Five Retail Stocks to Watch in 2010

NEW YORK ( TheStreet) -- Individual stock selection will become increasingly important in the retail sector in 2010.

Consumer spending is only expected to improve marginally next year, with Citigroup forecasting a meager 2% increase on the whole. "Without a robust consumer-spending recovery to boost sales universally across all retailers, individual stock selection will become more critical," Citi analyst Kimberly Greenberger wrote in a note.

In truth, retail stocks had an incredible run in 2009 despite lackluster fundamentals, Needham analyst Christine Chen said. The S&P Retail Index is up 40% for the year-to-date period to close on Friday at 407.05. In comparison, The Dow is up just 12.5%, while The S&P 500 has grown 18.3% during the same period.

So what can we expect for retail stocks in 2010 after this arguably unjustified rally?

"We believe valuations heading into 2010 are still reasonable, given that earnings estimates have likely bottomed and will continue to trickle upwards in the next few quarters as the economy continues to stabilize," Chen wrote in a note. "We believe there is room for upward-estimate revisions in 2010, resulting in both further multiples and stock price appreciation for those retailers with the right product to drive top-line growth."

Thus, according to Greenberger, investors should focus on retailers with: strong management teams and brands; sustainable sales growth via new stores or comparable sales expansion; high-income core customers; structural changes that will generate higher margins; and earnings growth driving incremental margin leverage given 2009 cost cuts.

And while luxury retailers were the last to go into the recession, analysts agree that stores that cater to the upper middle-income consumer are best positioned for 2010.

"These shoppers have both the ability and willingness to spend," UBS analyst Roxanne Meyer said. "Last year they still had the funds to spend, but turned off the willingness due to fear. Now there is a pent-up demand for self purchases."

Retailers that have a substantial international presence are also smarter bets for investors who are weary of a U.S. economic recovery. In addition, investors should avoid companies that are overexposed to traditional malls.

Ultimately, while in 2009 the predominant focus was on profits, 2010 will be a top-line story for retail. " Next year will be less about margin recovery," said Matt Arnolds, analyst at Edward Jones. "Retailers will be more reliant on consumer spending, as they have already pulled out all the tricks when it comes to cost cutting and inventory control."

Urban Outfitters

For many retail analysts, Urban Outfitters ( URBN) ranks as a favorite stock pick for 2010. One of the few growth stories left in the sector, Urban Outfitters has fared better than many of its rivals throughout the recession.

Indeed, with unique, differentiated fashion, Urban has been able to sell merchandise without resorting to drastic markdowns like competitors. And even while remaining true to its full-price model, the specialty retailer saw its same-store sales improve throughout the year and turn positive in the fourth quarter.

Meyer, for one, predicts Urban can return to its long-term 20% operating margin goal, which she believes is currently underappreciated in the stock. Fast lead times and increased speed to market should also help Urban reduce fashion risks and allow management to quickly replenish its fast-selling merchandise. Urban Outfitters' focus on the high-end consumer with a household income of $100,000 also makes it a good play on the return of the luxury shopper.

And, again, those investors looking for growth in 2010 won't need to look much further than Urban Outfitters. According to Citigroup, Urban's future store growth potential is 59%, compared with a sector average of 23%. The company currently has five concepts in its portfolio -- Urban Outfitters, Anthropologie, Free People, Leifsdottir and Terrain -- and is expected to announce new concepts next year.

"We believe the recovery of the financial and housing markets will improve the well-being of Urban's core customer and drive sales," Meyer wrote in a note. "In our view, Urban's high-end customer is more discriminating and expects more value for money spent with product that is authentic, scarce, fresh, differentiated, as this customer does not necessarily equate value with lowest price."

Tiffany

Tiffany's ( TIF) strong ties to the performance of the stock market and deep exposure in New York are positives for the luxury jeweler.

And, indeed, as the financial sector rebounds, Tiffany is seeing an uptick in sales. In November, Tiffany raised its full-year outlook, announcing that sales were trending better-than-expected during the month. Factor in that the New York market comprises about 30% to 35% of the company's total U.S. sales and, since Greenberg expects sales in this region to improve as the financial sector rebounds, that's a plus for Tiffany.

"The jewelry market is retrenching, which has allowed Tiffany to pick up market share," Arnold said. In fact, some 5% of the $60 billion U.S. jewelry market is up for grabs, as rivals closed stores and several filed for bankruptcy in 2009.

