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May 17, 2008

Retail Industry Health

We are being told again and again by the media, by pundits, and by anyone who manages to get a sound-bite in edgewise that retail is in dire straights. Is it true?

From TheStreet.com
Coming Week: Retail in the Spotlight

"Retailers are getting whacked now because of the financial strains that are weighing on consumers," says Tim Speiss, head of the wealth-management arm of Eisner LLP in New York.

Reuters/University of Michigan Surveys of Consumers reported Friday that its preliminary index of confidence fell to 59.5 in May from 62.6 in April. That marked the lowest reading for the index since June 1980 -- the depths of the worst economic slowdown in the U.S. since the Great Depression.

The report comes as Americans continue to reel from price declines in the U.S. housing market, a spike in mortgage foreclosures and a credit crisis on Wall Street that brought the fifth-largest investment bank, Bear Stearns (BSC - Cramer's Take - Stockpickr), to the brink of bankruptcy in mid-March.

Meanwhile, soaring food and fuel costs are taking a heavy toll on consumers, and a persistent bull run in commodities markets has raised the specter of global inflation. The inflation threat, along with hopes for an economic turnaround, have led investors to expect a standstill from the Fed, which has already slashed its key short-term interest rate by 325 basis points since last summer.

I follow some selected retail businesses and they have reported fabulous earnings for the past quarter:
True Religion [TRLG]:
Record Q1 08 Net Sales of $53.4 Million, an Increase of 47.4% From $36.2 Million in Q1 07

Urban Outfitters [URBN]:
Q1 Earnings Surge 45 Percent

Buffalo Wild Wings [BWLD]:
Earnings per diluted share increase of 16% to $0.36 includes charges related to restaurant relocations of $0.02

Chipotle Mexican Grill [CMG]:
Diluted EPS for the Quarter of $0.52, 37% Higher than 1st Quarter 2007

Hansen Natural [HANS]:
First Quarter Net Sales Rise 27.9 Percent to $212.2 Million; Reported Net Income for the First Quarter Increases 42.6 Percent to $28.8 Million

What gives?

As individual investors we should not lump retail into an index, into an average. Our job is to find the individual companies and the individual stocks (not the same thing) that are going to be doing well through thick and thin. The best advice in this area probably comes from Peter Lynch: find what is trendy and find concepts that can be replicated in market after market.

When an economy is booming, most retailers do OK but when the economy goes south, buyers have to adjust their spending habits. If you were to believe the indices, you would assume that everything gets cut back proportionally but that is not true by any means. This kind of spending is called "discretionary" for good reason -- buyers use their discretion about what to cut back and what not to cut back. It is really interesting to watch affluent people on a shopping spree. Suppose they want to give their loved one a sound system, they are as likely to buy Bang & Olufsen as a cheaper brand. But when it comes to buying daily necessities they will go to a Costco warehouse to get the bargain of the day instead of shopping at higher cost stores.

When you think about it, it makes perfect sense, why spend more for the same brand of toilette paper or the same brand of rice? But just because there is a recession, why buy low quality durable goods or why go to lower quality restaurants? People in the lower economic strata might not have this liberty simply because they don't have the liquidity to buy the large amounts that you have to buy at Costco so they are forced to buy the same products at retail and in relatively more expensive packaging. Lower economic strata people get hit hard by a recession but for more affluent people a recession is more of an inconvenience than a problem.

Based on the above, it makes sense that low cost merchandisers like Wal-Mart, Target and Costco do fine in a recession and it also makes sense that higher quality and iconic retailers do well as well. The brunt of the recession will be borne by the "me too" type products and the "me too" type establishments that don't have a loyal clientele. Here is where brand name plays such an important role.

In retail the two important issues are:

1.- The public must like the brand or the concept
2.- The brand or the concept must be able to grow into new markets

This means looking for businesses that have been around long enough that proof of concept has been firmly established yet are not so old that then already blanket all available markets. The five businesses listed above meet these criteria. In the past I bought Jamba which broke rule number 1 and I also bought Chico's FAS which broke rule number 2. In hindsight both were bad decisions.

Criteria number 2 keeps me out of Wal-Mart, The GAP, Starbucks, and many other highly successful chains. Those were buys in a bygone era, when they still had room to grow.

Denny Schlesinger

At TheStreet.com
Coming Week: Retail in the Spotlight

At The Motley Fool discussion boards
True Religion [TRLG]
Urban Outfitters [URBN]
Buffalo Wild Wings [BWLD]
Chipotle Mexican Grill [CMG]
Hansen Natural [HANS]

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