Consumer Still a Soft Touch

Updated from 2:24 a.m.

Because consumer spending never truly retrenched during the economic downturn, it would be logical to assume there is little pent-up demand to help drive a recovery. But upside earnings surprises from three retail stocks seem to tell a different story.

Footwear manufacturer

Skechers

(SKX) - Get Report

,

Jones Apparel

(JNY)

and video-chain store

Hollywood Entertainment

(HLYW)

all raised their earnings estimates Wednesday, citing better sales momentum and cost controls.

Shares of Skechers soared 20% to $22.71, while Jones rose 3% to $35.21 and Hollywood Entertainment added 5% to $17.90.

Meanwhile, Prudential analyst Stacy Pak raised her first-quarter earnings estimates on

AnnTaylor

(ANN)

, saying same-store sales for March should be above plan. AnnTaylor rose 1% to $40.48.

All this news correlates with a report from Instinet Research Redbook on Tuesday, which showed that March retail sales rose 5% from the same period a year ago, although they fell 1.1% from the previous month because of winter storms and unseasonably cool weather.

Wealth Effect

One reason for the overall strength in retail earnings, according to some economists, is that tax incentives continue to be felt by consumers and are boosting disposable income.

"The impetus from statutory tax rate cuts, sizable tax refunds and lower nonwithheld taxes is adding to consumer discretionary spending power," noted Morgan Stanley analyst Richard Berner in a research note. "About half of that benefit will persist throughout 2002."

In addition, net worth has begun to grow again because of modest gains in equity and home prices, and the employment picture continues to brighten. Indeed, improving job prospects were the single most important factor lifting consumer confidence in March.

"The loss of 1.5 million jobs crushed wage and salary income over the past year; even a moderate recovery in payrolls will refuel consumer spending power," Berner said.

James Glassman, an economist at J.P. Morgan, said consumer spending has proven to be much more resilient coming out of the downturn than most pundits had expected.

"Everything we look at points to a 3.5% gain in consumer spending" in the first quarter, he said. "That's even more impressive when you consider that it's coming on the heels of

a 6%

jump in the fourth quarter."

Economists had predicted that spending would retreat sharply in the first quarter because 0% financing incentives for autos would no longer be available. "We're not pulling back as much as we'd thought," Glassman added.

Double Dipping

Of course, some economists note that spending could slow over the next few quarters as energy prices and interest rates begin to rise. An expected increase in mortgage rates would reduce refinancing activity, which has helped boost spending over the last two quarters. Investors must also acclimatize to more modest equity returns, economists say.

For those reasons, and others, analysts remain cautious on the retail group.

Wal-Mart

(WMT) - Get Report

, in particular, saw its rating get cut after it said last week that same-store sales were below plan. Still, the retailing behemoth expects to meet sales estimates for March and projects that first-quarter same-store sales will come in at the high end of its range.

One of the big concerns among analysts is the group's stellar performance recently, which they believe may be running out of steam. Merrill Lynch analyst Daniel Barry said the sector has just experienced -- and finished -- one of the strongest relative bull markets in recent times.

The retail index has outperformed the market by 46% in the last five months, he said earlier this week, adding that he sees little room for further multiple expansion.

Retail stocks typically do well in the first year of an economic recovery but analysts believe that since many of these stocks started to outperform in advance of the recession, gains will be more muted this year than in the past.

Dennis Van Zelfden, who follows apparel stocks for Sun Trust Robinson Humphrey, agrees that the easy money has been made. His group has doubled since October, going from a multiple of 10 to 19. Still, he noted that valuations aren't "exorbitant" and he believes there may be room for further upside.

Indeed, some sectors are likely to do better than others. Small cap stocks or companies that are in the midst of a turnaround like Ann Taylor or

Gap

(GPS) - Get Report

will still attract attention, according to some analysts, but some of the larger cap names, particularly discounters, may have had their day in the sun.

The discount sector has performed very well in recent months as consumers remained sensitive to price, but UBS Warburg analyst Linda Kristiansen recently turned more cautious on the group, despite a favorable sales outlook.

Kristiansen said the relative stock price performance of discounters is "likely to ease sooner than the more depressed department store sector," noting that earnings of the discounters will begin to underperform in the third quarter while department stores will do so in the fourth quarter.

"We expect that retail stocks as a group are more likely to perform in line with the market over the next few months," she said.