Like Urban Outfitters, Tiffany is still a growth story. Citi calculates future store growth potential for the company at 44% versus the sector average of 23%.

It also has a strong international presence, with significant strength in Asia and Europe. Tiffany expects to triple the number of stores it has in China over the next five years, and plans to open more locations in airports.

Target

Target ( TGT) stands out as a play on both sides: discretionary and discount. Two-thirds of its business is comprised of low-priced discretionary and fashion merchandise, which is becoming more relevant to the consumer as the economy improves, Arnold said.

Citi analyst Deborah Weinswig has an optimistic outlook for both earnings and same-store sales for Target next year, predicting comparable sales will grow 1.7%, compared with the 3.1% decline predicted for 2009.

"We expect 2010 to be a year in which the U.S. consumer is still tightly controlling their wallet, but is increasingly more adept at shifting spending around to include more discretionary purchases," UBS wrote in a note. "This offers a boost to top-line for discounters, as portions of its discretionary merchandise mix could see better volumes in 2010."

Target should also see a big boost from the rollout of its P-Fresh store format. Like rival Wal-Mart Stores ( WMT), Target has been ramping up its selection of food and consumables, which is driving traffic to other discretionary departments within the stores.

The possible sale of Target's credit-card receivable portfolio would also give a boost to the stock.

"We believe Target would be willing to sell its credit-card receivables portfolio if it could find a buyer that would agree to assume the economic and accounting risks of the portfolio and maintain the key operational features of the business," Weinswig wrote in a note. "While the current credit environment has kept potential buyers away, improving credit trends and strong underlying portfolio could generate outside interest in the portfolio in 2010."

Even if Target doesn't shed the business, pressures from its credit-card unit should subside, given its implementation of two rounds of changes in terms and pricing on its credit card portfolio, according to Fitch Ratings.

CVS Caremark

As CVS Caremark ( CVS) patches up its pharmacy-benefits management unit, the drugstore is poised to become the turnaround stock pick of the sector.

While the company announced last month that it lost $2 billion in PBM contracts for 2010, it recently snagged a new $1 billion contract with the Texas Teacher Retirement System. This week the company also named Per Lofberg, co-founder of Generation Health, a genetic benefit management company, as the new president of its PBM business.

Top-line growth at drugstores is expected to remain steady or improve modestly in 2010, with overall industry prescription sales growth at around 2% annually, offset by weakness in front-end sales, according to Fitch.

Meanwhile, CVS continues to report solid retail sales, despite the economy, as same-store sales grew 5.7% in its third quarter. In comparison, Rite Aid ( RAD) posted a 0.5% decline in the third quarter. Walgreen ( WAG) was up 4.9%, but said this momentum was not carrying over into the holiday season, with December sales weak.

"The industry has favorable tailwinds with the impact of flu season likely to remain through March 2010 and with approaching robust generic drug pipeline beginning in 2010 and peaking in 2012, we feel investors should position themselves accordingly," UBS wrote in a note.

Still, growth at CVS through acquisitions remains limited. CVS (including its PBM unit), Walgreen ( WAG) and Rite Aid ( RAD) comprise about 46% of the revenue in the industry.

"Therefore, share gains will depend on generating above-average organic growth, store closings or share losses by weaker independents and regional chains, and small market fill-in acquisitions and prescription file buys," Fitch wrote in a note.

Macy's

Macy's ( M) is a turnaround bet for 2010.

The department store is expected to see a benefit from its My Macy's localization initiative on both sales and margins in spring 2010. The program's goal is to tailor merchandise to local markets by grouping stores into districts made up of 10 to 12 stores each -- and the company said some of its best-performing districts in the third quarter were those in the original test pilot program.

Weinswig also expects Macy's to receive a boost from product-cost deflation and the growth of private-label brands.

On the whole, department store sales are forecast to decline between 3% and 4% next year, according to Fitch Ratings. But well-capitalized retailers like Macy's, along with Kohl's ( KSS) and J.C. Penney ( JCP), will "consolidate share and post same-store sales in the plus 1% to minus 2% range, given investment in stores even during the economic downturn, improved assortments via exclusive and private brands and continued focus on providing compelling value," Fitch wrote.

"This will come," Fitch added, "at the expense of weaker operators that continue to execute poorly, have under-invested or are unable to invest appropriately in their store bases, or are compelled to close underperforming stores."

-- Reported by Jeanine Poggi in New York.

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