rothbort was long McDonald's, Yum!, Home Depot, although positions can change at any time.

    Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele. He also is the founder and manager of the social networking educational Web site

    TheFinanceProfessor.com

    .

    Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

    Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Term Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

    For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at

    www.lakeviewasset.com

    . Scott appreciates your feedback;

    click here

    to send him an email.